A LONG UNTOLD STORY-How Foreign Investors Finance Big Chinese Firms Via Variable Interest Entity Structures a lesson for Africa Firms

Lots of fun activities are ongoing in the Caribbean Islands, according to different tourist websites. Fishing tournaments, music festivals, carnivals etc.

What you won’t find out from the tourist websites is the ability of emerging market companies to raise capital by selling shares to investors.

Corporations often borrow from investors, especially foreign investors, via subsidiaries in tax havens such as the Cayman Islands, Bermuda, and Ireland. These countries’ liabilities to the rest of the world vastly exceed economic activity that actually takes place locally. The capital is being used somewhere else.

The Global Allocation Capital Project research provides publicly available estimates not only of the scale of these financing operations, but also of which investors are buying these offshore assets. The estimates cover bilateral investment positions for most countries in the world and look through these offshore subsidiaries. They also provide estimates that classify the geography of investment in bonds and equities in proportion to where the issuing firms make their sales, rather than classifying firms as belonging to a single country.

The Structure of VIEs- (Variable Interest Entities)

The VIE structure consists of at least three core entities:

1. A company with legitimate operations (referred to as the VIE or OpCo);
2. A wholly foreign-owned enterprise (WFOE) established as an intermediary in China; and
3. An offshore shell company that lists on a U.S. or other foreign exchange (ListCo).

To secure a MOFCOM (Ministry of Commerce People's Republic of China) business license, ownership of the VIE must remain in Chinese hands, often with the company’s founder. The owner and VIE then establish an intermediary, the WFOE, with which they enter into a series of contractual arrangements. These contracts model control without granting direct equity ownership. Since the WFOE neither directly owns the VIE nor owns any assets that are restricted from foreign investment, it does not require a MOFCOM license and may receive foreign investment.

Next, a shell company incorporated in a management-friendly jurisdiction like the Cayman Islands or British Virgin Islands (BVI) conducts an IPO on a foreign exchange, frequently the New York Stock Exchange (NYSE) or Nasdaq. This ListCo owns the WFOE and funnels capital from foreign investors into China. Compounding the structure’s complexity, the ListCo is generally a holding company that bears the same name as the Chinese VIE, obscuring the reality that investors purchase depositary shares of a shell company with a third-tier relationship to the lucrative VIE.8 (See Figure 1 below.)

The contractual arrangements that connect the ListCo and its WFOE to the Chinese VIE and its owner play a central role in facilitating the flow of Foreign Capital into the restricted industry. The contracts imitate ownership in function and form without granting investors direct equity ownership of the Chinese VIE. The contracts generally include the following characteristics:

• A loan agreement and equity pledge agreement whereby the WFOE provides an interest-free loan to the VIE’s owner to capitalize the VIE. In exchange, the VIE serves as collateral for the loan as the owner pledges all of its assets and liabilities to the WFOE.
• A call option agreement between the VIE and WFOE that provides the latter a right to purchase the VIE at a pre-determined price, usually the amount of the loan agreement.
• The VIE’s founders give the WFOE power of attorney, granting it shareholder rights such as voting, attending shareholder meetings and submitting shareholder proposals.
• A technical services agreement designates the WFOE as the exclusive provider of services like consulting and fulfillment to the VIE. This justifies the equity pledge agreement that entitles the WFOE to the VIE’s earnings. The entities may also sign an asset licensing agreement whereby the VIE pays the WFOE royalties for assets like intellectual property licensing.

Together, these contracts theoretically provide the WFOE rights over the VIE that a traditional parent company would have over its subsidiary through ownership. Because the WFOE assumes both the Economic Costs and benefits of the VIE and the ListCo directly owns the WFOE, U.S. accounting rules may require the ListCo to consolidate the VIE on its financial statements despite the absence of equity ownership.These consolidated financial statements, along with the contractual arrangements, supply the glue that holds the VIE structure together. They enable the ListCo, a shell company with no meaningful operations of its own, to attract foreign investors who provide capital to what they might think is an emerging Chinese company.

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Disclaimer

This client briefing has been prepared for clients and professional associates of Axe Capital. The information and expressions of opinion which it contains are not intended to be a comprehensive study or to provide legal, tax or financial advice and should not be treated as a substitute for specific advice concerning individual situations.

References:

China in Tax Havens (Christopher Clayton, Antonio Coppola, Amanda Dos Santos, Matteo Maggiori and Jesse Schreger? January 2023).

Buyer Beware: Chinese Companies and The VIE Structure-Prepared by CII Research Analyst Brandon Whitehill, December 2017-Council of Institutional Investors-The Voice of Corporate Governance