The Chinese Saga: The same old untold story
18 November 2022
Last Monday, after a busy weekend centered around the Communist Party’s 20th Congress Chinese stocks plummeted to earth. Heavy-tech the likes of Alibaba and Tencent dragged down the Hang Seng Index more than 6%, sparking havoc amongst investors.
The culprit? Xi Jinping and the new Politburo’s standing committee stacked with loyalists. The move cemented the current leadership and, according to many, has moved China from economic pragmatism to political ideology.
But what is really scaring the investors?
There are a series of longstanding issues with investing in China, nothing new, but problems most people are likely out of touch with. The issues reside in the ownership structure and the regulatory environment, which are far from being aligned with the best standard practices in Europe and US. Notwithstanding, investors lured by the Chinese growth and the tech aura of the biggest companies dismissed any potential risk and flocked to the Red Dragon.
There are two main issues that any investor should consider upon deciding into investing in Chinese companies. These are accounting issues and the corporate structure of Chinese companies listed outside of China.
Accounting has been a top discussion topic amongst market regulators for more than a decade. Western countries have long lamented the poor accounting standards of Chinese companies and the difficulty in assessing jobs done by local auditors in China1. This has led in the past to grotesque failures. The last of a long series has been Luckin Coffee, the “Chinese Starbucks”, which wiped out billions of dollars. The strong opposition of the Chinese government has been always justified on the basis of national security concerns arising from sharing sensible information. Over the years, the issue has been prioritized given the growing number of listed companies outside the national border and at the mercy of European and American investors.
In late 2020, US SEC put NY listed Chinese companies at risk of being delisted if they failed to comply with US audit rules. Fast forward to our days – in August – Washington and Beijing came together and agreed upon a resolution of the dispute.
Eventually, US regulator will access Chinese documents raising – hopefully – the bar on assurance services in Mainland China. A positive note for investors.
The second and more obscure problem is with the Variable Interest Entity (VIE) Structure of (almost) any Chinese listed company. The Chinese government restricts or prohibits foreign ownership in sensible industries. Needless to say, the lists includes many of the tech sectors such as e-commerce and media. Thus, the VIE structure has developed into a common practice that to circumvent the Chinese regulation, companies list in foreign markets and attract foreign investors.
But, what is a VIE structure?
The VIE structure are Cayman Islands registered shell companies that serve the double purpose of giving Chinese companies access to western capital and at the same time allowing western investors access to Chinese businesses. The process is pretty simple: the operating company in China set up a company in the Cayman Islands with its very same name which is then bound to the Chinese company through a complex set of legal agreements. The VIE structure is then ready to float in a main stock exchange – notably the NYSE – and to be acquired by foreign investors. A potential investor looking at the financial statements of the Cayman Islands is misled by a loophole in the accounting rules that makes it possible for the VIE entity to consolidate the operating entities. Investors beware. Eventually, the framework works that the Cayman Island effectively has a claim on the profit and the assets of the Chinese company given its legal agreements. But here is the trick, actually no ownership is transferred to the foreign investors.
To make a long story short, the foreign investor has simply a claim on a Cayman Island shell company that happen to have the same name of a Chinese company.
This has led in the past to some embarrassing moments on the side of western investors. In 2011, Jack Ma – founder and owner of Alibaba – transferred the entire ownership of Alipay out of the Alibaba Group without informing Yahoo – the main shareholder of the Alibaba Group – which had a stake of 40% in the business.
There is however, another point of greater concern. Basically, the VIE structure are completely illegal under Chinese law.
The Chinese government has simply turned to the other side in the last years. The segment has flourished and has become a common practice.
But investors beware, ignore information at your own risk. The structure is at the mercy of the Chinese government and any enforcement of the law could substantially upend the practice leaving the unaware investor with nothing. Occasionally, the Chinese government has enforced its control clearly showing the blatant weakness of the VIE structure.
Recently this year, the Chinese government launched a new review of the regulation regarding the filing system for all Chinese companies, VIE structures included. The draft rules directly addresses the so called “indirect overseas listing” requiring more stringent submission for new listing. Notwithstanding, the new regulation gives more clarity to the segment and relaxes some of the investors’ concern on arbitrary enforcement.
So now, what has made this possible?
A simple answer is money. Trillion of dollars of Chinese companies are now floating into foreign markets making huge fees for all the investment bankers and other players in the arena. But still, regulators have also likely done a poor job in protecting the interest of the investors. Tit-for-tat between SEC and Chinese government is not yet enough to ensure the safety of the game.
Western investors take for granted the regulatory environment in which they operate often dismissing crucial aspects. The Chinese case is a good case in point. Few, if any, know about the VIE structure at the core of foreign listing of Chinese company. Still, this is an open question which merits attention. One could simply argue that the Chinese government is not so mad to enforce unilaterally the rules of the game leaving foreign investors with nothing and jeopardizing the attractiveness of the Chinese business. Still, it is a concern that should be addressed. In the case of VIE structures, investors own nothing but a bunch of legal contracts in the Cayman Island with little protection in court.
Coupled with the accounting standards, whose reliability is far below the standards seen in the Western countries, investment in Chinese companies should be taken with a grain of salt. However, recent developments have reassured investors about positive future developments. This has been true in the case of accounting – where now external auditors will access local documents – and VIE structures – with the new draft rules providing, hopefully, more clarity.
Still an open question remains: what is in the head of Xi Jinping next?
NOTES / BIBLIOGRAPHY
1 From the Alibaba Annual Report: “…our auditor, is required under U.S. law to undergo regular inspections by the PCAOB. However, without approval from the Chinese government authorities, the PCAOB is currently unable to conduct inspections of the audit work and practices of PCAOB-registered audit firms within the PRC on a basis comparable to other non-U.S. jurisdictions. Since we have substantial operations in the PRC, our auditor and its audit work are currently not fully inspected by the PCAOB, and as such, investors of our ADSs, Shares and/or other securities do not have the benefit of such inspections…Inspections of other auditors conducted by the PCAOB outside of China have at times identified deficiencies in those auditors’ audit procedures and quality control procedures.”
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