What are some risks with investing in these structures?
Investors should carefully consider the company’s risk factor discussion in its prospectuses and annual reports when evaluating the risks of investing. In addition to the general risks of an investment in any particular industry or region, there are specific risks to be aware of when considering an investment in a U.S.-listed company with contractual relationships with a China-based VIE (variable interest entity) structure. If the parties to the contracts between the U.S.-listed company and the China-based VIE do not meet their obligations as intended or there are effects on the enforceability of these arrangements from changes in Chinese law or practice, the U.S.-listed company may lose control over the China-based company, and investments in these securities may suffer significant economic losses.
The Chinese government has never approved these structures. Many U.S.-listed companies with contractual arrangements with China-related operating companies use VIE structures to bypass Chinese restrictions on foreign investment. One significant risk of this structure is that the Chinese government has never expressly acknowledged it as a way to legally navigate the country’s investment restrictions. The Chinese government thus could determine at any time and without notice that the underlying contractual arrangements on which control of the VIE is based violate Chinese law. Any such determination from the Chinese government could result in a significant loss in the value of an investment in a U.S.-listed company that utilizes this VIE structure. In addition, China’s legal system is substantially different from the legal system in the United States. Should China’s legal system explicitly address the enforceability of contracts with these VIE structures, there may be risks and uncertainties concerning the intent, effect, and enforcement of its laws, rules, and regulations on these contracts. This lack of certainty may result in the inconsistent and unpredictable interpretation and enforcement of laws, rules, and regulations, which may change quickly.
Private Education Businesses case study. In July 2021, the Chinese government banned for-profit educational tutoring. Included in the ban are guidelines that specifically prohibit foreign investment in educational companies by way of VIE structures.
A breach of the contractual agreements between the U.S.-listed company and the China-based VIE (or its officers, directors, or Chinese equity owners) will likely be subject to Chinese law and jurisdiction. All or most of the value of an investment in these companies depends on the enforceability of the contracts between the U.S.-listed company and the China-based VIE. Any breach or dispute under these contracts will likely fall under Chinese jurisdiction and law. For example, many agreements require that disputes be handled before a Chinese arbitration body. This raises questions about whether, and how, a U.S.-listed company or its investors could seek recourse in the event of an adverse ruling as to its contractual rights.
Investments in the U.S.-listed company may be affected by conflicts of interest and duties between the legal owners of the China-based VIE and the stockholders of the U.S.-listed company. The individual equity owners of the China-based company may have conflicting interests with the U.S.-listed company’s investors. Officers and directors of these two entities may also have differing and conflicting fiduciary duties to act in the best interests of the respective companies because they are separate companies and also because of the differing laws and regulations in the jurisdictions in which the companies are organized. These conflicts of interest and diverging duties may create issues or circumstances that adversely impact the value of the investments in the U.S.-listed company.