China’s government has a “nuclear weapon” at its disposal if it chose to declare the VIE structure that has been used to list many Chinese companies in New York, circumventing regulations in China that these companies could not be majority foreign owned. To quote the FT:
“Variable Interest Entities are legal investment vehicles in which an investor does not have a controlling stake but, nonetheless, retains a controlling interest. They rose to prominence after Enron made liberal use of them to mask widening losses from its investors in the early 2000s.
For Chinese companies they serve a different purpose: VIEs allow them to access foreign capital which would not be available to them due to state rules on foreign ownership of certain industries and state assets.”
In theory, China would be unlikely to ever declare these entities illegal and cut them off because of the damage it would do to its credibility in international capital markets. After all, we were talking about the possibility of $2tn of equity exposure being pulled from US markets.
Yet where China has not wanted such work around structures to exist, they have precedent in shutting them down, both in individual cases such as Baosheng Steel or the entire category operations; such as "Education-related" stocks.
"Second Strike" Weapon
In my view, the better way to think about this “weapon” is, to continue the analogy is not as a first strike weapon, but as a second-strike response. The scenario would play out something like this:
U.S. regulators follow through on their on again, off again move to delist all companies from US exchanges whose auditors fail to provide access to the US Public Company Accounting Oversight Board. This includes roughly 200 Chinese companies, who claim that Chinese government regulations prevent them from complying. Regulators give companies a year to comply. This is the equivalent of “first strike”, albeit slow developing.
Chinese government officials could claim they have been forced to act in order to protect the underlying businesses within mainland China and to minimize damage to the domestic economy. Specifically, Chinese regulators could declare that all VIE structures listed in the US immediately null and void, that they had no claim over the underlying operating assets of their businesses in China. It is important to recognize that this move would have no impact on the operations of the business in China. The business would continue, customers would continue to be served – so the government’s first priority of no disruption to Chinese consumers would be met.
Who would then own this business? Technically it would be owned by the individual (usually a trusted Chinese senior executive in the business) who was given ownership of the Chinese asset pre its IPO when the value of the Chinese asset was essentially zero because all the value created passed on contractually to the NY listed entity. All of a sudden, they become owner a very valuable asset.
One option of course would be Shanghai. In many ways a great option. Domestic Chinese investors have not been able to invest directly in the stocks of these companies before now. If they relisted in Shanghai, they would increase the number of quality stocks in the market and soak up excess investment capital stuck in China. Foreign investors, if they wanted to reinvest in these stocks would be able to do so through the various cross border investment channels now in place.
What about Hong Kong? Someone smarter than me could doubtless find a way to interpret “1 country, 2 systems” to allow this to happen. A Hong Kong relisting would create the option of reinstating shareholders of the now worthless US listed shares – in full or in part.
Winner and Losers
There are a surprisingly large number of winners from this shift and losers for whom the Chinese government might have only modest levels of sympathy.
Who loses? US based investors who may hold half a trillion dollars of these Chinese stocks and a large number of Chinese billionaire entrepreneurs. Would the Chinese government be concerned about either of those groups?
Who wins? Beyond the owners of the underlying assets in China, the Shanghai and HK stock exchanges, investment banks and other professional service firms who support relisting, domestic Chinese investors who get access to these stocks and US lawyers who would probably live off filing cases related to this for decades.
For instance, take this quote from Eric Liu of Ruane, Cunnifff & Goldfarb, the firm that runs the famous Sequoia Fund, from 2018:
The VIE structure is pretty complicated; we have thought about it and our ultimate conclusion was that the Chinese government is interested in attracting capital to its capital markets and is unlikely to rock the boat there and do something unusual.
Now that it seems the Chinese government has got a taste for the unusual, we wonder if she, and others, will have a sudden and miraculous change of heart.