The Chinese government’s crackdown on large technology firms has led to increased scrutiny of variable interest entities (VIEs). U.S.-listed Chinese companies commonly use these corporate structures. For example, Alibaba Group Holdings, Didi Global Inc., Baidu, Inc., and virtually every other Chinese internet company listed on a U.S. stock exchange, use variable interest entities. The variable interest entity structure sets up offshore shell companies to attract foreign investors.

Collectively, investors have poured tens of billions of dollars into Chinese companies via offshore shell companies. Variable interest entities often incorporate in the Cayman Islands or other offshore tax havens.

The Rise in Popularity of Variable Interest Entities

China has largely closed off its stock markets to foreign investors to prevent foreign intervention in Chinese companies. However, variable interest entities enable investors to bypass Chinese restrictions on foreign investments in domestic businesses. Foreign investors buy shares in variable interest entities, which enables them to participate in investment opportunities with China’s fast-growing companies.

More than two decades ago, observers associated the variable interest entity corporate structure with companies like Enron. But Enron fell apart amidst accounting fraud scandals. Enron used numerous shell companies to conceal significant debts that it did not report on Enron’s balance sheet. In the aftermath of the Enron scandal, accounting rules underwent modification. Today, variable interest entities must report financial results on companies’ financial statements.

Chinese companies widely use the variable interest entity corporate structure because of its unique features. Chinese companies will consolidate the financial statements of their business operations into offshore shell companies. As a result, global investors may hold shares in the offshore holding company. This enables non-Chinese investors to financially benefit from popular Chinese companies.

How Variable Interest Entities are Structured

In a variable interest entity structure, non-Chinese investors hold shares in a shell company. The shell company has an ownership stake, either directly or indirectly, in an entity in China. This entity is referred to as a wholly foreign-owned entity (WFOE). Incorporated in China, the WFOE has contracts with the variable interest entity. These contracts enable the WFOE to effectively control the variable interest entity. Because they are not parties to the contractual agreements, nor do they have input in drafting them, this structuring presents risks for non-Chinese investors.

Ivy Wong, a capital markets partner at the international law firm Baker McKenzie, succinctly describes the appeal of variable interest entities. “This structure enables foreign investors to invest and hold shares in a listed company that is incorporated overseas and carries on and owns businesses that would otherwise be subject to foreign ownership restrictions in the relevant place of operation,” she stated.

Catching Regulators’ Attention

In the summer of 2021, the Securities and Exchange Commission (SEC) stated it plans to crack down on companies using variable interest entities. The SEC wants to ensure these companies transparently disclose their risks and structures.

In a September 2021 Wall Street Journal opinion article, Gary Gensler, the chair of the SEC, expressed concerns about investors putting money into variable interest entity-structured Chinese companies. Gensler believes U.S. investors are not fully aware of the risks. In the article, Gensler noted that these offshore shell companies “raise capital on U.S. exchanges, but the contracts don’t actually confer ownership of the operating company to American investors.”

Nana Li, a project director at the Asian Corporate Governance Association in Hong Kong, highlights the dilemma from the perspective of both investors and regulators. “Many investors didn’t understand the risks they were taking with the variable interest entity structure until the SEC statement,” she says. “Chinese regulators know they should’ve dealt with this a long time ago. Now they are being put on the spot by the SEC and have no choice but to address it.”

The China Securities Regulatory Commission (CSRC) is crafting regulations to tackle the issue. However, two decades of use, plus practical considerations, may make it challenging to regulate variable interest entities. They have enabled global investors to skirt China’s rules restricting foreign investment in many Chinese companies.

Marcia Ellis, a Hong Kong-based partner at the international law firm Morrison & Foerster, noted it is unlikely for Chinese regulators to outlaw the variable interest entity structure. “What the CSRC would like to have is approval rights over the ex-China listing of offshore-incorporated companies with their assets and operations in China, whether they use variable interest entity structures or not,” Ms. Ellis stated.