Chinese Internet companies could have a tougher time listing on U.S. stock exchanges because of an expected Beijing clampdown on a favored corporate structure.
It is unlikely to halt all new U.S. listings of Web companies that want to follow in the footsteps of heavyweights such as Baidu and Renren , but it could prevent some and slow the progress of others.
Earlier this week, Reuters reported legal sources saying the China Securities Regulatory Commission has authored a request to the Chinese government's equivalent of a cabinet, the State Council, asking it to take action against the structure, known as a Variable Interest Entity, or VIE.
Web companies and others from sectors deemed important to China's interests use the VIE structure, which usually involves an entity in the Cayman Islands or another offshore haven, to get around Chinese restrictions on direct foreign investments in strategic sectors.
VIEs operate in a legal gray area - the structure means that the shares foreign investors get to own in Chinese companies listed in the U.S. are really shares in a revenue stream rather than direct equity stakes in the operating company.
Because VIEs are agreements between the Chinese operating company and its listed counterpart to funnel the revenues to investors, they expose the foreign investor to risk should the agreement fall apart.
Chinese authorities have tightened rules and threatened further crackdowns several times in recent years.
"In China, if what you're doing is not explicitly permitted, you have to assume it's not," said David Wolf, chief executive of Beijing management-advisory firm Wolf Asia Group.
The possibility of increased regulation was confirmed on Tuesday when Commerce Ministry spokesman Shen Danyang said that while he was unaware of the report to the State Council his ministry would work with other Chinese government departments to keep a closer eye on the use of VIEs.
Many in the U.S. believe there will be a crackdown due to mounting pressure from a series of accounting scandals at many U.S.-listed Chinese companies that have resulted in auditor resignations, stock exchange delistings and investigations.
U.S. regulators are accused alternately of being too harsh and too slow to react to the scandals. Chinese regulators, meanwhile, have done little to curb the alleged fraud and have denied inspectors access to China-based auditors.
The move to more closely examine VIEs could be an acknowledgment by China that its lack of oversight is a liability and it needs to take a more hands-on approach since the alleged fraud has hurt investor appetite.
It also comes amid a wider assault by the Chinese authorities on the relative freedom that Internet companies have had in recent years.
The use of the Internet, particularly Tweet-type services, to protest about the behavior of authorities - highlighted by public outrage about a deadly rail crash in Wenzhou in eastern China in July - is threatening to a leadership in Beijing that has watched Arab Spring protests topple governments.
The expected transition of power in 2012 from President Hu Jintao to Vice President Xi Jinping has also made the authorities ultra-sensitive to any signs of unrest.
The VIE structure, which has been effective in circumventing foreign investment rules, would not be that easy to replace.
"For Chinese companies that are looking at accessing international capital markets there are not too many alternatives to VIE structures," said Thomas Shoesmith, head of law firm Pillsbury Winthrop Shaw Pittman LLP's China practice. "In the Internet space there is no alternative. If you're on the Chinese side and you don't do a VIE structure you can't access the money."
Still, he said any changes may be modest. "It's unlikely that the Chinese government is going to slam the door," he said. "It's certainly almost impossible that they would unwind anything, unlikely that they would slam the door on a significant industry sector - but not impossible, so it's worth being wary."
China is unlikely to touch companies that are already listed but VIE regulations could slow down new foreign listings if, for example, companies have to first get approval from the Ministry of Commerce to form a VIE, said a telecoms and Internet research analyst who spoke on condition of anonymity.
If nothing else, more control over VIEs could allow China to pick which Internet companies succeed or fail.
Those that are in political favor could be allowed to raise money in the United States but others without government support might struggle to get approval for a VIE.
This could also be a way to direct more Chinese companies onto the nation's own capital markets then this could give them another lever with which to do that.
The Internet sector is currently the hottest in the U.S. new issues market. Daily deals site Groupon and gamemaker Zynga are readying U.S. IPOs that are likely to be valued in the multi-billions of dollars. Social networking phenom Facebook is also expected to go public sometime next year.
So far this year technology companies have accounted for 40 percent of the Chinese companies listing in the United States through IPOs and 2.5 percent of all U.S. IPOs, according to Thomson Reuters data.
The reason investors keep jumping into Chinese Internet stocks is simple. China is the world's largest Internet market by users but only has a 30 percent penetration rate. Japan and South Korea have penetration rates of more than 70 percent - so China has plenty of room for growth.
"Some of these companies have the potential to be enormous just given the population base that China has," said Scott Powell, a vice president at investor relations firm MZHCI, which has a number of Chinese clients.
At least two high-profile Chinese Internet companies are planning U.S. IPOs for next year: Chinese online retailer Jingdong Mall is expected to raise $4 billion to $5 billion in the first half of 2012, which would make it the biggest-ever U.S. Internet IPO. Travel website Qunar, majority-owned by Baidu, is also mulling a U.S. listing.
What's to Lose?
Texas-based investor John Bird, who is known for shorting Chinese stocks, argues that the U.S. would be better off without VIEs, which he calls a "Frankenstein construction".
"You end up with an economic interest in something you can never own," he said.
VIEs leave foreign investors entirely vulnerable if anything goes wrong. Under the agreement, investors do not actually own the Chinese company they have invested in or the licenses required to operate it.
The description of the structure in the prospectus for the recent IPO by children's social networking and entertainment site Taomee is typical.
"Foreign ownership in Internet related businesses is subject to restrictions under current PRC laws, rules and regulations. To comply... we conduct our operations in China primarily through Shanghai Taomee, our significant variable interest entity, or VIE, in China via a series of contractual arrangements," Taomee wrote.
"(The) VIE or its shareholders may breach the contractual arrangements with us. In such cases, we would have to rely on legal remedies under PRC law, which may not always be effective, particularly in light of uncertainties in the PRC legal system," the company wrote.
So far, investors have been willing to pay rich valuations and put up with VIEs because they have been desperate to tap into Chinese Internet growth.
However that might no longer be such a sure bet as accounting scandals have raised questions about the torrid growth claimed by some Chinese companies, said a U.S.-based exchange executive who spoke on condition of anonymity.
"That's all there really was for a lot of these companies. Some of those claims are now called into question," the executive said.
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