Son of Enron: Investors Weigh the Risks of Chinese Variable Interest Entities

type="main"> Investors are heading back to China after ending a buyers' strike in response to numerous accounting scandals and corporate governance failures. There have been several successful IPOs in recent months, and the market is awaiting the listing of the internet giant The Alibaba Group. The Alibaba IPO has focused investor attention on the use of the variable interest entity (or VIE) structure by other overseas listed Chinese companies as well as Alibaba. The VIE structure allows outside investors some measure of influence or control over Chinese operations that is exercised through contracts instead of actual equity ownership. By using such contracts, companies are able to circumvent Chinese laws that severely restrict ownership in many industries, including the internet sector. The contracts attempt to replicate the benefits of direct ownership, but do so imperfectly. The biggest concern over the VIE structure is the enforceability of the contracts. China has a law that invalidates contracts that attempt to do what is illegal through legal means. One court case involving a VIE-like structure led China's Supreme Court to rule that the contracts were unenforceable, and arbitrators reached the same decision. The biggest nightmare of investors in Chinese VIE structures is that the Chinese owner of the operating company could choose to abrogate the contracts and take ownership of the VIE. The highest profile example of this took place in 2011, when Alipay faced increased regulatory scrutiny and Jack Ma responded by extracting it from the Alibaba Group. The fix for China's VIE problem has to come from Chinese regulators, and reforms to foreign investment rules that have been proposed may make the VIE structure obsolete. But until then, investors have to weigh the unusual risk of investing in companies that they do not own.