Beijing might finally close the IPO loophole that allowed Didi to list overseas

Now, according to Bloomberg, Beijing is preparing to seal a loophole that allowed Internet titans like Didi to grow so big in the first place: the law on Variable Interest Entities (VIEs), which Chinese companies have exploited to earn foreign investment and list on U.S. stock exchanges.

What is a VIE?

Beijing forbids foreign investment in certain sectors of Chinese industry that the government considers critical to national security, such as the Internet or telecoms. That means Chinese digital giants like Didi, Alibaba, Baidu and Tencent are all technically forbidden from selling shares to overseas investors.

The VIE structure sidesteps that restriction by allowing companies to sell shares in a shell company that has a contractual arrangement with the real company—creating an administrative moat between the foreign investors and company ownership.

Here’s how it works:

• A Chinese firm that wants to sell shares to foreigners but is prohibited from doing so creates a shell company outside of China, in a place like the Cayman Islands, where company registrations are easy and corporate taxes are low.

• Executives then use that shell company to create a new Wholly Foreign Owned Enterprise (WFOE) in China, putting on paper that the WFOE operates in a sector that has no relevant restrictions on foreign ownership.

• The WFOE then signs a contract with the registered company that guarantees the WFOE’s books will reflect the finances of the registered entity in China. The party the WFOE signs the contract with is the VIE.

If that sounds complicated, it is. Here’s the chart Didi included in its IPO prospectus to illustrate the arrangement:

The VIE is Beijing Xiaoju Science and Technology Co. The WFOE is Beijing DiDi Infinity Technology and Development Co above it.

Sina Corp, which owns China’s popular online messaging platform Weibo, was the first Chinese company to list in the U.S. using a VIE structure, joining the Nasdaq in April 2000.

Since then, Beijing has typically turned a blind eye to VIE structures, but it’s never outright endorsed the practice.

According to data from 2011, 42% of all Chinese companies listed in the U.S. used VIEs, although that ratio has likely increased in the past decade given the number of major tech IPOs in recent years. Due to Beijing’s restrictions on foreign investment in the tech, media and technology sector, VIEs are the only way for China’s biggest tech startups to gain foreign investment.

What do VIEs mean for investors?

The VIE structure means foreign investors don’t actually own shares in the company. Instead, they own shares in the shell company that has a contractual guarantee to reflect the earnings of the real company. But, because VIEs operate in a grey-area of Chinese law, investors have little way to seek compensation if those contracts are broken.

“Ownership through contracts—especially contracts that are probably not enforceable—is vastly inferior to actual equity ownership,” says Paul Gillis, a professor at Peking University’s Guanghua School of Management.

Yahoo learned the risks of investing in a VIE arrangement the hard way in 2011, when Alibaba founder Jack Ma spun payments platform Alipay out of Alibaba, the e-commerce giant, without seeking approval from Alibaba’s shareholders first.

At the time, Yahoo owned 43% of Alibaba—or rather, it owned 43% of Alibaba’s shell company—and the investment was considered the most lucrative in Yahoo’s portfolio. But the VIE structure left control of Alibaba’s business operations almost entirely in Ma’s hands, rather than divvying up ownership of the company.

The Alipay spin-off slashed the value of Yahoo’s 43% stake in Alibaba, and Yahoo’s own shares entered a tailspin on the news. But because Yahoo didn’t own a real stake in Alibaba, it had limited legal means to protest the surprise spin-off. Alibaba eventually settled the matter with Yahoo, guaranteeing the search engine a payout if Alipay went public, but the deal was pocket change compared to what Yahoo lost.

Generally, however, VIEs function as promised.

Why does Beijing dislike VIEs?

The VIE workaround “essentially makes a mockery of China’s foreign investment restrictions,” Gillis says, and creates complicated corporate structures that are harder for Beijing to control. But cracking down on the structure isn’t solely a matter of reining in U.S. listings.

Companies that operate in the sectors where Beijing has restricted foreign investment need to establish VIEs to gain foreign investment even before they go public. Didi created its VIE ownership structure in 2013, when the company established a Cayman Islands holding company, Xiaoju Kuaizhi Inc, and its WFOE, Beijing Didi.

Tencent, for instance, needed a VIE structure to list on Hong Kong’s stock exchange. Even companies that eventually list on Chinese markets might do so using a VIE.

Beijing has largely tolerated the setup because domestic tech leaders need foreign capital to grow. But now those tech giants have become too powerful, in Beijing’s view, and the government seems to be seeking new ways to bring them under control.

What are the proposed new rules?

According to Bloomberg, the new rules proposed by China Securities Regulatory Commission, would require companies that use VIEs to gain regulatory approval before going public in the U.S. or Hong Kong.

Beijing could use this review process to force companies to list at home rather than abroad. The rule might also force companies like Alibaba, which has already listed overseas, to seek approval before issuing new shares.

One upside is that the new rule could provide a level of legitimacy to the previously suspect VIE setup, creating new security for investors.