Didi VIEsIn my old life, I was a derivatives structurer at an investment bank, and an experience that I frequently had was getting calls like this: Relationship banker: Our client wants to do ______. Me: That’s illegal. Relationship banker: Yes that’s our problem. Me: Ah. Relationship banker: We were hoping there was a … derivative?
Sometimes there was! If you came to me and said “our client would like to buy 8% of a public company, but not disclose her ownership,” I would say “well, under U.S. law you do have to disclose that level of stock ownership, but I could put you in a nice derivative that gets around that requirement.” The client could enter into a swap that gives her economic exposure to the shares, but not actual ownership, so she would not be subject to the laws about ownership disclosure. Everyone is happy, more or less. (No one is happy, and we have talked a few times about how mad everyone is that Archegos Capital Management was allowed to do this.) So I have a soft spot for Chinese VIEs. The idea is that, under Chinese law, it is somewhere between “complicated” and “forbidden” for foreigners to own certain big important Chinese tech companies. This is a problem for those companies if they want to raise capital from foreign investors and list their stocks on foreign stock exchanges. But there is a solution. “Ownership” of a company is a complicated notion, a vague jumble of rights to elect directors and approve mergers and claim a residual interest in the company’s cash flows. You could break those things up and sell them separately. Write a profit-sharing contract that says “A will pay B all of A’s profits after expenses for the next 100 years, renewable at B’s option,” and hey that’s a residual claim on cash flows. (Or something vaguer: “A will pay B an annual consulting fee that B decides in its total discretion based on the economic value of the relationship,” etc.; not technically a residual claim but what else is it?) “B will provide management services to A and A will follow B’s instructions,” hey that’s basically control. “B will have the right to appoint a majority of A’s board of directors,” put it in a contract, it’s not actually stock ownership. Etc. Write some contracts that, bundled together, look like ownership, but aren’t ownership. With Chinese companies this sort of thing is generally called a “variable interest entity.” You set up a company in the Cayman Islands that can be owned by anyone. The Caymans company enters into a series of contracts with the local Chinese company, giving it, not ownership, but certain carefully curated economic interests and control rights over the Chinese company. Then you list the Caymans company in the U.S., and people buy its stock, and they sort of pretend that they’re buying stock in the Chinese company — they sort of pretend that the Chinese company is a subsidiary of the Caymans holding company — even though really they’re only buying an empty shell that has certain contractual relationships with the Chinese company. The problem with this is that it sort of sounds like you’re kidding. So here is the prospectus for Didi Global Inc., a Cayman Islands company that has certain contractual relationships with a giant Chinese ride-hailing company. (Technically the top-level Chinese company is called Beijing Xiaoju Science and Technology Co. Ltd., though colloquially it is “Didi Chuxing.”) Didi Global did an initial public offering of its American depositary shares last week; it has a market capitalization of something like $57 billion. Page 12 of the prospectus has a diagram of the corporate structure, which looks almost normal:  Looks like a holding company with some intermediate holding companies and operating subsidiaries, fine. The only weird thing is that somewhere near the middle there is a double arrow (representing “contractual arrangements”) rather than a single arrow (representing “equity interest”). Didi Global’s shareholders “own,” in some fairly normal sense, everything above the double arrow, right down to one “wholly foreign owned enterprise” (WFOE) in China. Everything below the double arrow — the actual ride-hailing business, etc. — is slightly askew; they just have contractual rights to do stuff with it. The actual contractual rights are spelled out on pages 100-102 of the prospectus under the heading “Contractual Arrangements with Our Variable Interest Entities,” and they are worth reading. “Agreements that Allow Us to Receive Economic Benefits from Our Variable Interest Entities” is one sub-heading, describing a contract providing that “Beijing DiDi or its designated parties have the exclusive right to provide Xiaoju Technology with comprehensive technical support, consulting services and other services,” and that “Xiaoju Technology agrees to pay services fees, the amount of which is determined by Beijing DiDi on the basis of the work performed and commercial value of the services.” Is that a residual claim on the cash flows of the ride-hailing business? Maybe! “Agreements that Provide Us with Effective Control over Our Variable Interest Entities” and “Agreements that Provide Us with the Option to Purchase the Equity Interest in Our Variable Interest Entities” are two other sub-headings. (The latter is less of a stock option and more of a transfer restriction: It’s not that Didi can practically buy the shares in the VIE; it’s that it doesn’t want the shareholders selling those shares to someone else.) And here’s this: Spousal Consent Letters. The spouses of the shareholders of Xiaoju Technology have each signed a spousal consent letter agreeing that the equity interests in Xiaoju Technology held by and registered under the name of the respective shareholders will be disposed pursuant to the contractual agreements with Beijing DiDi. Each spouse agreed not to assert any rights over the equity interest in Xiaoju Technology held by the respective shareholder.
Somebody owns the ride-hailing business, in a technical legal sense, and it’s not Didi Global or its shareholders. You don’t want the actual owners, or their spouses, to go around selling the shares out from under Didi. I don’t want to pick on Didi. This is a standard method for mainland Chinese internet companies to go public, Didi is just the latest in a long line of big companies to use it, the market has come to accept it, and Didi’s Chinese counsel has opined that “the ownership structure of our principal variable interest entity ... will not result in any violation of the applicable PRC laws or regulations currently in effect” and that “the agreements under the contractual arrangement among Beijing DiDi, Xiaoju Technology and its shareholders are currently valid, binding and enforceable in accordance with their terms and the applicable PRC laws or regulations currently in effect.” It’s all fine! But, again, it sounds like you’re kidding, and as that legal opinion sort of implies, the laws can change. So! Regulators in Beijing are planning rule changes that would allow them to block a Chinese company from listing overseas even if the unit selling shares is incorporated outside China, closing a loophole long-used by the country’s technology giants, according to people familiar with the matter. The China Securities Regulatory Commission is leading efforts to revise rules on overseas listings that have been in effect since 1994 and make no reference to companies registered in places like the Cayman Islands, said the people, asking not to be identified discussing a private matter. Once amended, the rules would require firms structured using the so-called Variable Interest Entity model to seek approval before going public in Hong Kong or the U.S., the people said. The proposed change is the first indication of how Beijing plans to implement a crackdown on overseas listings flagged by the country’s State Council on Tuesday. Closer oversight would plug a gap that’s been used for two decades by technology giants from Alibaba Group Holding Ltd. to Tencent Holdings Ltd. to attract foreign capital and list offshore, potentially thwarting the ambitions of firms like ByteDance Ltd. contemplating going public outside the mainland. … Pioneered by Sina Corp. and its investment bankers during a 2000 initial public offering, the VIE framework has never been formally endorsed by Beijing. It has nevertheless enabled Chinese companies to sidestep restrictions on foreign investment in sensitive sectors including the Internet industry. The structure allows a Chinese firm to transfer profits to an offshore entity -- registered in places like the Cayman Islands or the British Virgin Islands -- with shares that foreign investors can then own. While virtually every major Chinese internet company has used the structure, it’s become increasingly worrisome for Beijing as it tightens its grip on technology firms that have infiltrated every corner of Chinese life and control reams of consumer data. Authorities so far have little legal recourse to prevent sensitive overseas listings, as with the recent Didi Global Inc. IPO, which went ahead despite requests for a delay from regulators. The additional oversight could bestow a level of legitimacy on the VIE structure that’s been a perennial worry for global investors given the shaky legal ground on which it stands.
Yeah that’s not the worst outcome. The worst outcome would be something like the Chinese government declaring “all these VIE contracts are actually a disguised form of foreign ownership, which is not allowed by the rules, so they are all void and your Didi and Alibaba shares are worthless.” That would … I mean, these VIE contracts are a disguised form of foreign ownership, and a fairly thin disguise. (It’s not like Chinese government authorities are unaware that foreign investors own shares in Alibaba; it’s just that they seem to accept this level of technical compliance with the rules.) This is a real risk! It’s in Didi’s risk factors: PRC laws and regulations impose restrictions on foreign ownership and investment in certain internet-based businesses. We are an exempted company incorporated in the Cayman Islands and our PRC subsidiaries are considered foreign-invested enterprises. To comply with PRC laws, regulations and regulatory requirements, we set up a series of contractual arrangements entered into among some of our PRC subsidiaries, our VIEs and their shareholders to conduct some of our operations in China. ... We have been further advised by our PRC legal counsel that there are substantial uncertainties regarding the interpretation and application of current or future PRC laws and regulations. Thus, the PRC government may ultimately take a view contrary to the opinion of our PRC legal counsel. If the PRC government otherwise find that we are in violation of any existing or future PRC laws or regulations or lack the necessary permits or licenses to operate our business, the relevant governmental authorities would have broad discretion in dealing with such violation, including, without limitation: … revoking the business licenses and/or operating licenses of our PRC entities; ... requiring us to restructure our ownership structure or operations, including terminating the contractual arrangements with our VIEs and deregistering the equity pledges of our VIEs, which in turn would affect our ability to consolidate, derive economic interests from, or exert effective control over our VIEs and their subsidiaries; ...
If the Chinese government decides “VIEs are okay, but you have to get our permission to list them abroad,” that's not a worst-case scenario even if it never grants permission. The bad news would be if the ones already listed abroad were just, you know, voided. Anyway there is a whole mess of Chinese and U.S. government proclamations about cracking down on Chinese companies listing abroad. On the Chinese side, “Didi Plunges Below IPO Price as China Crackdown Brings U.S. Pain,” and “China’s crackdown on US listings threatens $2tn market.” And on the U.S. side: “Investment Review Panel Gets Wider Role Under Biden in Rivalry With China,” and “Republican senator Marco Rubio lambasts ‘reckless and irresponsible’ Didi listing.” If U.S. regulators ban Chinese firms from listing in the U.S., and Chinese regulators also ban Chinese firms from listing in the U.S., I guess it will be hard for Chinese firms to list in the U.S. But maybe they’ll find a way anyway. Maybe there’s a derivative. | 
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