China restricts foreign investment in a number of sectors, including a couple of the sectors that are most popular for foreign investment: internet, anything e-commerce related, or anything in education. 

They also restrict many other sectors that are less interesting to foreign investors. Some sectors are completely prohibited and off-limits. You can’t make nuclear weapons in China, for example. But no one’s looking to do that. 

Many companies are interested in participating in China’s e-commerce, because China is the hottest e-commerce market on the planet. 

China doesn’t allow foreign companies to operate in that sector because you need to have an internet content provider’s license (ICP), and that won’t be given to a company that has foreign investment in it. 

Faced with this problem, China’s internet companies had to find a work-around. It’s called the variable interest entity, or VIE for short. 

A VIE is a term that comes from the U.S. accounting literature. It’s a very technical accounting term. It basically allows for a company to control another company through contracts instead of through ownership.

By controlling through contracts you can try to achieve many of the same results you would get as controlling through ownership. 

The key thing with a VIE is that if they’re properly structured, the company is allowed to consolidate the operations of the VIE with the parent company as if it owned it as a wholly-owned subsidiary. 

That was a really important thing for these companies to be able to list abroad. They could not own the company, but they wanted to include its results in its financial statements. 

The way a VIE structure works is that a public company in China, or wanting to be public company, is usually set up as a Cayman Islands company for the foreign companies to invest. 

The internet content provider license, however, is owned by a Chinese company owned by a Chinese individual - often the founder or key executives of the company. 

They set up a company that’s privately owned by Chinese-only individuals and they get the license to operate the website that’s to be used for the business. 

Then the Chinese owners of the company, or the VIE, sign contracts with the public company and its Chinese subsidiary, which is called a wholly-owned foreign enterprise (WFOE). They sign contracts with that company which basically transfers control of the VIE over to the public company. 

Any decisions that are going to be made have to be made by the public company. If there are any dividends to be paid, they have to be paid over to the public company. 

They also put in place an agreement to provide services form the WFOE to the VIE, and the plan is to extract all of the profits out of the VIE in the form of service charges. 

Under the U.S. accounting rules, they are borrowing on the rule that was put in place to stop what Enron was doing.

Back around 2000, Enron had become very clever at structuring off balance sheet financing. That is, it was able to borrow money and keep it off their balance sheet by using special purpose entities that were owned by their Treasurer, not actually owned by Enron even though Enron was really on the hook for all of these liabilities. 

When Enron imploded, the accounting standard setters said they can’t let this happen again. So they put in rules that require a company to be consolidated if it’s controlled even if it’s not owned. 

Those rules were called the VIE rules. 

Accountants in China were very clever. The VIE rules, as originally designed, were intended to make companies put liabilities on their balance sheet. Accountants in China figured out a way to allow companies to put assets on the balance sheet, assets of companies they don’t own. 

That solved a big problem. It allowed Chinese companies then to list in the United States, raise considerable capital and report the results of entities they don’t own as if it was their own.

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