Variable interest entity

Variable interest entity (VIE) is a term used by the United States Financial Accounting Standards Board (FASB) in FIN 46 to refer to an entity (the investee) in which the investor holds a controlling interest that is not based on the majority of voting rights.[1] "VIEs operate using contractual arrangements rather than direct ownership, leaving foreign investors without the rights to residual profits or control over the company's management that they would otherwise enjoy through equity ownership."[1]

Since around 1999, an increasing number of VIEs have conducted initial public offerings on U.S. Stock Exchanges.[1] In 2017, approximately 20 Chinese companies using VIE structures conducted or filed for initial public offerings (IPOs) in the U.S.[1]

VIEs are also closely related to the concept of a special purpose entity. Similarly, VIEs "are often established as special purpose vehicles (SPVs) to passively hold financial assets, or to actively conduct research and development. For example, a company may establish a VIE to finance a project without putting the whole enterprise at risk. However, just as other SPVs have been misused in the past, these structures are frequently used to keep securitized assets off corporate balance sheets."[2]

One importance of identifying a VIE is that a company needs to consolidate such entities if it is the primary beneficiary of the VIE.

Note: The guidance in FIN 46 and FIN 46R was subsequently revised when FASB issued Statement 167.[3]

Criteria

A VIE is an entity meeting one of the following three criteria as elaborated in FASB ASC 810-10 [formerly FIN 46 (Revised)]:

  • The equity-at-risk is not sufficient to support the entity's activities (e.g.: the entity is thinly capitalized, the group of equity holders possess no substantive voting rights, etc.)
  • As a group, the equity-at-risk holders cannot control the entity
  • The economics do not coincide with the voting interests (commonly known as the "anti-abuse rule")

Difference between a VIE share and a traditional stock certificate

A share of stock, or a stock certificate, certifies ownership of a portion of a company. In other words, it provides proof of a legal proprietary interest in company assets.[4]

In contrast, a VIE Share (often mistakenly referred to as a share of stock) certifies ownership of a contractual right to a percentage of a company’s profits.[5] Unlike a traditional stock certificate, the VIE share provides a legal proprietary interest in a completely separate company's assets (sometimes referred to as a shell company).[5] The contractual right certified by the VIE share is derived from a contract between (1) the company named on the VIE share and (2) the shell company.

In other words, VIE shareholders only have a traditional stock certificate in the completely separate company, which is entitled to a percentage of the named company's profits.

Alibaba as an example

For example, Alibaba, the world's largest retailer and e-commerce company,[6] uses a VIE structure allowing U.S. citizens to purchase VIE shares in Alibaba on the New York Stock Exchange (NYSE).[7] In September 2014, under the ticker symbol BABA, Alibaba went public on the NYSE at a VIE share price of around $68.[8] It began trading with a bang, soaring 38 percent to close at $93.89 per share.[8] As of September 13, 2019, the share price was around $179 at the closing bell.[9] This represents an increase of around 163%, or 21.36% 5-year compound annual growth rate.

BABA shareholders own a stake, through American depositary shares, in Alibaba Group Holding Limited, a Cayman Islands-registered entity,[10] which is under contract to receive the profit from Alibaba's lucrative Chinese assets.[11] BABA shareholders do not have a proprietary interest in the Chinese-registered Alibaba company's assets, only its profits.[11]

The following is an excerpt from Alibaba's Form F-1 [a public document as required by the Securities and Exchange Commission (SEC)]:

"Due to PRC legal restrictions on foreign ownership and investment in, among other areas, value-added telecommunications services, which include Internet content providers, or ICPs, we, similar to all other entities with foreign-incorporated holding company structures operating in our industry in China, operate our Internet businesses and other businesses in which foreign investment is restricted or prohibited in the PRC through wholly-foreign owned enterprises, majority-owned entities and variable interest entities. The relevant variable interest entities, which are 100% owned by PRC citizens or by PRC entities owned by PRC citizens, hold the ICP licenses and operate the various websites for our Internet businesses. Specifically, our variable interest entities are generally majority-owned by Jack Ma, our lead founder, executive chairman and one of our principal shareholders, and minority-owned by Simon Xie, one of our founders and a member of our management. These contractual arrangements collectively enable us to exercise effective control over, and realize substantially all of the economic risks and benefits arising from, the variable interest entities. See "Our History and Corporate Structure — Contractual Arrangements among Our Wholly-foreign Owned Enterprises, Variable Interest Entities and the Variable Interest Entity Equity Holders." The contractual arrangements may not be as effective in providing operational control as direct ownership."[10] ""PRC" are to [sic] the People's Republic of China, excluding, for the purposes of this prospectus only, Taiwan and the special administrative regions of Hong Kong and Macau."[10]

Alibaba's Form F-1 also includes a Mission Statement:

"Our mission is to make it easy to do business anywhere. Our founders started our company to champion small businesses, in the belief that the Internet would level the playing field by enabling small enterprises to leverage innovation and technology to grow and compete more effectively in the domestic and global economies. Our decisions are guided by how they serve our mission over the long-term, not by the pursuit of short-term gains."[10]

On July 16, 2019, BABA shareholders voted in favor of a one-to-eight stock split at the company's annual general meeting.[12] As of September 13, 2019, the vote is widely rumored to be in preparation for a future IPO in Hong Kong.[12]

References
  1. Whitehill, Brandon (December 2017). "BUYER BEWARE: CHINESE COMPANIES AND THE VIE STRUCTURE" (PDF). Council of Institutional Investors.
  2. Hayes, Adam. "Understanding Variable Interest Entities". Investopedia. Retrieved 2019-09-14.
  3. "FASB issues Statement 167, amendments to FIN 46(R)" (PDF). Ernst & Young. 2009 (22). 12 June 2009.
  4. "Stock certificate", Wikipedia, 2019-09-11, retrieved 2019-09-14
  5. DUGGAN, Wayne (February 9, 2017). "6 Things Investors Should Know About Variable Interest Entities". Lightspeed, a division of Lime Brokerage.
  6. "Alibaba Group", Wikipedia, 2019-09-13, retrieved 2019-09-14
  7. "Alibaba tweaks a controversial legal structure". The Economist. 2018-08-09. ISSN 0013-0613. Retrieved 2019-09-14.
  8. Reuters, CNBC with (2014-09-22). "Alibaba IPO biggest ever; shares decline". CNBC. Retrieved 2019-09-14.
  9. "Alibaba Group Holding Limited (BABA) Stock Price, Quote, History & News". finance.yahoo.com. Retrieved 2019-09-14.
  10. "Form F-1". www.sec.gov. Retrieved 2019-09-14.
  11. Kitchen, Michael. "Beware: Alibaba IPO isn't really selling Alibaba". MarketWatch. Retrieved 2019-09-14.
  12. Kharpal, Arjun (2019-07-16). "Alibaba shareholders approve stock split that could boost shares ahead of reported Hong Kong IPO". CNBC. Retrieved 2019-09-14.


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