China crash underscores risk for US investors

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As a vicious bear market unfolds in domestic Chinese stocks, U.S. institutional and retail investors in the country's securities that list here, like Alibaba, are feeling the burn.

But some experts question why many of these investors even own these stocks in the first place.

Some of the most popular Chinese U.S.-listed stocks are Internet companies with a "VIE" structure, which stands for variable interest entity. Since China restricts foreign ownership in the domestic shares, the VIEs are a workaround that gives the companies access to U.S. capital through the NYSE and Nasdaq.

But the VIEs give foreign investors no actual share of ownership in the Chinese companies, no say in the company's direction, and could actually be deemed illegal by the China's court system at any point. Not to mention, the SEC doesn't require the VIEs to disclose some past scandals, such as bribery and corruption.

"I've never seen investors invest in things they don't own before," said Paul Gillis, editor of The China Accounting Blog and an accounting professor at Peking University.

It's the blind, momentum buying of these types of securities that has contributed to the tremendous overvaluation in China's stocks listed everywhere, he said.

The 10 biggest VIEs, such as Alibaba and Baidu, have lost more than $40 billion in market value over the last month for U.S. investors as the Chinese stock market collapses.

"Investors in general don't understand the risk of VIEs," said Christopher Tsai, who runs hedge fund Tsai Capital. "This is being tested now. VIE structures are like black boxes. We don't know what's inside until we go through a full cycle of instability."

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A report a year ago from the U.S.-China Economic and Security Review Commission explained the risks of investing in these structures and why they were created.

The paper explains that these Internet companies do not get enough capital from China's banking system or stock market to expand and compete on a level equal to U.S.-funded global powerhouses so they need a way to get access to foreign capital.

The paper, written by policy analyst Kevin Rosier, explains how VIEs are set up:

"VIEs, usually based in tax havens such as the Cayman Islands, are essentially holding companies that link foreign investors and Chinese firms via a set of complex legal contracts. In theory, the VIE structure guarantees that economic benefits flow to the foreign investors; meanwhile operating control of the business remains within the Chinese firm, ostensibly to comply with Chinese laws."

The question that Tsai and others don't quite know the answer to is what happens next to these securities if the domestic sources of capital collapse, like what is happening now.

"It does seem that the government has lost control of the market and we are in a 1929-type crash situation," said Gillis. "This is a case of irrational exuberance that finally popped."

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If the Chinese market continues to crash, affecting the whole economy, companies like Alibaba (likely with guidance from the Chinese government) will be forced to change their business plans in order to make it through the tough times. These changes could include buying back stock, layoffs or cutting capital expenditures.

But U.S. investors will have no say in what steps should be taken.

And not only that, the Chinese government could suddenly wipe out these VIE structures. Says the commission's paper:

"U.S. shareholders face major risks from the complexity and purpose of the VIE structure. For example, the legal contracts that serve as the basis of the structure are enforceable only in China, where rule of law remains rudimentary. Though listing VIEs on U.S. exchanges is legal in the United States, they can be considered illegal in China. As Internet giants Alibaba, Baidu, and Weibo become synonymous with 'Chinese Amazon,' 'Chinese Google,' and 'Chinese Twitter,' risks could mount for unsuspecting U.S. investors who buy into their precarious VIE structures."

To be sure, Gillis and Tsai don't believe this plunge in Chinese stocks would give any reason for the government to deem these VIEs illegal, but the point is that no one really knows for sure.

And this uncertainty risk is certainly not priced into the shares, many of which are still up for the year despite the one-month pullback.

"I don't see them (VIEs) unraveling just because the market in China has corrected by 30 percent," said Tsai. "They are too much to the advantage of management and even though foreign investors don't understand all the risks associated with VIEs, they continue to buy them."

U.S. investors continue to buy them...until they don't.