There’s a pretty simple idea behind buying shares: Do so, and you end up owning some part — however small — of a company. As ever, in China things are not always so straightforward.

Invest in a Chinese company listed on the New York Stock Exchange or any other foreign market — as millions of people do via their pension funds and other products — and the chances are you’re exposed to a variable interest entity, or VIE-structure. Chinese companies like tech giants Alibaba and Tencent, which operate in sectors where foreign investment is banned or limited, commonly use these structures. 

For tech companies and others who want to attract global investors, the typical way to get around the Chinese rules is to set up an offshore entity, often with the same name, which is then listed on an exchange like the NYSE. This listed company doesn’t own key parts — or sometimes any — of the underlying China operations. But it can consolidate that company’s results and balance sheet onto its own financial statements, thanks to various contracts between the two set up under the VIE structure. 

And presto! Foreign investors who buy shares in the listed company gain an effective stake in the Chinese operating company — theoretically, without anyone breaking any rules. 

The VIE structure has barely changed for years: Indeed, the structure can work for all sides as long as no one involved rocks the boat. 

The waters, though, are getting choppier. The recent trend for Chinese bosses of major tech companies to come under political or regulatory fire, such as JD.com founder Richard Liu Qiangdong, has brought some major issues associated with VIEs sharply into focus — in particular, the so-called ‘key-man’ risk inherent to these structures. 

Having a company founder step down in favour of a new CEO can create some murky corporate governance at the best of times: But when the same person is still in overall control of the company’s operating entities it only exacerbates the problem. 

This risk arises because the biggest owners of the equity in the VIE — that is, the operating company inside China — are typically major company insiders like its founder, chairman or chief executive. Problems can easily emerge when the interests of those insiders fall out of line with those of the overseas shareholders in the listed company. 

In the case of tech companies where founders or other prominent figures have recently been stepping back, there is little evidence that they have also been reducing their shareholdings in the VIEs. Having a company founder step down in favor of a new CEO can create some murky corporate governance at the best of times. But when the same person is still in overall control of the company’s operating entities, it only exacerbates the problem. 

These issues are rarely dealt with satisfactorily by companies — partly because it’s not in the interests of the insiders to cede any control. Crucially, too, VIE structures normally don’t have any active governance or board oversight mechanisms to monitor or resolve issues before they escalate. Even if such mechanisms are mentioned in the paperwork before a company floats on the NYSE or elsewhere, we often see little evidence they are actively in use.

The case of NYSE-listed online real estate company KE Holdings is particularly extreme. After its chairman Zuo Hui recently passed away, the company issued a press release detailing how it would deal with the corporate governance and ownership fallout. But nowhere did it set out how it would dispose of the former chairman’s controlling stake in two of KE Holdings’s three VIEs.

This, along with the lack of any governance structure for the VIE, means that overseas investors in KE Holdings currently have no idea who controls their operating entities in China; nor is there any clarity on how the company and the board of directors means to deal with this issue.

While the KE Holdings situation may be unusual, the core problems with VIE structures are present for any company that uses them. That represents a huge risk for investors outside China, who may assume they are simply investing directly into Chinese companies when they buy their shares on the NYSE or other foreign markets. 

Even so, it looks like VIEs will be around for some time yet. Having treated VIEs as a grey area for years, Chinese regulators have recently at least acknowledged their existence, by proposing that any new ones need to be submitted for approval. 

This could be a positive if it leads to more clarity over the rules governing VIEs. But as yet it doesn’t get rid of the corporate governance issues described above, nor the other issues inherent to the structure, such as their tax inefficiencies, the fact that shareholders in the listed company have little say over how the Chinese company is run, and even the legality and enforceability of VIE contracts in China.

If we are stuck with the VIE structure for some time to come, it’s at the very least time to make sure we’re minimizing the risks involved and taking minority interests into account. One proposal is that companies using this structure appoint someone — perhaps the company’s chief financial officer — to oversee how it operates, and to report annually to the board on what efforts have been made to mitigate the risks for foreign shareholders.

At a time of broad tension between the U.S. and China, it’s possible VIEs could be added to the list of grievances. Taking steps now to make sure companies take American minority shareholders into account might not just make sense from a corporate governance perspective, but a geopolitical one as well.

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