To The Moon

Chinese companies often use the Variable Interest Entity (VIE) structure to conduct initial public offerings (IPOs) outside the People’s Republic of China (PRC) and avoid certain restrictions on foreign investment. Recently the China Securities Regulatory Commission (CSRC) and other regulatory agencies published draft rules for such overseas offerings, which if adopted will be beneficial for investors.

However, additional measures are needed to protect investors from a number of harmful practices currently occurring. Of particular concern is the use of depositary receipts (DRs) to offer securities in non-PRC markets.

While many foreign companies use DRs to list outside their local market, the practice is especially problematic for PRC companies utilizing the VIE structure. That’s because investors in those entities do not normally have the alternative of holding locally traded shares if they are unhappy with terms of the DRs. While the PRC’s securities regulators did not address these particular issues in their new overseas listing rules, it should give the matter serious consideration.

In its most basic terms, the VIE structure involves an operating company forming an offshore shell through which securities are sold. Rather than directly offering its shares to the public, the offshore entity hires a depositary bank to issue DRs representing an interest in the shell company’s shares. 

Although DRs can provide some practical benefits, this comes at a steep cost. Both the PRC company and the depositary bank derive significant profits at the expense of investors, and in many cases, investors are deprived of voting and other rights.

A key concern for investors is the excessive fees charged by depositary banks, including DR issuance fees, DR cancellation fees, fees on the distribution of cash, and annual administrative servicing fees. Depositary banks share a large portion of such fee revenue with the companies that appoint them.  In contrast, no such fees are charged by entities that use the VIE structure but issue shares directly to investors instead of using DRs.

The fees generated by depositary banks can be excessive given the routine and limited services depositaries provide. A depositary bank serves as a basic transfer agent and registrar for the issuance of DRs. As such, the amounts charged to investors are not nearly commensurate with the ministerial nature of these services and the minimal work and risk depositary banks take on.

For example, the depositary bank for Alibaba Group (BABA.US, 9988.HK)reported that during three recent fiscal years a total of approximately $150 million in fee revenue was shared with Alibaba. With more than 100 PRC-Cayman DR programs currently effective in the U.S., we estimate that many hundreds of millions of dollars in total fees are charged to DR investors each year. 

Since PRC companies generally receive the lion’s share of these payments (while still leaving the depositary bank with an enormous profit), there is an inordinate incentive for them to continue employing the DR structure when accessing foreign markets, largely to the detriment of investors.

The VIE/DR structure can also be used to strip investors of voting power and limit other rights. As a rule, DR investors cannot vote directly on company-related matters because they are not shareholders. Instead, they provide voting instructions to their respective depositary bank, which then votes the shares represented by the DRs based on those instructions. 

However, in many DR programs the depositary bank will grant a discretionary proxy to the offshore company with respect to DRs for which voting instructions were not received in a timely manner. A company can take advantage of this by delaying the delivery of proxy materials to the depositary bank, leaving DR holders with insufficient time to return their voting instructions. The result of this practice is that voting power is diverted from investors to management.

In addition, DR programs generally place restrictions on other rights, including limitations on the liabilities for which DR holders can obtain relief and restrictions on the jurisdictions where holders can bring legal proceedings.

I am hopeful the relevant PRC authorities may consider taking further action to address these and other concerns. A critical step would be either prohibiting PRC entities and their depositary banks from charging any fees to investors (i.e., no administrative servicing fees or cash distribution fees allowed) or significantly limiting such fees to a very small fraction of the current rates.

Additionally, as is the case in other jurisdictions, PRC entities could be prevented from receiving discretionary proxies from a depositary bank. Such measures would significantly enhance investor rights and help ease the burdens imposed on investors from companies that utilize the VIE structure.

In essence, my suggestions seek to reverse the erosion of rights that occurs when investors hold their investment in the form of DRs. Because DRs are an arcane derivative instrument that is poorly understood and often not properly regulated, they allow investors to be exploited financially and otherwise by a small group of international banks.

I would urge the CSRC to strengthen the proposed rules and for all investors in DRs, large and small, to let PRC/Cayman issuers know that they can no longer expect to receive fees that direct shareholders would never be charged.

George Gregor is a founder and Managing Partner of Global Capital Service Group Ltd., a Wall Street-based investment banking and advisory firm. You can contact him at ggregor@gcaps.com or through linkedin at https://www.linkedin.com/in/george-h-gregor-0772b35/

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