It's a long-standing and well-recognized rule that there are certain sectors within the Chinese economy in which foreign companies are prohibited from investing.

It is equally well known that there are acts of corporate deception which may allow foreign investors to enter into this hallowed ground providing, of course, they keep their collective heads down.

These furtive corporate expeditions have always been visible in the penumbra of the regulatory spotlight, but a couple of recent forays have been caught full-beam thus throwing into relief the hazards of venturing into uncharted territory.

The sleight of hand in question goes under the unprepossessing name of the "variable interest entity."

During the first wave of Chinese IPOs during the early 2000s, domestic companies were stymied because of the restrictions in foreign investment in areas such as steel, education, mining and the Internet. The Shanghai and Shenzhen exchanges were not an option as the PRC was not at the time allowing private companies to list in China. The solution to this problem lay in some clever jiggery-pokery with a set of re-tooled accountancy rules which had been dusted off in wake of the Enron scandal in 2003.

It would work like this: an independent offshore company is established by the PRC company, typically in the Cayman islands or the British Virgin Islands, which in turn sets-up a WOFE subsidiary in China. The domestically owned company then enters into a suite of contracts with the WOFE thus allowing the funneling of money from the former to the latter, through loan agreements, equity pledges, service contracts and other assorted agreements between the two entities.

The WOFE and the domestically owned companies are technically independent, which is a sweet deal as it allows the PRC outfit to legitimately hold the valuable operational licences, which are available only to domestic companies, and permits foreign investors to get their hands on the returns that percolate through the WOFE without needing to retain a shareholding in the PRC company.

While most accountants were laboring to ensure that special purpose vehicles were kept off company balance sheets, the pioneers of the VIE did the reverse: they worked to ensure that offshore companies remained conspicuously present on corporate financial documents. This ensured that the offshore companies would be required to consolidate their Chinese counterparts, despite the fact that the listed companies owned no shares in them.

The VIE, while not running contrary to any black letter law, is hardly built on the firmest of regulatory foundations, so it is surprising to see the alacrity with which foreign money has latched onto them - recent research indicates that 77 out of 177 Chinese companies listed on the NYSE or the NASDAQ have used a VIE.

The use of the VIE is pretty much an open secret, the elephant in the room that goes about its business formally unacknowledged. But there's the rub: technically permissible the VIE may be, but it is glaringly at odds with the government's general policy of insulating specific industry sectors.

In a recent piece appearing in "Study Times," scholars were openly critical of foreign investment in the Internet sector, suggesting that VIEs have allowed foreign investors to take by stealth a controlling interest in the Internet sector. How is this finger wagging likely to affect foreign investors?

It is more than likely that pragmatism may take the day. Most of the protected sectors are investment hungry and foreign capital inflows appear to be tolerated as an acceptable evil rather than welcomed as an unmitigated good, as long as such transactions are carefully monitored.

A recent tightening-up of capital transfer regulations between foreign owned and domestic companies suggest that regulators are keen to keep a close watch on what's happening on the ground.

The recent debacle involving Yahoo's loss of Alipay - an online payment system jointly owned with Alibaba - to a wholly owned domestic entity, seems to indicate that VIEs will be countenanced so long as the controlling shareholding resides with Chinese nationals. At least for the time being.

The author is Of counsel at Allbright Law Firm. The views are his own.

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