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Sometimes, when the Chinese government is considering or planning a policy change, it will make some sort of formal announcement in advance. But not always: Often, it will signal its intentions more subtly. That is the kind of behavior that keeps policy analysts in business and keeps all of us watching for statements and remarks that may signal a warning of an impending change.

VIE another day?

Xinhua may have issued such a warning to foreign investors in Chinese online companies a few weeks ago. In an article examining the Yahoo (NASDAQ:YHOO)-Alipay (OTC:ALBCF) dispute, Xinhua suggested that the structure Yahoo used to invest in Alibaba – and that is used my a number of overseas investors to circumvent laws restricting foreign investment in the Internet – may no longer escape government scrutiny.

The structure, called a variable interest entity or “VIE,” is essentially a set of technical service agreements between a foreign entity and an internet company in China, allowing a foreign company to be paid for its “services” based on the performance of the Chinese company. One hard look at how these deals actually work would reveal them to be what my mentor Jeanne-Marie Gescher calls “functional equivalents,” in that they are the functional equivalent of an investment. While keeping within the letter of the law, they stray outside its intent.

And that is the problem. As Xinhua notes:

Fang Xingdong, founder of blog provider bokee.com, said that there is a tendency among Internet companies and foreign investors to gamble on whether the government will actually enforce its rules.

The Alipay case shows that the VIE structure may not be safe for foreign investors anymore and it is hurting the credibility of Chinese regulators, according to Fang.

Remembering Zhong Zhongwai

Those who are skeptical that the government would step in this way would do well to recall (or look up) what happened in the case of another functional-equivalent structure used during the 1990s to siphon foreign investment into the restricted Chinese telecommunications sector. That structure, called a “sino-sino-foreign” (SSF) arrangement, circumvented the letter of the law by creating an onshore equity joint venture between a local company and a foreign investor. The joint venture, ostensibly a Chinese company, would then make the investment in the local telco.

After ignoring them for several years, the government pulled the plug on those entities in 1998, declaring them to be illegal under the law restricting foreign investment in Chinese telcos. The government required the local companies to buy out the foreign investors, most of whom were large global players like Deutsche Telekom (OTCPK:DTEGF), and rode roughshod on the process to make sure it happened. The denouement of SSF was ugly, a distraction for all involved, and an unequivocal warning from the Beijing aparatchiks: You may sneak around the law, but eventually we’ll catch up.

When Will the Bell Toll?

The bell will probably ring at some point for the VIEs, and it might be soon: The Alipay case could serve as a first warning shot, and it need not require some sweeping, high profile legal or policy change to end the validity of these arrangements, just a small change in the administrative rules of a single ministry. In the Alipay case, according to Xinhua:

The central bank created a rule last September that requires all payment-service companies in the country to obtain a specific type of business license, which can only be granted to Chinese-owned entities.

For online entities, the axe could fall from any of a number of directions: The Ministry of Commerce (MofCom), the State Administration for Radio, Film, and Television (SARFT), the Ministry of Industry and Information Technology (MIIT), or a player to be named later. If history is any guide, the only real question is “when?”

Soon, Probably

For many companies, operating in the gap between law and enforcement is the only available way to participate in the market, and when your competitors are doing the same thing, it is hard to resist the opportunity. Many of us have done it, and it is more common that any of us would care to admit. But that is no justification for complacency.

There are varying degrees of regulatory risk in China, but when you count on either lax enforcement of the law or enforcement limited to the letter of the law, you place your money at the mercy of bureaucratic whim. Regulators tend to get very jumpy during times of political change, looking for ways to clean up their patch to show the new leadership that they are on the case. As we approach 2013 and the handover to a new generation of national leaders, we are on the cusp of such a change in China.

So the Alipay case and Xinhua’s response to it should be construed as a warning. Companies depending on a VIE for an investment in China or for a local business operation need to start thinking about those two magic words: Exit strategy.

Source: China's Yahoo-Alipay Warning