Can there be a highly developed financial market without the legal protection of investors and creditors? The law and finance literature is built on the premise that legal protection is essential to the development of a financial market. In the 17th century, for example, the English monarch was able to borrow money whereas his French counterpart could not, because the former’s creditors were protected by constitutional rules. In the contemporary world, common law jurisdictions with strong protection for shareholders and creditors dominate the international financial market, with the world’s three leading financial centers (New York, London, and Hong Kong) all common law jurisdictions.
In my recent paper, I investigate how two financial markets of trillions of dollars have developed extralegally in the past two decades, thereby risking regulatory enforcement and contract defaults. More specifically, I examine (1) how Chinese internet companies from Sina to Alibaba have designed contracts to circumvent the Chinese government’s ban on foreign capital in high-tech industries and to get listed on overseas stock markets, and (2) how Chinese entities and foreign investors contract out of China’s stringent regulations on the issuance of international bonds.
In the past two decades, Chinese companies have adopted the structure of variable interest entity (“VIE”) to circumvent the government’s ban on foreign capital in China’s internet industry and to get listed on overseas stock markets, resulting in an era of the so-called “China concepts stock” (i.e., stock of companies whose assets or earnings reflect significant activities in mainland China, a number of which are listed on stock exchanges abroad, particularly New York and Hong Kong). In the VIE structure, foreign investors do not hold equity shares in the Chinese company, but instead hold claims to control and to financial gains through a multi-layered contractual arrangement. Such contract arrangements are extralegal as their main purpose is to circumvent Chinese restrictions on foreign investment. Nevertheless, all Chinese internet companies listed overseas, including Tencent and Alibaba, have adopted the VIE structure since its invention in 2000 at the overseas initial public offering (IPO) of Sina, which was at the time the main internet news website in China. As of May 2021, of the 261 Chinese companies listed in the U.S., 184, or 70.5 percent, use the VIE structure, representing a combined market capitalization of US$2.1 trillion. VIEs thus literally raises a “trillion-dollar question” about law and finance.
The market for Chinese-issued international bonds has captured far less attention than that for “China concepts stock,” even though the value of international bonds issued by Chinese entities has exceeded that of the total equity funds raised by Chinese entities from the U.S. and Hong Kong stock exchanges since 2012. China has stringent regulations on cross-border capital flows, including a quota and approval system for the issuance of overseas debt and limits on the credit support that Chinese companies can provide to overseas entities. Much of the practice on the Chinese-issued international bond market concerns how to circumvent the relevant Chinese regulations, raising questions about their legality and enforceability. This article focuses on one of the most notable extralegal forms called keepwell deeds (“KWDs”) used by onshore Chinese companies to provide credit support to their overseas subsidiaries through which the former issue international bonds indirectly.
The VIE market is about the same size of the Nasdaq Nordic and Baltics (2.13 trillion) created in 2003 and the Deutsche Boerse AG (2.1 trillion) founded in 1993, and about two-thirds of the size of the London Stock Exchange (3.39 trillion) and three-seventh of the size of the Hong Kong Stock Exchange (4.82 trillion). The market of Chinese-issued international bonds is of similar scale and duration. The scale and duration of both markets are remarkable.
My in-depth studies of the financial markets of VIEs and KWDs, both of which have ongoing implications for the Chinese and global economy, reveal that (1) the extralegality of both markets originates from China’s struggle between development, which requires access to the international capital market, and control, which requires keeping market and capital on a short leash, and that (2) a combination of private reputation and state reputation mechanisms sustains the aforementioned financial markets without law.
Overall, the network of financial intermediaries that controls access to the international capital market, the industry-specific communities of Chinese entrepreneurs and corporations that need access to that market, and the Chinese state, which promotes stability and predictability in both financial markets despite their extralegal contractual basis, have replaced judicial enforcement to support financial development of a remarkable duration and scale. Based on the findings of these studies, I argue that social and political mechanisms can support the development of highly sophisticated extralegal financial markets. This argument is potentially applicable to both China’s domestic financial markets and markets beyond China, for example, to the Bitcoin market worth hundreds of billions of dollars.
Understanding alternative mechanisms that support financial development is essential, as most developing countries do not have a well-functioning rule of law system, including China, whose development in the past four decades has posed serious questions around the necessity of law to development. This article does not argue that such markets are optimal or risk-free; nor does it predict that such markets are sustainable in the long run. In the long run, both VIEs and KWDs are likely to decline or even disappear into history, just like the societas publicanorum (an early form of shareholder company) in the Roman Republic. Nor do I argue that such finance without law is fair or just considering the dominance of financial intermediaries, entrepreneurs and regulatory agencies, and the lack of participation by individual investors in the process. Nevertheless, their existence by far already deserves a more nuanced understanding of the relationship between law, state, and finance.
Shitong Qiao is a Professor of Law and the Ken Young-Gak Yun and Jinah Park Yun Research Scholar at Duke Law School.
This post is adapted from his paper, “Finance Without Law: The Case of China,” forthcoming at Harvard International Law Journal and available on SSRN.
