CHINESE UPDATE – Variable Interest Entity (VIE) Structure for Foreign Investment in the PRC May Face Challenge
- The VIE structure (i.e. reliance upon contractual arrangements to control a PRC operating company) has been a popular structure in the last decade for both foreign and Chinese investors alike.
- A number of recent cases involving companies using a VIE structure have exposed the inherent defects and potential legal and regulatory risks inherent in such structure.
- The problems associated with the VIE structure as well as a concern over losing supervision powers over key companies has attracted increasing attention on the part of the Chinese regulators. Hints of a possible clampdown on the VIE structure have caused great concern to the market and investors. The number of VIE companies currently in place is likely to give the Chinese authorities pause before taking any drastic action.
- The newly introduced National Security Review System for the first time expressly clarified that foreign investors shall not evade the security review by way of contractual arrangements.
- It is likely that the VIE structure issue will be tackled by the government at some stage in the future.
The variable interest entity (“VIE”) has long been a popular structure for foreign parties to invest in sectors which are restricted by China’s industrial policy to foreign investment. In addition the VIE structure has also been used as a means by which Chinese domestic entities could list offshore on international capital markets.
The first well known VIE structure was that of Sina.com in its 2000 listing on NASDAQ. Indeed the VIE structure is also commonly known as a “Sina Structure”. Sina used the VIE as a workaround structure to avoid restrictions on foreign direct investment (FDI) in the value-added telecom services sector. Since then, both foreign and Chinese investors alike have replicated the VIE structure in many other sectors of China’s economy where FDI is either restricted or prohibited to foreign investors.
In essence a VIE structure refers to a structure whereby an entity established in China which is fully or partially foreign owned (“Controlling Company”) has control over an operating company (“Operation Company”) which holds the necessary license(s) to operate in a FDI restricted/prohibited sector. As such sector is restricted/prohibited by the PRC authorities, the foreign investors are not able to directly invest in such Operation Company. Accordingly, the foreign investors adopt various contractual arrangements between the Controlling Company and the Operation Company in order to obtain de facto control over the operation and management of the Operation Company. The profits of such Operation Company would also flow back to the Controlling Company and then ultimately be consolidated by the foreign investors.
For domestic companies, especially companies in the restrictive industries without much physical assets (such as internet or telecommunication), the VIE structure was widely used to enable them to obtain financing from overseas market through overseas listings. Gradually, companies from heavy industries also started to adopt the VIE structure to list overseas and the overseas shell company started adopting such VIE structure to circumvent the approval requirement stipulated by relevant PRC M&A Rules.
From the government’s perspective, although there is no clear prohibition against the VIE structure in China there has also been clearly no express endorsement of the VIE structure either. Accordingly, the VIE structure has always been a grey area in the Chinese legal system. Although the VIE structure allows both the domestic and foreign investors to circumvent government reviews and regulation, this also means that the VIE structure does not have the backing of the authority and therefore the VIE structure possesses inherent defects and potential legal and regulatory risks.
Recent Alibaba case
Despite its popularity there are inherent defects and risks for the VIE structure involving: (a) the level of protection enjoyed by the beneficial owners from VIE arrangement is far lower than a direct equity holding in the Operating Company; (b) the potential conflict of interests between the legal shareholders of the Operating Company and the beneficial owners; and (c) the level of uncertainty in the enforceability of the VIE contractual arrangements between the Controlling Company and the Operating Company in the event of a dispute.
The recent case of Alibaba, a wildly popular shopping website which had a successful IPO on the Hong Kong stock exchange in 2007, is a good example illustrating the potential risks of VIE structure and that illustrates reason for possible government intervention in the future.
Alibaba’s structure is a typical VIE arrangement: Zhejiang Alibaba, a private company held by Ma Yun and acting as an operating company, was in fact controlled by Alibaba Group Holding through a VIE arrangement. No problem arose until Ma Yun decided to complete a 70% equity transfer of Alipay from Alibaba Group Holding to Zhejiang Alibaba allegedly without majority shareholders’ approval on the part of the Alibaba Group (i.e. Yahoo and Softbank). The argument from Ma Yun was that Alipay would be unable to acquire the necessary operational license from the People’ Bank of China if it was held by foreign investors.
The Alibaba matter shone a spotlight on VIE arrangements and it has been widely reported that CSRC, China’s securities regulator, submitted an internal report to the State Council asking the government to clamp down on this controversial yet popular corporate structure. This has resulted in even greater concerns on the part of investors and cast doubts as to the feasibility of the VIE structure going forward.
The Implication of the Report on the future of VIE structure
There have always been great controversy regarding the legality of the VIE structure, mainly because (a) it circumvents the restrictions on foreign investors making it possible for them to invest in restricted/prohibited industries in PRC; (a) it circumvents approval requirements by Ministry of Commerce (“MOFCOM”) in accordance with the M&A Rules, especially by offshore shell company making round trip investments (i.e. where PRC owned businesses and assets are owned by an offshore entity owned by the PRC owners); and (c) it may constitute price transferring and consequently result in tax evasion in some cases.
The leaked report supposedly analyses the legality of the VIE structure as well as the current status of PRC internet companies listed overseas by using VIE structure and more importantly, it recommends future overseas listings using a VIE structure should first obtain MOFCOM and CSRC approval. The leaked Report, is causing gave concerns for foreign and domestic investors alike as nothing has been officially confirmed much less what requirements will be introduced.
Notwithstanding the above, it was recently reported by the Shanghai Securities News that the Report, which was allegedly drafted by a research department of CSRC, was created solely for internal study and communication. Therefore, it is not an official report submitted to the State Council and therefore the actual implementation, if any, is unclear.
However, the investors should note that since the overseas listing of domestic companies by way of VIE structure has gradually been extended from the traditional light industries to heavy industries involving material assets (such as railways, minerals) and therefore also avoiding PRC government supervision, the motivation for the PRC government to regulate the VIE structure has become greater. Although we expect the government will not launch a severe clamp down upon the VIE structure in the short run, it is an issue very likely to be tackled by the government at some time in the future.
Potential effect from NSR system on the VIE structure
Even though currently there are no laws or regulations directly regulating the VIE structure, a newly established National Security Review (“NSR”) system by the Chinese government may prevent foreign acquisitions of domestic companies if the purpose is to evade the governmental security review. This system, similar to those in many other countries, bestows upon the government the authority to review and approve a proposed foreign M&A transaction if it involves one of several key sectors (i.e. military, key technology and agricultural products) that have a bearing on China’s national security. However, since these newly enacted security review regulations are broad and highly discretionary in practice, whether a foreign investment which uses a VIE structure in a key industry will be constituted as a M&A transaction and consequently be required to go through NSR procedure is unclear.
The NSR review may be a means by which MOFCOM may strike down transactions using the VIE structure. However, as currently no precedent case has occurred it is still uncertain whether the NSR system would be used by the government as a step to bring foreign investments using VIE structure under their supervision