The variable interest entity ("VIE") has long been a popular structure for foreign investors in sectors that are subject to China's investment restrictions. VIEs have also been used as a means by which Chinese domestic entities are able to list overseas on international capital markets.
The first well known VIE structure was that of Sina.com in its 2000 listing on the NASDAQ. Indeed the VIE structure is also commonly known as the "Sina Structure". Sina used a 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 from foreign investment.
In essence, a VIE refers to a structure whereby an entity established in China that is wholly or partially foreign owned (the "Controlling Company") has de facto control over an operating company (the "Operating Company") which holds the necessary license(s) to operate in an FDI restricted/prohibited sector. As such sectors are subject to investment restrictions in China, foreign investors are not able to directly invest in the Operating Company. Accordingly, the foreign investors adopt various contractual arrangements between the Controlling Company and the Operating Company in order to obtain de facto control over the operation and management of the Operating Company. The profits of the Operating Company would also flow back to the Controlling Company and ultimately be consolidated with the finances of the Controlling Company.
For domestic companies, especially companies in restricted industries that don't typically have many physical assets (such as internet or telecommunications companies), the VIE structure was widely used to enable companies to obtain financing from overseas markets through overseas listings. Gradually, companies in the heavy industries also started to adopt the VIE structure to list overseas, as did offshore shell companies that were looking to circumvent approval requirements stipulated by China's M&A Rules(1).
From a regulatory perspective, although there is no clear prohibition against the VIE structure in China, there has also been no express endorsement of the VIE structure either. Accordingly, the VIE structure has always been a gray area in the Chinese legal system. Although the VIE structure allows both domestic and foreign investors to circumvent government reviews and regulation, this also means that the VIE structure does not have the backing of the authorities and therefore possesses inherent defects and potential legal and regulatory risks.
I. Recent Alibaba Case
The risks and uncertainties facing VIE structures include: (a) the level of protection of the rights of beneficial owners in VIE arrangements being far lower than a direct equity interest in the Operating Company; (b) the potential conflicts of interest between the legal shareholders of the Operating Company and the beneficial owners; and (c) the uncertainty in whether VIE contractual arrangements are enforceable between the Controlling Company and the Operating Company in the event of a dispute.
The recent case of Alibaba, a 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 a VIE structure and the rationale for possible government intervention in the future.
Alibaba's structure is a typical VIE arrangement: Zhejiang Alibaba, a private company held by Ma Yun (Jack Ma), acted as an operating company 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 placed a spotlight on VIE arrangements and has been widely reported that the CSRC(2), 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 concern on the part of investors and has cast doubts as to the feasibility of the VIE structure going forward.
II. The Implication of the Report on the future of the VIE structure
There has always been a 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 the PRC; (a) it circumvents approval requirements by the Ministry of Commerce ("MOFCOM") in accordance with the M&A Rules, especially by offshore shell companies making round trip investments (i.e. where PRC national owned businesses and assets are owned by an offshore entity owned by PRC owners); and (c) it may constitute price transferring and consequently result in tax evasion in some cases.
The leaked report supposedly analyzes the legality of the VIE structure as well as the current status of PRC internet companies listed overseas by using the VIE structure. More importantly, the report recommends future overseas listings using a VIE structure should first obtain MOFCOM and CSRC approval. The leaked Report, is causing grave concerns for foreign and domestic investors alike as nothing has been officially confirmed. Furthermore, there is substantial uncertainty as to what (if any) 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 the CSRC, was created solely for an internal study. Therefore, it is not an official report submitted to the State Council and therefore the actual policy implications, if any, are unclear.
However, the investors should note that since the overseas listing of domestic companies by way of VIE structure has gradually been extended from traditional light industries to heavy industries involving material assets (such as infrastructure and natural resources) 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 clampdown 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.
III. 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 government's 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 constitute 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 structures under their supervision.
(This article was first published on XBMA.com)
1、 Rules on the Merger and Acquisition of Domestic Enterprises by Foreign Investors was promulgated on August 8, 2006, and was revised in 2009.
2、 China Securities Regulatory Commission.