Analysis of the VIE model from a legal perspective

By Zhang Biwang, AllBright Law Offices
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The term “VIE (variable interest entity) model”, often referred to as the “agreement control model” in China, in offshore listings means that a listed entity registered abroad is separate from a domestic business operating entity but the domestic business entity is controlled by the offshore listed entity by way of agreements. The business entity is the VIE of the listed entity.

张必望 ZHANG BIWANG 锦天城律师事务所 合伙人 Partner AllBright Law Offices
张必望
ZHANG BIWANG
锦天城律师事务所
合伙人
Partner
AllBright Law Offices

The essence of the VIE model is that, despite the absence of an equity relationship between the listed entity and the business operating entity, the listed entity and the business operating entity that is actually controlled by it can be consolidated due to the series of agreements between them. Because the VIE model was originated by Sina, it is also known as the “Sina model”.

According to incomplete statistics, among the Chinese enterprises listed on the three major US stock exchanges (the New York Stock Exchange, NASDAQ and the American Stock Exchange), 42% of them have adopted the agreement control model. Internet enterprises have secured foreign capital through the VIE model, thereby promoting the development of domestic internet enterprises. It could be said that were it not for VIE, a bunch of outstanding internet enterprises would have been very unlikely to appear in China. However, on the other hand, the debate on the VIE model continues to rage.

Legally speaking, the VIE model is in essence to control a company by way of agreements rather than through the control of equity. As the origin of the application of the VIE model in China is actually found in the wish to circumvent restrictions on foreign investment in certain industries, it has the feature of being intrinsically flawed. On the one hand, a VIE agreement poses the legal risk of being found to be an invalid agreement, with the potential of being deemed to be a legal form covering for an illegal objective, to harm the public interest or to violate mandatory provisions of laws or administrative regulations. This also greatly enhances the actual controller’s exposure to moral hazard. On the other hand, government authorities may tighten oversight over the operating licences of operating entities (canceling administrative permissions or increasing the review conditions for such administrative permissions), thereby substantively negating the VIE model directly from a business operation perspective.

At the end of 2016, the Supreme People’s Court published its final judgment in Changsha Yaxing Real Estate Development vs. Beijing Ambow Shida Education Technology (the Ambow case). As this case is, to a certain extent, a systematic examination of the VIE model, it has been called the “first VIE case”. At one time, it was rumored in the market that the court upheld the legality of the VIE structure in the case.

Both the Hainan Provincial Higher People’s Court and the Supreme People’s Court held that the cooperation framework agreement in the case was lawful and valid, and reiterated that the Catalogue for Guiding Foreign Investment in Industries, and the Ministry of Commerce’s Provisions on Implementing Security Reviews for Foreign Investors’ Acquisition of Domestic Enterprises, were ministerial level rules and regulations, and therefore could not serve as the basis for determining the validity of a contract. However, the courts held that the relevant VIE agreements did not fall within the scope of review in the case and did not express any opinion on the validity of the VIE agreements.

With regard to the basis for evaluating the validity of a VIE agreement, not only are there such ministerial level rules and regulations as the Catalogue for Guiding Foreign Investment in Industries, there are also such laws as the Law on Sino-Foreign Equity Joint Ventures, the Law on Sino-Foreign Cooperative Joint Ventures, the Law on Wholly Foreign-Owned Enterprises. Accordingly, the risk of a VIE agreement being found to be an invalid agreement remains. Furthermore, the Supreme People’s Court expressly pointed out in the Ambow Case, “the possible entry of a foreign investor into the compulsory education sector in a disguised manner, and its involvement in the management of the school through control of the founder of the school, should be regulated and, through administrative law enforcement, penalties should be imposed for violation of the law”. In this respect, it issued a judicial recommendation to the Ministry of Education.

What then are the prospects for the VIE model? In fact, entrepreneurs need not worry too much and should, at the macro level, clearly understand the trend in strengthened government oversight of the VIE model. As for the government, it either needs to abolish provisions that restrict foreign investors or resolutely plug up the holes in VIE. As the outcome of the state’s thinking on foreign investment, including the VIE model, the Draft Law on Foreign Investment addresses the VIE model directly, facing the concept of “actual controller” head on.

If one clearly recognizes the current situation, it is not difficult to arrive at conclusions. Firstly, stop with the delusions, gambling that the government will continue to look the other way and the VIE model can still be used to circumvent the restrictions on foreign investment in laws and regulations. Secondly, there is also no need to worry about the sky falling in, as the three methods mentioned in the Draft Law on Foreign Investment leave those enterprises that have used the VIE model and whose actual controller is a Chinese investor room for manoeuvre. Enterprises whose actual controller is a Chinese investor need not necessarily dismantle their VIE structures.

Thirdly, attention needs to be given to the negative list for access by foreign investors. For example, against the background of the relaxation of the restrictions on foreign investment in online data processing and e-commerce business in the Shanghai Free Trade Zone, there is absolutely no need to bring up the VIE model. Lastly, at the technical level, an enterprise may additionally resolve its difficulties by such means as spinning off the business, dismantling the VIE or using VIE while maintaining actual control.

In the end, the VIE model may only be a transient guest. Someone once said: “What we really need to get rid of is not VIE itself, but the cause that gave rise to VIE.” Fortunately, this time, the Chinese government, as represented by the Ministry of Commerce, is on the right track.

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