Are variable interest entity (VIE) structures still viable as an investment structure in China?
VIE structures became an investment structure for the PRC in the late 1990s with the US listing of Sina. But since the fall of 2011, with the Ministry of Commerce (MOFCOM) issuing regulations on national security review procedures and unsubstantiated talk of a China Securities Regulatory Commission (CSRC) internal report calling for a crackdown on VIE structures, there has been uncertainty in the China legal and investment market as to their continued viability.
Many US technology companies – particularly online and Internet companies – are already familiar with VIE structures, which channel investment into Chinese businesses that are restricted or even prohibited from receiving foreign investment. Chinese entrepreneurs have often used them to raise offshore financing from foreign investors, because they offer foreign investors a tried and true way to exit their investments through trade sales or initial public offerings on exchanges outside China (without Chinese regulatory approvals in most instances). VIE structures are also popular with PRC founders, as start-up companies in China have traditionally been unable to raise substantial financing from onshore investors and exit through A-share listings, because companies listing domestically must meet requirements (such as prior profits) that start-ups probably cannot meet.
This article will not discuss VIEs in detail, but typically the holding company or the technical services wholly foreign-owned enterprise (WFOE) loans funds to PRC individuals (domestic shareholders) who in turn set up a PRC entity. In return for the loans and/or guarantees of full performance of various contractual arrangements, the PRC individuals pledge their shares in the PRC entity to the technical services WFOE and grant options to the holding company and/or the technical services WFOE to transfer their shareholding in the PRC entity to any designee at any time, or alternatively to convert the PRC entity into a foreign-owned entity when PRC laws and regulations permit.
The technical services WFOE also enters into a series of service agreements with the PRC entity where income of the PRC entity is moved into the WFOE and control over the PRC entity’s operations is granted to the WFOE.
PRC regulatory developments have made VIE structures more prevalent. MOFCOM’s 2006 M&A regulations require ministry approval of reverse investment structures where Chinese individuals set up offshore holding companies to acquire businesses in China. Before the 2006 M&A regulations, PRC individuals could easily inject their onshore businesses into offshore holding vehicles, which could be used for further financing, trade sales or initial public offerings (as they could be sold or listed without PRC government approval or visibility).
Ironically, the 2006 M&A regulations increased the use of VIE structures for China exits. It was simply not possible in practice to procure MOFCOM approval to inject onshore assets into offshore holding vehicles. So investors and investment banks opted for the VIE “contractual control” structure, where the offshore holding company holds no equity in the key PRC entity holding the required regulatory licences to operate the business, and VIE structures spread from their original uses in new economy businesses, like e-commerce, to many other industries such as education, pharmaceutical distribution and even heavy industry.
As the use of VIE structures increased, MOFCOM elaborated a merger control regime with a national security review of China acquisitions (including acquisitions of offshore companies with China assets and turnover). In 2011, State Council Circular 6 and MOFCOM’s implementing regulations set out specific procedures for the national security review, somewhat similar to the CFIUS review regime in the US. The August 2011 implementing regulations for the first time contained specific anti-avoidance language: whether a transaction is subject to national security review will depend on the transaction’s actual content and impact, and foreign investors must not avoid review by structuring transactions as “nominee holdings, trusts, multiple levels of re-investment, leases, loans, agreements granting control, offshore transactions, and other forms”.
This increases complexity and uncertainty for foreign investors acquiring or holding China businesses through a VIE structure. Foreign investors already invested in VIEs may face this review if they increase their shareholding. MOFCOM has not issued an official “blacklist” of sensitive industries – although some local commerce authorities did publish a list online – so investors and their advisers are left trying to assess whether an M&A transaction should apply for national security review.
Wait and see
Most investors seem to be taking a wait-and-see approach and have not actively sought national security reviews of their transactions. Besides this uncertainty over M&A approval, some speculate that this regulation suggests that MOFCOM will eventually crack down on VIE structures.
Concern increased when a research paper – purportedly a CSRC report to the State Council, but possibly just a trial balloon floated by PRC government personnel – advising a crackdown on VIE structures was published online last autumn. The report sees foreign participation in Chinese businesses via VIE structures as illegally circumventing PRC foreign investment regulations and potentially threatening national security (as foreign investors effectively control crown jewels of the PRC Internet market, threatening network security). The report recommends that the CSRC and MOFCOM vet future VIE listings on overseas securities exchanges, and advises other governmental departments not to accept or confirm these VIE structures.
Regardless of its veracity, this CSRC internal report should give pause to companies considering using VIE structures in China investments, greenfield or acquisitions. Even before last autumn, VIEs were not risk-free.
Although there is still no specific Chinese law or regulation clearly stating that using VIE structures to circumvent PRC foreign investment restrictions is illegal – as there is in some jurisdictions – they are at least arguably contrary to existing PRC rules.
In the mid-1990s, PRC regulators forced the termination of 20 joint ventures by foreign companies using a form of VIE to invest in China Unicom’s telecommunications infrastructure and services in China.
If Chinese regulators have not unwound other VIE structures since, it is not for lack of a legal basis to do so, but rather because, at least until recently, the government apparently did not consider foreign investment in e-commerce and online or other service-oriented businesses excessively sensitive or contrary to the interests of state-sponsored champions in key businesses like financial services, telecoms and other key industries.
The fear generated by the MOFCOM regulation and supposed CSRC internal report has died down, although there are continued rumours of possible government regulatory action (e.g. requiring disclosure/approval of VIEs). But it may be hard to craft a workable policy. It would be difficult to differentiate between VIE structures set up by Chinese individuals (the Ma Yuns and Robin Lis of this world) and those set up by foreign technology companies, and any attempt to exempt Chinese founders from regulation would lead to a huge outcry from US and European business interests.
Disclosure or approval requirements may hurt the Chinese economy by increasing delay and uncertainty for Chinese companies listing overseas at a time when onshore financing and exits are still very difficult for start-ups in China. Various regulatory agencies – like the CSRC, MOFCOM and the State Administration of Foreign Exchange) have widely divergent views, so reaching consensus will take time.
For now, there still seems to be a place for VIEs as an option for companies considering PRC investments. While acquisitions of VIE structures potentially face a MOFCOM national security review, investors are still using them in greenfield investments. But given the new uncertainties, companies need to examine direct acquisition or purely onshore investment structures more carefully before opting for the ease of a VIE.
One key to assessing the viability of a VIE is the associated industry-sector risks: certain industries and sectors are less sensitive than others, and investment in new economy sectors and businesses through VIEs is likely to be less risky than their use in more sensitive sectors like heavy industry.
Another factor is the relationship with the PRC shareholders (or founders in some cases). VIE structures with very active PRC shareholders or founders could be more at risk, because it is unclear whether Chinese courts will enforce VIE agreements in cases of major conflict (e.g. over control) between such foreign investors and the PRC shareholders.