Executive Summary/Highlights:

• Reuters reported on Sept. 18, 2011 that CSRC, the Chinese securities market regulatory watchdog, submitted a report urging the State Council to “clamp down” on  the VIE structures employed in thousands of investments by foreigners into domestic Chinese companies.
• The VIE structure was adopted to gain access to the sectors where China had not yet opened to foreign investors.
• If the PRC government decides to take action against the structure, it would be a huge blow to both the overseas IPOs of Chinese companies as well as private investment (both industrial and private equity) by foreign companies into Chinese companies.
• Since the story on the CSRC Report, many Chinese law firms have become very cautious or even reluctant to issue previously standard opinions on the validity of VIEs.

MAIN ARTICLE

The Challenges

Reuters reported on Sept. 18, 2011 that China Securities Regulatory Commission (“CSRC”), the Chinese securities market regulatory watchdog, submitted a report (“CSRC Report”) to the State Council (the cabinet of Chinese national government), urging the State Council, through the Ministry of Commerce of the PRC (“MofCom”),  to “clamp down” on the VIE structures “used by companies such as Sina (SINA.O) and Baidu (BIDU.O) to list overseas, and employed in thousands of other investments by foreigners into domestic Chinese companies.”[1]  CSRC has not confirmed this report.  MofCom spokesman did report on Sept. 20, 2011 that they are in discussion with other authorities on how to regulate VIE.[2]

This was at least the third incident this year where the VIE structure was questioned.  If the PRC government decides to take action against the structure, it would be a huge blow to both the overseas IPOs of Chinese companies as well as private investment (both industrial and private equity) by foreign companies into Chinese companies.

Concept

VIE, or variable interest entities, is “a term used by the United States Financial Accounting Standards Board in FIN 46 to refer to an entity (the investee) in which the investor holds a controlling interest that is not based on the majority of voting rights.”[3]  It is accomplished, in the context of Chinese regulatory framework, by setting up Chinese domestic companies (“Domestic Companies”) by nominee shareholders controlled by ultimate shareholders.  The nominee shareholders are usually Chinese nationals, and therefore are not subject to the market access restrictions to foreigners.  The ultimate shareholders also set up one or several special purpose entities (“SPV”), often offshore, to own a wholly owned subsidiary in China (a “WFOE”).  The nominee shareholders will borrow from the SPV or the WFOE, and pledge the shares of the Domestic Companies to the SPV or the WFOE.  The WFOE also enters into a series agreement to get all the financial benefit from operations of the Domestic Companies.  As the result, the SPV may consolidate the balance sheet of the Domestic Companies as if they were part of the SPV.  Chinaaccountingblog.com has a very good article explaining how it works. [4]

The VIE structure was adopted to gain access to the sectors where China had not yet opened to foreign investors.  Because the foreign investors contractually control and benefit from operation of the Chinese Domestic Companies, they effectively have bypassed the regulatory hurdles to these restricted markets.  Recently, the structure has been used to bypass the regulatory requirement for foreign investors to acquire Chinese companies.

Incidents

The VIE has always been controversial.  Because the effect has been for the foreign investors to penetrate the Chinese market otherwise inaccessible, the government’s effort to counter the use of VIE structure may be traced back as early as in 2006, when the Ministry of Information Industry (“MII”) requested all the telecommunication companies (the Domestic Companies) to own their own domain name, trademark, and servers etc.  Nevertheless, throughout the years, the VIE structure has become more popular (while more sophisticated), and has applied in more varieties of industry from TMT to education.

The recent incident was Buddha Steel case, reported in April 2011.  It was a typical VIE structure, but used for the first time in the iron and steel industry.  According to the media, Hebei Province (a Northern Province of China) government advised the operating company that the VIE agreements “contravene current Chinese management policies related to foreign-invested enterprises and are against public policy.”  The VIE was unwind.  Buddha Steel requested that its S-1 filing with the SEC be withdrawn.[5]

In May 2011, Jack Ma, the founder of Alibaba, transferred the Alipay (the PayPal equivalent in China) from Alibaba Group, a company whose major shareholders include Yahoo!, Softbank, and Jack Ma, to Zhejiang Alibaba, a company controlled by Jack.  While the details of the transfer still remain as a mystery, according to media, People’s  Bank of China would refuse to grant a third party payment license, which is essential for Alipay to run payment business, to any company contractually controlled by foreigners.[6]

On August 25, MofCom issued the Rules on the Implementation of the National Security Review Mechanisms (the “New SR Implementation Rules”).[7]  Under Art.9 of the New SR Implementation Rules, MofCom, for the first time in its regulatory history, highlights that it would look at the substance through forms for national security review.  For that purpose, MofCom would include contractual control, i.e., VIE etc., as acquisition.

Outlook

There have been standard disclaimers in VIE opinions issued by Chinese law firms.  Basically, the opinion would say that each contract (being part of the VIE structure) is legal and binding to their respective terms, but lawyers do not guarantee the government would not challenge the substance if looking at the structure as a whole.  The disclaimer had been relaxed by many Chinese law firms, until recently.  Since the CSRC Report, yet confirmed, many law firms have become very cautious or even reluctant to issue opinion on this issue.

There has always been risk associated with VIE structures.  However, with the New SR Implementation Rules, it has become relatively clear that there is a national security checkpoint in the regulations concerning buying Chinese interests.  The VIE structure is not likely to pass this checkpoint now, even if it would have in the old days.  Nevertheless, it may be too early to conclude VIE would not work at all for other conventional purposes.