On January 19, 2015, China’s Ministry of Commerce (MOFCOM) issued for comment a new draft foreign investment law that if implemented would be the most significant change to China’s foreign investment regime in at least the past 15 years and fundamentally alter the way foreign investors access some of China’s most compelling investment opportunities, including through overseas initial public offerings (IPOs) of many China-based technology companies. The draft law is open for comment until February 17, 2015.
If the proposals are implemented, the most broadly impacted group of investors would be the large number of foreign individuals and businesses who make direct investments in China each year since the changes would significantly reduce the role of Chinese government approvals in the foreign investment process in favour of a post-facto filing regime for the vast majority of cases. Blakes will provide a more detailed comment on these aspects of the proposal in the coming days.
Though the effect on these investors would be significant, the impact on foreign investment in restricted sectors in China could be more deeply felt. This is because the proposals would limit the use going forward of the variable interest entity (VIE), structure and similar arrangements that have been used in virtually all foreign investment in Chinese sectors in which foreign investment is now restricted or prohibited. That includes foreign investment in many of the China-based telecommunications, Internet and education businesses that are listed on overseas stock exchanges or accessed through foreign venture capital and private equity investments. It is an ongoing development worth following since many of China’s largest and most familiar names in the technology sector use a VIE structure.
Most Canadian investors have accessed investment opportunities in Chinese VIEs through portfolio investments in companies listed on non-Canadian (mainly U.S.) stock exchanges and through direct investment via private equity-style investments and mergers and acquisitions. The structure has not been widely used for Chinese listings on the Toronto Stock Exchange or the TSX Venture Exchange, though the Exchange has nonetheless weighed in on the issue. In its 2012 Consultation Paper on Emerging Market Issuers, it signalled a willingness to approve listings of VIEs as long as their use was supported by necessity, a legal opinion and adequate disclosure.
VIES’ PLACE IN THE CURRENT LANDSCAPE
Under China’s current foreign investment regime, the National Development and Reform Commission, China’s top economic planning agency, periodically issues a foreign investment catalogue that classifies foreign investments in various sectors as encouraged, restricted or prohibited. Foreign investment in sectors not appearing in the catalogue is permitted. Foreign investment is currently restricted in, among other sectors, telecommunications, Internet services and education.
In the past 15 years, VIEs have been used in hundreds of transactions in which Chinese businesses have structured around these restrictions when seeking foreign investors, whether through IPOs on non-mainland Chinese stock exchanges, private equity or venture capital investments, or through mergers and acquisitions.
Under a simplified version of the typical VIE structure, the Chinese founder of a China-based operating company establishes an offshore holding company—often in the Cayman Islands—into which foreign investors invest. However, since foreign-invested companies are restricted from operating in sectors like the Chinese Internet, the holding company does not directly invest in the onshore Chinese operating company. Instead, the holding company’s Chinese subsidiary enters into a series of contractual arrangements with the operating company (i.e. the VIE) designed to transfer the control and economic rights of the business to the offshore holding company while maintaining “legal” ownership in the hands of the China-based founder. More recently, the structure has been refined to ensure that as much of the economic value of the business as possible is in the hands of the holding company’s onshore Chinese subsidiary, rather than in the VIE, thereby reducing investors’ risk.
The structure works because, despite the absence of any ownership link between the offshore holding company and the VIE, U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards require that the VIE be consolidated with the results of the offshore holding company that does the overseas IPO or receives other foreign financing.
In addition to their use in response to foreign investment restrictions, VIEs have also been used for other structuring and Chinese regulatory purposes, even in industries where foreign investment or control is permitted.
The legal risks that come with investing in a VIE structure are well documented, most transparently in the public disclosure of the many U.S.-listed China-based companies that use the structure. Not least of these risks is the fundamental and relatively untested question of whether the contractual arrangements underpinning the VIE would be enforceable in the Chinese courts.
While acknowledging risks exist, thousands of investors—including many of the most sophisticated foreign investors active in China—have become accustomed to investing in these businesses through VIEs. Still, many have decided not to invest through the structure, though in our experience this has been the case less often among portfolio investors as among direct investors in China (e.g. through private equity- or VC-style investments, mergers and acquisitions, or greenfield investments).
The consensus among the many who have invested through the structure has been that the Chinese regulators would be unlikely to introduce a solution to the use of VIEs that would threaten the success that many Chinese companies have enjoyed through their overseas listings and access to earlier stage foreign financing opportunities. However, it has been equally clear that the Chinese regulators would be very likely to respond in some way to this structuring alternative. Any Chinese regulation would be in addition to recent suggestions by non-Chinese regulators like the TSX and the U.S. Securities and Exchange Commission that they are considering ways of regulating the use of VIEs.
In short, for many years the use of VIEs has been an issue calling out for a solution.
THE NEW PROPOSAL
The new proposal on VIEs can be seen as an attempt to achieve a measure of balance on the issue.
The proposal would introduce the concept of “control” into the analysis of whether a particular entity is or is not “foreign” for Chinese law purposes, including the application of foreign investment restrictions. The definition of control would include ownership of more than 50 per cent of the equity of an entity, the ability to otherwise exercise voting rights or the ability to appoint a majority of the entity’s board. Importantly, the definition would also extend for the first time to include control exercised by way of contractual arrangements, such as VIE structures.
On the one hand, this would prohibit the future use of VIE structures for non-Chinese controlled foreign investment in restricted sectors where foreign control is prohibited. Any such foreign investment into those sectors using a non-Chinese controlled VIE could be subject to a range of possible penalties, including asset divestitures, fines and even imprisonment for management of offending companies.
On the other hand, the proposal will offer a way of bringing into compliance a large proportion of existing foreign-invested VIE structures since many are controlled by their Chinese founders, whether by way of outright majority share ownership or through the use of multiple voting shares or other voting arrangements. The Chinese subsidiary of a Chinese-controlled overseas company may be treated as a Chinese investor under the new rules and the VIE would be allowed to continue in place. It may also be possible for these Chinese-controlled companies to collapse their VIE structures in exchange for direct equity ownership in the onshore operating entities, perhaps with the oversight of the Chinese regulators. Similarly, it is also possible that in the same way, the broad definition of control may be used to permit future investments in restricted sectors by foreign-incorporated companies that do not use a VIE structure, as long as they are controlled by Chinese investors.
These details require fleshing out, as does the level of scrutiny existing VIE structures will receive from Chinese regulators as they are either brought into compliance or otherwise forced to comply with the new rules. The regulator has said it is considering several alternatives on that issue.
Another aspect of the proposal that requires more detail is how companies that are non-compliant under the new rules will be handled, especially after the expiry of the proposed three-year transition period during which non-compliant VIEs will be required to change their corporate structures. Some of these companies are widely held, overseas-listed “Chinese” companies that, while lacking a Chinese controlling shareholder, were established offshore primarily to facilitate an IPO or other financing and not necessarily in response to foreign investment restrictions. It is difficult to imagine a circumstance in which a prominent overseas-listed Chinese company would be permitted to fail as a result of these changes. Fortunately, the regulators have a number of tools that would allow them to prevent severe consequences.
For example, the regulators may make use of the licensing authority under the proposed rules to effectively exempt certain companies from compliance with the strict application of the foreign investment restrictions. Similarly, as has been pointed out by other commentators, other regulatory developments may be used in tandem with the VIE regulation to offer another safety net to non-compliant Chinese companies. One example of this is the recently announced liberalization of foreign investment restrictions in the value-added telecommunications sector in the Shanghai Free Trade Zone.
This evolving story will continue to be watched by investors and other market participants both inside and outside of China during the many months the new proposals will take to make their way through the comment and legislative processes.
In the short- to medium-term, they may result in fewer new investment opportunities for foreign investors in the Chinese telecoms, Internet and education sectors, assuming foreign control in those sectors continues to be prohibited under Chinese law. However, since the proposal would remove much of the legal uncertainty surrounding VIEs, there will no doubt be many positive results, including more mergers and acquisitions opportunities and perhaps better valuations for the companies involved because of the elimination of regulatory uncertainty. Increases in strategic M&A may also be seen as non-compliant VIEs seek alternatives to forced restructurings or other consequences under the new rules. Finally, an increase in M&A may be further supported by a new willingness by the Chinese regulators to accept merger filings under China’s Anti-monopoly Law for mergers and acquisitions involving companies with a VIE structure.