The Variable Interest Entity (VIE) structure is often used to circumvent foreign ownership in restricted or prohibited industries or other requisite government approvals in  China and has been exceedingly popular among Chinese internet-based companies seeking a listing in  the US, such as Alibaba, Baidu and Tencent. For more information on VIEs, please see “Alibaba’s VIE  Structure: Does It Have a Place in Singapore?” published in the Stamford Law Chronicle Issue 34  which is accessible here.

For more than a decade, the Chinese government has largely turned a blind eye to VIEs’ extralegal  status, but this will change with the latest proposed sweeping changes to the foreign investment  regime in China.

CHINA’S NEW OPEN ECONOMIC SYSTEM

On 19 January 2015, the Ministry of Commerce of China (MOFCOM) released a draft version of the  Foreign Investment Law (FIL) for public comments. Under the proposed new rules, foreign investment  will no longer be differentiated by the form of organisation, such as Sino- foreign equity joint  venture (EJV), Sino-foreign cooperative  joint venture (CJV) and wholly foreign-owned enterprises  (WFOE), but will instead be assessed and regulated based on the actual control of the business  enterprise. Under the new framework where substance takes precedence over form, a Chinese  subsidiary controlled by foreign investors will be treated as a foreign investor and conversely, a  foreign company controlled by Chinese persons will be regarded as a Chinese investor.

The new regime will also adopt a ‘negative list’ approach in respect of foreign investment approval  similar to the model adopted for the Shanghai Pilot Free Trade Zone, where foreign investment  projects will no longer require pre-approval by MOFCOM unless it deals in industries that are  prescribed in the list, though foreign investments that could potentially damage national security  will be subject to a separate national security review regime regardless of industry sector. The  ‘negative list’ has yet to be published, but in view that China is currently negotiating bilateral  investment treaties with the US and the EU which reportedly will also have a ‘negative list’  structure, it is highly likely that the ‘negative lists’ in US, EU and China will be mutually  consistent.

The scope of the new rules expressly includes the regulation of control over Chinese entities by  way of contractual or trust arrangements (such as VIEs) and any offshore transaction that results  in actual control of a  Chinese company being transferred to foreign investors. For the investor community, the new rules will be a double-edged sword because foreign investments using VIEs to overcome restrictions on foreign shareholding could equally become legitimate or illegal, depending on whether ultimate control vests in Chinese persons.

THE KEY QUESTION – DEFINITION OF CONTROL

The big question then is how Chinese officials will define ‘control’. For now, the draft rules contemplate that a person will be deemed to ‘control’ a company if such person holds more than 50% of its equity or voting rights, has the power to appoint more than half of the board or equivalent bodies of the company, has the ability to exert significant influence on such bodies, or otherwise has the ability to exert significant influence over the company by contract, trust or other measures.

In VIEs where Chinese control is exerted solely through majority shareholding interest, an increase in the level of foreign investment could be fatal – a solution therefore might be to employ a dual-class structure like Alibaba, which concentrates the power of nomination of board members in the hands of a cabal of Chinese managers. While not expressly stated, the new rules imply that if existing VIEs are not ultimately controlled by Chinese persons, investors may be forced to unwind the VIE structure and divest the underlying Chinese companies. Much will depend on what sectors will be covered by the ‘negative list’, though foreign companies using VIEs to enable themselves to become players in China’s internet industry are likely to be in a very precarious position indeed.

TREATMENT OF EXISTING VIES

MOFCOM is currently contemplating 3 approaches to dealing with the vast inventory of VIEs that exist today: (1) to grandfather any existing VIE that files a record with MOFCOM to confirm that its actual controlling shareholders are Chinese persons; (2) to grandfather any existing VIE that obtains approval from MOFCOM confirming that its actual controlling shareholders are Chinese persons; or (3) MOFCOM to decide and approve on a case-by-case basis whether to grandfather any existing VIE upon its application. Foreign invested enterprises will have a 3-year transitional period to conform to the new regulatory regime.

Clearly, the first option will have the least effect on existing VIEs since it only requires a filing with MOFCOM, whereas the last option will have a debilitating effect on potential foreign investments if there is insufficient transparency in MOFCOM’s review process or uncertainty with respect to the approval criteria. MOFCOM will consider public comments in relation to these options and may present additional or amended proposals on the regulation of VIEs.

IMPACT ON SINGAPORE 

From the Singapore perspective, VIEs have long been viewed as legally risky since the contracts that form the cornerstone of the entire set-up are enforceable only if Chinese courts are willing to uphold them, which is questionable when the structure is built for the very purpose of circumventing Chinese government regulations in the first place. For that reason among others, the Singapore Stock Exchange has been relatively wary of VIEs and since 2006, new VIE entrants have been virtually non-existent in the Singapore market. 

If passed, the new rules will represent a major step in China’s efforts to rationalise its foreign investment regulatory regime in line with prevailing international best practices. The legitimisation of VIEs under Chinese law will certainly go a long way to allay investor fears and the problem of VIEs trading at a discount whenever some kind of scare regarding VIEs come up. Arguably, there may not even be any need for VIEs in future since Chinese companies could raise international financing directly through offshore vehicles provided that they are controlled by Chinese persons. 

Recent proposed changes to Singapore’s legal landscape would dovetail nicely with the control requirement for legitimisation of foreign investment in restricted industries in China. Starting from the second quarter of this year, a public company in Singapore will, subject to prescribed safeguards, be allowed to issue shares with differing voting rights, which is a structure that could be employed to facilitate Chinese control as required under China’s new foreign investment regime. With these new developments, the prospects for a Singapore listing of Chinese businesses in restricted industries may just be looking brighter again.