For more than a decade, variable interest entities (or “VIEs”) have been used as a vehicle to facilitate foreign participation in Chinese industries subject to restrictions on foreign investment. The structure has become commonplace and is used by many of China’s best-know offshore-listed companies. The enforceability of VIE arrangements, however, has been a sensitive subject, and there has been an aversion to testing the structure in court. Not the least, the VIE structure raises a potential public policy issue: if the VIE facilitates foreign participation in an industry that is explicitly restricted to foreign investors under the Industry Guideline Catalogue for Foreign Investment (the “Catalogue”) issued by the Ministry of Commerce (“MOFCOM”), should the contracts governing the structure be deemed void? The defendant in a recent case Yaxing v. Ambow was a VIE in the education industry. Although the Supreme People’s Court skirted the question of the ultimate enforceability of VIE arrangements, some interesting and thought-provoking arguments emerged from the Court rulings.
I. The Case: Yaxing v. Ambow
Changsha Yaxing Property Development Company Limited (“Changsha Yaxing” or “plaintiff”) sued Beijing Shida Ambow Education Technology Co., Ltd. (“Beijing Ambow”) to unwind its sale of two elementary and middle schools to Beijing Ambow consummated in 2009 (the “Transaction”), claiming that the underlying framework agreement should be invalidated because, immediately after consummation of the sale transaction, the two schools were controlled by Ambow Education Holding Ltd. (“Ambow Education”), a foreign company, through a VIE in violation of the Catalogue.
The case was brought before the Hunan Higher People’s Court, which ruled in favor of the defendant Ambow, and was appealed to the Supreme People’s Court, which upheld the original judgment.
II. Key Takeaways
Whether a VIE constitutes a foreign invested enterprise (“FIE”).
Both Courts determined that, under the current legislative regime, whether an entity is a foreign invested entity is to be determined by the identity of its shareholders registered with the State Administration for Industry and Commerce. The fact that the shareholders in a domestic entity may have granted voting proxies and transferred economic interest in such domestic entity to a foreign invested entity should not result in such entity being characterized as an FIE regardless of being associated with foreign investment. In effect, the Courts ruled that a VIE should be treated as a domestic entity notwithstanding foreign control.
Whether violation of the Catalogue and the National Security Rules can be the basis for invalidation of an otherwise binding contract.
Concerns around VIEs largely derive from their use to ostensibly circumvent the Catalogue and the National Security Rules. The Supreme People’s Court ruled that violation of the Catalogue and the National Security Rules cannot be the sole basis to invalidate an otherwise binding contract because neither of them rise to the status of a law or administrative regulation. A further argument could be logically drawn from this reasoning, although the Supreme People’s Court did not explicitly reach such conclusion: the standard suite of VIE contracts should not be subject to invalidation solely for violation of the Catalogue or the National Security Rules.
Whether Ambow’s VIE arrangement endangers national security in the education industry.
The Hunan Higher People’s Court found lack of evidence to support the plaintiff’s argument that Ambow’s VIE arrangement rose to the level of endangering national security. Grant of voting proxies and the transfer of economic interests of the two schools were not deemed to be sufficient evidence that foreign parties had any control over the curriculum of the schools.
The Supreme People’s Court, however, dodged this question by asserting that this specific issue was outside of the scope of the case and deferred to the judgment of the Ministry of Education. From the outset, since both schools held valid administrative permits issued by the Ministry of Education for their operations, and there was no evidence indicating either the Ministry of Education or MOFCOM considered the Transaction in violation of the relevant administrative rules, the Supreme People’s Court could not find sufficient grounds to declare the Transaction in violation of national security norms.
Whether Ambow’s VIE arrangement violates Sino-foreign Cooperative School Regulations.
The Sino-foreign Cooperative School Regulations prohibit Sino-foreign cooperative schools from offering elementary and middle-school compulsory education. The Supreme People’s Court deferred to the position of the Ministry of Education, which replied to the Court that the two underlying schools should constitute domestic schools, not Sino-foreign cooperative schools, because their owners of record were PRC citizens, and therefore, concluded that the Sino-foreign Cooperative School Regulations simply did not apply to this case in the first place, let alone any potential violation of such regulations. Given that relevant administrative rules regulating the education industry – and for most industries generally – do not specifically address schools with VIE arrangements, this implies that none of these rules explicitly prohibit foreign involvement through VIE arrangements in such industries.
III. Further Implications in Terms of VIE Structures
Enforceability of VIE structure continues to remain uncertain.
The Supreme People’s Court explicitly did not review the enforceability of the VIE arrangements between Beijing Ambow and Ambow Education in this case and refrained from giving any opinion on the enforceability of such arrangements. The court’s deferral to the Ministry of Education may signal its position that the legitimacy of VIE structures in specific industries should be determined by the relevant government authorities in charge of such industries (the “Industry Authorities”). This seems consistent with current market practice where red-chip companies with VIE structures typically hold informal sessions with relevant Industry Authorities to discuss their views before an offshore listing.
Continuing questions around VIE structures.
Over the years, certain Industry Authorities and other governmental authorities have indicated their negative views about the VIE structure.
- Anti-trust. From an anti-trust perspective, MOFCOM has deemed “exerting a decisive influence on other business operators by contract” to be one of the various forms of concentration, equivalent to acquisition of controlling stake, and therefore subject to anti-trust review if relevant thresholds are met. At the same time, MOFCOM has refused to accept anti-trust filings involving VIE companies, apparently on the premise that this would be a de facto approval of the VIE structure.
- Online Games. The General Administration of Press and Publication specifically prohibits foreign parties from controlling any online game business in China through contractual arrangements.
- Telecoms. The Ministry of Information Industries strives to eliminate ”disguised” foreign participation in the operation of telecommunications businesses.
- Steel. The offshore listing of a cold-rolled steel business in Hebei through Buddha Steel, Inc. was called off as a result of local Hebei government advising that such VIE arrangements were against public policy. The Buddha Steel case, however, was arguably one of a kind, and its implications are largely considered to be limited to the steel industry.
The “control” element in the Draft Foreign Direct Investment Law, if adopted, may supersede this case.
The draft Foreign Direct Investment Law, circulated in January 2015 for comment, indicated that domestic enterprises “controlled” by foreign investors should be regarded as foreign-invested enterprises subject to foreign investment restrictions. It further defined “control” to include holding rights and interests in a domestic enterprise by contract, trust or other means. This “control” concept was clearly intended to sweep up VIE arrangements, and if adopted, will mean that Beijing Ambow should be treated as an FIE (which would also bring it under the Catalogue). The impact of the proposed direction of the draft Foreign Investment Law would be substantial and it would render elements of the Ambow case moot. Inasmuch, it has been the subject of much debate.