China’s draft Foreign Investment Law represents the first-ever effort by Chinese government to directly resolve VIE structures and their legitimacy.
The draft Foreign Investment Law was circulated by China’s Ministry of Commerce (MOFCOM) for public comment on 19 January 2015. We have summarized the various effects of the draft law in our recent Chinese investment e-bulletin titled “China plans to reshuffle foreign investment regulation”.
This article specifically discusses the impact of the draft Foreign Investment Law on VIE structures.
VIE structures were initially used to facilitate offshore listings and financings of Chinese companies, and to enable foreign investors to indirectly invest in restricted or prohibited sectors in China. The structure has since spread to sectors that were permitted or encouraged for foreign investment.
The primary risks of VIE structures are:
- Regulatory risk – foreign investors using a VIE structure to engage in restricted or prohibited sectors in China may be considered as circumventing Chinese law. If so considered, then the VIE structure will be considered invalid in China. So far, VIE structures used by foreign investors have been generally tolerated by the Chinese government, though there has never been much assurance that they will continue to be tolerated. The draft Foreign Investment Law indicates that the days of tolerance may have come to an end.
- Structural risk – contractual control over a PRC domestic operating company and its shareholders is not as secure as shareholder control. If the contracts are breached, then investors can lose control of the PRC domestic operating company.
As a matter of practice, listed companies that use VIE structures disclose these risks to the market. Legal opinions and reports on informal discussions between advisors and Chinese regulators regarding the likelihood of no-action being taken are included in listing prospectuses.
VIE-related provisions in the draft Foreign Investment Law:
- Definitions of “foreign investment” (article 15) and “control” (article 18) – “Foreign investment” is defined to explicitly include a foreign party using contracts or trusts to control or hold an interest in a PRC domestic company. “Control’’ exists if any of the following tests are met: (a) at least 50% equity ownership; (b) the right or actual ability to nominate at least half of the directors; (c) holding voting rights sufficient to exercise major influence over shareholders’ or directors’ decisions; or (d) decisive influence over operations, finances, human resources or technology through contract, trust or any other arrangement.
- Foreign investments controlled by Chinese investors (article 45) – A foreign investor that is actually controlled by Chinese investors may be granted Chinese-investor status for the purpose of investments in restricted activities or sectors.
- Penalties for bypassing foreign investment regulation (article 149)– Foreign investment using VIE structures would be subject to China’s foreign investment regulation. Specifically, use of VIE structures by foreign investors in prohibited sectors, or in restricted sectors without prior governmental approval, would be subject to orders to cease implementation of the foreign investment, dispose shares or other assets, confiscation of illegal gains, cancelation of approvals, and other penalties.
- Existing VIE structures (article 158) – The draft Foreign Investment Law does not provide a solution for existing VIE structures. Rather, the draft Foreign Investment Law only contains a placeholder for how existing VIE structures will be handled. Options that the government has flagged in an explanation are outlined below.
Issues for VIE structures:
- New VIE structures: Foreign investment vs. domestic investment
Foreign investors that are not controlled by Chinese investors will very likely need to stop setting up VIE structures to invest in restricted or prohibited sectors in China. Once the draft is officially made a law, VIE structures not controlled by Chinese investors will require market entry approval. Thus there will be no approval-related advantage for using a VIE structure. Accordingly, new VIE structures for foreign investors will fade and such arrangements will become less common.
Foreign investors controlled by Chinese investors may still use VIE structures in permitted and restricted sectors if the Chinese investors are able to prove their control over the foreign investor. Chinese investors in this situation may be exempt from market entry requirements (especially shareholding limitations). This would allow them to continue to take advantage of the greater flexibility afforded by foreign corporate law; for example, engaging in forms of financing that are difficult if not impossible under Chinese law.
- Existing VIE structures
The draft Foreign Investment Law does not provide a solution for existing VIE structures, perhaps because a hasty proposal might unsettle international capital markets and the legal community. MOFCOM has, however, raised three possible approaches in its explanations to the draft Foreign Investment Law. These are:
- filing with MOFCOM a declaration that an entity contractually controlled under a VIE structure is actually controlled by Chinese investors; this would preserve the existing VIE structure;
- applying for confirmation from MOFCOM that an entity contractually controlled under a VIE structure is actually controlled by Chinese investors; upon MOFCOM’s confirmation, the existing VIE structure could be preserved; or
- applying to MOFCOM for market entry approval; MOFCOM (working together with other relevant governmental authorities) will determine whether to grant such approval based on a variety of factors (including the identity of the actual controlling shareholder).
With respect to existing VIE structures controlled by Chinese investors, regardless of which approach the draft law will ultimately endorse, it is likely that Chinese investors will be allowed to keep the VIE structures and continue business (including in restricted and prohibited business that is allowed for domestic Chinese investors).
However, with respect to existing VIE structures controlled by foreign investors, it is likely that governmental approval will be required in order to continue with a VIE structure. This will in practice mean that foreign investors will no longer be able to maintain existing VIE structures in order to engage in unapproved restricted or prohibited business (e.g., internet culture activities or online video/audio activities, if such will still be prohibited or restricted).
MOFCOM has indicated that it will continue to reduce restrictions on foreign investment, including further opening up the education, finance, cultural and healthcare sectors. We can expect these changes to be included in the catalogue for special administrative measures, a new catalogue that is contemplated in the draft Foreign Investment Law. Sectors deemed sensitive will no doubt continue to be restricted or prohibited.
Last but not least, it is expected that the “grandfathering” of existing VIE structures will be possible in circumstances in which Chinese investors have historically controlled the VIE structures but have lost controlling status because of a public listing or offshore financing. These may well be decided on a case-by-case basis.
- Who has control?
Determining who has “control” requires a fact-based analysis. In practice, we expect that the Chinese government will take a substance over form approach. However, questions remain regarding the criteria for determining whether a Chinese investor ultimately holds control under the draft Foreign Investment Law.
It will often be clear who has control in an initial VIE structure set up by Chinese investors. However, with successive rounds of financings from foreign investors and a possible listing, Chinese control will be diluted. Control may also be further diluted through the grant of preferred rights (including veto rights and nomination of directors) over the key matters of the group (including the wholly foreign-owned enterprise used for control purposes and PRC domestic operating company), or in a public listing. In such situations, who has actual control could be difficult to determine.
Another situation in which difficulties will arise is if Chinese investors and foreign investors both satisfy the “control” test. This may happen, for instance, if the Chinese investors hold a majority of shares and, at the same time, foreign investors are deemed to have a decisive influence due to their preferred shareholder rights. These issues will need to be clarified before effective implementation of the law.
In order to maintain the existing VIE structure, foreign investors who have partnered offshore with Chinese investors should be prepared for requests from the Chinese investors for control over the offshore entities. Such requests, although appearing reasonable, might be opportunistically pursued by Chinese investors. Foreign investors should consider alternative mechanisms to protect their interests.
Given the importance of VIE structures, particularly for foreign-listed companies, the Chinese government appears willing to recognize VIE structures in a more regulated environment. For the moment, however, there remain significant questions and uncertainties.
The draft Foreign Investment Law will undergo revisions and further legislative procedures before being issued as law. While it remains possible that the final version of the law will be very different from the draft, the trend toward regulating the VIE structure will likely continue. Accordingly, foreign investors that employ VIE structures are recommended to prepare to reshape their business in China. This will almost certainly involve pulling out of prohibited sectors, and seeking due approval in restricted sectors. In some instances, it may make sense to give a Chinese party control over the investment.
The deadline for public comment on the draft Foreign Investment Law is 17 February 2015. We are preparing comments for submission to MOFCOM, and we would be delighted to hear from you if you have comments that you wish to make.