In 2013, three high-profiled internet companies, Wisdom Group, Forgame Holding Limited and Boyya Interactive (Hong Kong) Limited, have successively completed their initial public offerings ("IPO") at the main board of the Hong Kong Stock Exchange, following which, in 2014 two leading PRC e-commerce giants, Jingdong Group (f.k.a. 360buy.com Group) and Alibaba Group have officially filed their  initial public offering prospectus with the U.S.  Securities and Exchange Commission. One thing in common about the above-mentioned issuers is that they have all adopted a VIE structure. The VIE structure has thus again attracted much attention from both practitioners and researchers.

A VIE (variable interest entity) structure, commonly known as a "Sina structure" by virtue of Sina's successful listing in the United States which firstly adopted the concept of VIE, is also often regarded as a "captive structure"  or  a "contractual arrangement". Under an VIE arrangement, the de facto controller (the "Founder") over a domestic operating entity (the "Domestic Company") usually establishes certain offshore entities which further sets up a wholly foreign owned enterprise onshore (the "WFOE") and the WFOE controls the Domestic Company by entering into a series of exclusive agreements with the Domestic Company and the Founder, through which most revenues and profits of the Domestic Company will flow up to the offshore entity and the controlling power of the Founder over the Domestic Company should also be delegated to the WFOE. In this way the accounting statements of the Domestic Company may be consolidated into that of the offshore entity. The Domestic Company becomes the VIEs (variable interest entity) of the offshore entity in this regard.

The foundation and establishment of the VIE structure may be achieved through the following five steps: Step 1 -- The Founder establishes an offshore Company A; Step 2 -- Company A (usually jointly with VC/PE investors) establish a Cayman company as a future offshore listing entity in the Cayman Islands; Step 3 -- The offshore listing entity establishes a wholly-owned Company B in Hong Kong; Step 4 -- Company B establishes a WFOE in mainland China; Step 5 -- WFOE enters into a series of captive agreements with the Domestic Company and the Founder so as to achieve the purpose of full de facto control over the Domestic Company. The VIE structure, as shown below, will be essentially established upon the completion of the above five steps.

Click here to view the diagram.

As a widely used structure for foreign investors to enter into relevant domestic industries in China whereby foreign investment is prohibited or restricted, also as a common approach for Chinese originated enterprises going listed overseas through the so-called red-chip re-organization, VIE structure has come into being, developed and become very popular in China (particularly in e-commerce sector). The most important reasons for its popularity are mainly following: For one thing, VIE structure might help to circumvent the so-called affiliated parties acquisition as defined under the Provisions on Merger and Acquisition of Domestic Enterprises by Foreign Investors promulgated by Ministry of  Commerce (amended in 2009) (Circular 10)[1]. According to Circular 10, affiliated parties acquisitions are subject to review and approval by the Ministry of Commerce at the central governmental level, which approval is extremely difficult if not impossible to obtain. Given that affiliated parties acquisition is to some extent inevitable for red-chipping re-organization, such re-organization becomes extremely difficult after implementation of the Circular 10. Accordingly, the VIE structure, which may enable the offshore listing entity to achieve the de facto control over the domestic operating entity via contractual arrangements rather than via affiliated parties acquisition and thus circumvent the review and approval for acquisition amongst affiliating parties, becomes a viable option to many potential red-chip issuers. For the same reason, the VIE structure may also help to circumvent the foreign investment industry restriction under  the  Catalogue  of Industries for Guiding Foreign Investment. For another, VIE structure enables the accounting statement of a domestic operating entity to be consolidated into that of an offshore listing entity. By way of VIE structure, the offshore listing entity is purely a shell company established for purpose of financing or listing without actual assets or business operation, in this regard, whether the profit and loss of the domestic operating entity can be consolidated into the shell company becomes a critical step for overseas listing. According to the provisions of FIN46 stipulated by US Financial Accounting Standards Board ("FASB"), the "primary beneficiary" who bears the main risks and enjoys the main profits of the VIE shall consolidate the assets of the VIE into its own financial statements to be disclosed as balance-sheet assets. Pursuant to such provision, although there is no direct or indirect equity relationship between the offshore listing entity and the domestic operating entity, the offshore listing entity is able to legitimately consolidate the accounting statements of the domestic operating entity into its own, which thereby meets the financial standards of going public in aboard and achieves flotation.

Though VIE structure may help to circumvent the above-mentioned regulations, in practice, VIE structure is commonly used for companies engaged in restricted or prohibited industries only. According to the Listing Decision of Hong Kong Stock Exchange HKEx-LD43-3 (HKEx-LD43-3) (2012 Revision), Hong Kong Stock Exchange clearly holds that VIE structure will not cause the listing to be inappropriate. It will continue, provided that the relevant requirements of listing decision are satisfied, to accept VIE structure on a case-by-case basis by taking into consideration of the rationale for adopting VIE structure. However, in the meanwhile, it has been emphasized that it will reject those enterprises engaged in permitted or encouraged foreign investment industries adopting VIE structure for listing. With this position, Hong Kong Stock Exchange requires the issuer adopting the VIE structure that intends to go public in Hong Kong to firstly make an explanation about whether its business falls within the restricted or prohibited industry. For example, Forgame Holding Limited specifically disclosed in the chapter of Contractual Arrangements - Background and emphasized again in the chapter of Risk Factors that "Pursuant to Provisions on the Administration of Foreign-invested Telecommunication Enterprises, the ownership of foreign investor(s) to a company who engaged in value-added telecommunication business (including web games and mobile game operation) shall not exceed 50%".

Logically speaking, overseas listing regulatory authorities will be more willing to observe and respect the foreign investment approval from Chinese government by way of anti-monopoly review and national security review, which are more transparent and specific than the traditional foreign investment regulations based on an ambiguous Catalogue for the Guidance of Foreign Investment Industries and are more reasonable and in line with procedural justice and the spirit of the rule of law. In the event that the VIE structure is like to breach the aforesaid anti-monopoly and security review requirement, the overseas listing authorities would probably take a more prudent and conservative position in granting exemption of such violation. In fact, no reputable PRC law firms have ever issued a clean  legal opinion  without reservation to endorse a VIE structure which might trigger the anti-monopoly review or national security review.

As the Chinese government has not promulgated any law or regulations to endorse or deny the legality of VIE structure yet and the regulation over the VIE structure is continuously strengthening, the inherent risks associated with the VIE structure are getting imminent. In this respect, all companies that apply for overseas listing adopting a VIE structure have highlighted the risks of VIE structure (Contractual Arrangements) in the chapter of Risk Factor in their respective listing prospectus.

For instance, Alibaba explicitly pointed out in its prospectus, that: "If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations"; "Although the structure we have adopted is consistent with longstanding industry practice, and is commonly adopted by comparable companies in China, the PRC government may deem that these arrangements are not complying with PRC licensing, registration or other regulatory requirements, or inconsistent with policies or requirements that may be adopted in the future"; And, "It is uncertain whether any new PRC laws, rules or regulations relating to variable interest entity structures will be adopted or if adopted, what they would provide. If we or any of our variable interest entities are found to be in violation of any existing or future PRC laws, rules or regulations, or fail to obtain or maintain any of the required permits or approvals, the relevant PRC regulatory authorities would have broad discretion to take action in dealing with such violations or failures, including revoking the business and operating licenses of our PRC subsidiaries or the variable interest entities, requiring us to discontinue or restrict our operations, restricting our right to collect revenue, blocking one or more of our websites, requiring us to restructure our operations or taking other regulatory or enforcement actions against us."

Furthermore, because the overseas listing entity does not have direct equity interest in the operating entity under a VIE structure and it could only rely on the proper performance of the controlling agreements signed with the operating entity and its shareholders so as to control the operations and take over the profits of  the operating entity, the financial performance of the overseas listing entity may be seriously negatively affected in case of breach of contracts by the operating entity or its shareholders. Therefore, Alibaba states explicitly in its prospectus that "our contractual arrangements may not be as effective in providing control over the variable interest entities as direct ownership". Such risk has been demonstrated in the Alipay event in 2011. According to the statement submitted to SEC by Yahoo in May 2011, "on March 31, 2011, Yahoo and Softbank were notified by Alibaba Group of the transfer of ownership of Alipay without the knowledge or approval by the Alibaba Group board of directors or shareholders".

The two corner stones for a successful IPO adoption a VIE structure are: firstly, the financial of the operating entity can be consolidated into that of the overseas listing entity, and secondly, the issuer shall obtain a clean legal opinion without significant reservations issued by a reputable PRC law firm. Taking Alibaba for example, its PRC counsel, Fangda Partners, has issued the legal opinion which commented on Alibaba's VIE structure as follows:

  1. The ownership structures of the variable interest entities do not violate any applicable PRC law, regulation or rule.

To exclude and minimize Fangda's potential risks due to future change of Chinese law and policies, Fangda has restricted the applicability of the above conclusion specifically to before and when the legal opinion is rendered and the IPO is completed.

Fangda emphasizes "each of the VIE agreements" therein instead of using the wording of "each and all", so it has avoided to comment on the overall effectiveness of the VIE contractual arrangements in English context. This is the prevailing practice in PRC law firm' legal opinions when a VIE structure is involved, and has been accepted  by  regulatory authorities in almost all major listing jurisdictions.

  1. Fangda has also advised there are substantial uncertainties regarding the interpretation and application of current PRC laws, rules and regulations, and accordingly the PRC regulatory authorities may in the future take a view that is contrary to the opinion of Fangda in terms of the effectiveness and legality of variable interest entities arrangement.​ The aforesaid quoted wordings and expressions are widely and necessarily disclaimers used by PRC counsels in listing projects of Chinese operating companies through red-chip reorganization, and are applicable to almost all fields whereby the legislation is disputable or uncertain. Currently, regulatory authorities in major listing locations accept such similar reservations against VIE structure made by PRC counsels, and do not require PRC law firms to consult PRC government to verify whether possibly the government has "different understanding". Even some PRC government authorities, e.g. State Administration of Press Publication Radio Film and Television ("GAPP") once issued an VIE injunction by saying "foreign investment shall not use contractual arrangements to indirectly control Chinese operating company in online game industry", also several Chinese judicial decisions and arbitration awards pronounced that "some contractual arrangements are void, as they beach the Contract Law and General Principles of Civil Law intentionally and evade Chinese restriction on foreign investment", so far overseas listing using VIE structure has not encountered with substantial obstacle. Taking the Forgame referred above as an example, JINGTIAN&GONGCHENG Law firm, the Forgame's PRC counsel, only mentioned under the chapter of Risk Factors about the aforesaid GAPP's regulations and relevant adverse judicial decisions regarding VIE structure's effectiveness and legality in the opinion, and made reminders on risks.

Based on above disclosed information and the listing results, it can be seen that overseas regulatory authorities, either in USA or HK, would not simply refuse a listing application where VIE structure exists. But all those regulatory authorities require appropriate disclosure about VIE structure, and will examine that whether applicants have proved the legality of the VIE structure and their ability to perform the arrangements properly based on the facts provided by applicants and the opinions rendered by PRC counsels. Amongst which, compliance history, management mechanism, measures on protection of shareholders' interests and regulation practices of applicants all falls into the scope of examination by regulatory authorities. Moreover, in order to review the legality of the VIE structure, normally applicants would be asked to obtain an confirmation on the legality from the PRC regulatory authority, if unavailable, PRC counsel's statement on legality of VIE structure would then be requested.

Not only Chinese internet industry and overseas investors are benefited from VIE structure, most of Chinese innovative enterprises also benefited from it. On one hand, VIE structure cultivates a large quantity of overseas listing companies for China; on the other hand, it also brings with some future risks to the company due to the inherent problems in connection with VIE structure. Therefore, how to supervise VIE structure more effectively without negative impact on the companies that already being listed overseas under VIE structure, will be a challenge for PRC government. In this regard, we are keeping an eye on it.