For many years, regulators in the People’s Republic of China appeared to have turned a blind eye to the use of variable interest entities (VIEs) by Chinese companies seeking to conduct public offerings on foreign stock exchanges. As a workaround to Chinese regulatory restrictions on foreign investment in certain restricted industries, VIEs enable a foreign company or foreign-invested enterprise, through a series of contractual arrangements, to control and obtain an economic interest in a domestic Chinese company operating in a sector that is off-limits to foreign investors. While the legal basis for VIEs has always been a bit tenuous, the structure has been used numerous times by US-listed Chinese companies, including well-known Chinese Internet giants Sina, Baidu and DangDang.

In recent months, evidence has been mounting that the central government intends to introduce measures to regulate the use of VIEs for offshore listings. In April 2011, Buddha Steel, Inc., a Chinese company in the process of a US$38 million underwritten public offering in the US, pulled out of its IPO plans because government officials in Hebei Province alleged that the VIE agreements Buddha Steel had executed were against public policy. The move by the Hebei authorities was the first of its kind in China, and created added uncertainty as to the viability of the VIE structure. Moreover, news has been circulating that the China Securities Regulatory Commission (CSRC) has submitted an internal report to the State Council recommending the regulation of VIEs in connection with foreign public offerings.

Against this backdrop of uncertainty regarding VIEs, the Chinese Ministry of Commerce (MOFCOM) released the Regulations of the Ministry of Commerce for the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (MOFCOM Circular 2011 No. 53, "商务部实施外国投资者并购境内企业安全审查制度的规定"), effective September 1, 2011 (Circular 53). Circular 53, together with the Notice of the General Office of the State Council on the Establishment of the Security Review System for the Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (Guo Ban Fa [2011] No. 6 "国务院办公厅关于建立外国投资者并购境内企业安全审查制度的通知") (the State Council Notice), sets forth a regulatory regime and related administrative procedures (collectively, known as the Security Review System) with respect to the review of foreign investments in certain domestic Chinese businesses, particularly those related to national security. A joint review panel led by the National Development and Reform Commission and MOFCOM has been formed to implement the Security Review System.

The State Council Notice focuses on foreign acquisitions of domestic interests in the military sector, entities related to China’s national defense and domestic enterprises that operate in industries deemed to have a significant connection to national security (e.g., important agricultural products, energy and resources, infrastructure and transportation, and key technologies).

Circular 53 is of particular interest to foreign-invested companies operating in China because it specifically prohibits companies from circumventing the Security Review System through the use of contractual control arrangements, such as those commonly relied upon in a VIE. Investors that have used or intend to use a VIE in connection with acquiring companies in China are likely to be subject to review under the Security Review System.

Overview of the Security Review System

  1. National Security and Stability

The panel carrying out a review under the Security Review System will consider the impact of a proposed transaction on (i) national defense, including the ability to produce domestic products and to provide domestic services required for national defense and related equipment and facilities; (ii) the stability of the national economy; (iii) social/civil stability; and (iv) the capacity to research and develop key technologies related to national security. The inclusion of the ambiguous and potentially broadly interpreted "social/civil stability" category gives Chinese regulators tremendous discretion to reject proposed transactions.

  1. Regulated Transactions and Regulated Enterprises

The Security Review System covers "regulated transactions" (defined below) to be entered into, or that have been entered into, by foreign investors with respect to their investment in a "regulated enterprise" (defined below).

Regulated transactions include four categories of inbound mergers or acquisitions in which a foreign investor, directly or indirectly: (i) purchases the equity interests of, or subscribes to the increased capital of, a domestic non-foreign-invested enterprise, and consequently converts it into a foreign-invested enterprise; (ii) purchases equity from the Chinese shareholder(s) of, or subscribes to the increased capital of, a foreign-invested enterprise; (iii) establishes a foreign-invested enterprise through which it purchases (a) assets of a domestic enterprise with the intention of operating such assets, or (b) equity interests of a domestic enterprise; or (iv) purchases the assets of a domestic enterprise, and then invests such assets to establish a foreign-invested enterprise that will ultimately operate the assets.

"Regulated Enterprises" cover two types of domestic PRC enterprises:

(a) "Military Related Enterprises", which are (i) enterprises that operate in the domestic military industry and any related ancillary industry; (ii) enterprises that are located near major and/or sensitive military facilities; and (iii) other entities involved in national defense and/or national security; and

(b) "Important Enterprises", which are enterprises that are involved with "important" agricultural products, energy, natural resources, infrastructure, transportation services, "key technologies", or manufacturing of "major" equipment. Note that, while both Circular 53 and the State Council Notice use the words "important", "key" and "major" in their characterizations of Important Enterprises, neither regulation defines the terms, which means that the scope of Regulated Enterprises is subject to a broad range of governmental discretion.

  1. Actual Control

The State Council Notice provides that the following types of transaction would trigger a review: (i) any Regulated Transaction entered into by foreign investors with respect to Military Related Enterprises; and (ii) any Regulated Transaction that results in a foreign investor taking "actual control" of an Important Enterprise.

"Actual control" is established if, following a merger or acquisition by a foreign investor of a domestic enterprise: (i) the total percentage of shares/equity held by the foreign investor, its parent holding company and/or a commonly-controlled subsidiary is equal to or greater than 50 percent; (ii) the total percentage of shares/equity held by multiple foreign investors is equal to or greater than 50 percent; (iii) the total percentage of shares/equity held by the foreign investor is less than 50 percent, but its voting power is sufficient to cause a material impact at the shareholders’ meeting, or any shareholders’ resolution and/or board resolution; or (iv) any other circumstance arises that results in the transfer of actual control with respect to, among other things, business decisions, financial affairs, personnel or technologies.

  1. Voluntary and Involuntary Application Procedures

Circular 53 requires foreign investors to submit an application for review to MOFCOM if the domestic enterprise that is the subject of a merger or acquisition falls within the scope defined in the State Council Notice.

A foreign investor would also be forced to file an application for review if a third party, such as a related State Council department, national industry association or any other company involved in the same industry, including a direct competitor (each a "Third Party"), asks MOFCOM to conduct a review of the transaction, and MOFCOM agrees to carry out the request.

Anti-Circumvention Mechanisms

  1. Regulated Transactions with respect to Regulated Enterprises will be scrutinized to determine the actual substance and impact of a transaction, rather than the mere form or structure of the transaction. As such, a reviewing panel could examine the details of a variety of schemes (including nominee holding, trust, multiple-level re-investment, lease, loan, contractual control and offshore transactions) to determine whether such structures fall under the scope of the relevant review. Nominee holding and contractual control are specifically noted as possible circumventing schemes, and will likely be under close scrutiny.
  2. As discussed above, any Third Party may submit a statement to MOFCOM explaining its view of the potential impact that a given transaction may have on national security, and request MOFCOM to review such proposed or executed transaction.
  3. A panel may authorize MOFCOM and any other competent agencies to disapprove, terminate or unwind a Regulated Transaction with respect to a Regulated Enterprise if it determines that the Regulated Transaction (i) has had or will have a material impact on national security; (ii) was not initially submitted for review; or (iii) was previously approved by MOFCOM but, due to subsequent developments following the transaction (including a change of business activities, a change of control or an amendment of the relevant agreements or documents), the transaction should be unwound. In addition, MOFCOM has the power to order the parties to transfer the relevant equity interests/assets to a designated party with a view to eliminating or mitigating the impact of the transaction on national security.


As always, new regulations in China have the tendency to quell some fears while creating others. With the Security Review System in place, foreign investors that have applied for and received MOFCOM approval for their transactions now have a level of assurance that they previously did not enjoy. However, some would say that a panel’s reversal power leaves the position of foreign investors largely unchanged. It is also unclear whether the review measures will be retroactively applied to completed mergers and acquisitions. In light of the profound implications that this would have for businesses in China, especially those listed abroad, many suspect that the new regulations would not be retroactively applied, at least not on a general basis. However, unless MOFCOM provides further clarification on this question, it remains a risk that will need to be considered by foreign investors. Leaving aside the level of comfort that the new circulars provide to investors, the one thing that appears certain is that China’s eyes are wide open with respect to VIEs and that, going forward, China will expect these structures to be in the plain view of regulators. Foreign investors seeking to acquire certain types of enterprises or assets in China should be prepared for a more complex and prolonged transaction approval process.