While the internet recently exploded inside and outside China on speculation (some of it quite creative to avoid censors) related to the country’s likely next leader’s disappearance from public view, legal and accounting professionals have spent the past couple of months parsing a few lines from China’s Ministry of Commerce (MOFCOM) for clues to the government’s official view toward a complex corporate structure employed to launch some of China’s biggest IPOs.
In granting its August approval for Wal-Mart to acquire a majority stake in Yihodian, China’s biggest on-line supermarket, MOFCOM imposed certain restrictions on the transaction, including specifically prohibiting Wal-Mart from employing a variable interest entity (VIE) ownership structure to avoid PRC prohibitions on foreign ownership in certain specified economic sectors.
MOFCOM’s August decision marked the first time a PRC regulatory authority referenced the VIE structure. Combined with the announcement by another US-listed PRC company that the U.S. Securities and Exchange Commission may have accounting concerns with respect to such company’s own VIE structure, our clients considering transactions in China have raised questions both about the nature of the VIE-structure and its long-term validity under PRC law.
Almost 50% of Chinese companies listed on U.S. stock exchanges, including those held by prominent mutual funds, employ this VIE-structure. Many U.S. passive investors, therefore, unwittingly have exposure to this seemingly obscure issue of PRC corporate law embedded in their 401k accounts. “For years, big internet companies in China, like Alibaba and Baidu, have raised billions of dollars by effectively skirting Chinese regulations that ban foreign investors from acquiring stakes in companies operating in restricted industries, like energy, telecommunications and the internet,” noted The New York Times earlier this year.
This article then will (1) briefly describe the VIE structure and some acknowledged risk factors and (2) conclude (hopefully for the holders of such equities) that Chinese authorities are unlikely to unwind existing VIEs, but foreign-invested companies deploying this structure could face additional regulatory hurdles in the future.
China’s Foreign Investment Industrial Guidance Catalogue (the “Catalogue”) divides 473 industries into three possible categories for foreign investment – encouraged, restricted or prohibited. Investment in industries not specifically listed in the catalogue is considered “permitted,” but all such foreign investment would still be subject to review - regardless of its categorization - by, at least, the National Development and Reform Commission or its local branches depending on the size of the investment. Even though this most recent revision to the Catalogue expanded the list of “encouraged” industries, with a special emphasis on emerging energy and manufacturing technology, and reduced the list of “restricted” or “prohibited” industries, foreign investment still faces regulatory roadblocks in several key areas.
To work around restrictions on foreign ownership of Chinese companies in “sensitive” sectors, especially in connection with e-commerce, practitioners developed the VIE structure to allow foreign investors to exercise contractual control and derive economic benefits without actually owning the equity in such PRC companies. According to China’s MOFCOM, “VIE is a common practice by foreign firms to control – but not legally own – companies operating in China to bypass restrictions on foreign investment in certain areas.”
In a simple VIE transaction, the founders of the PRC company own 100% of the equity in a Chinese company holding the required license to operate the “sensitive” business in China. Such founders and foreign investors then establish a holding company outside China which, in turn, owns 100% of Chinese wholly foreign-owned entity (a “WFOE”). Shares in the holding company would be offered to investors who then control the WFOE through a direct subsidiary relationship. The WFOE then contracts with the PRC company to enable the WFOE (and therefore its parent company) to exercise management control and receive the revenue derived from the PRC company’s license. The Chinese founders also would pledge their ownership interests in the PRC company to the WFOE in the event of default, although the true value of such pledge is suspect as enforcement would contravene the PRC laws restricting foreign ownership the whole structure was designed to work around.
At the end of the day, those purchasing shares on the NYSE do not actually hold shares in the company licensed to do business in one of China’s restricted sectors. Instead, foreign shareholders own a contractual right to manage and receive the revenue from such Chinese company.
Obviously, this contractual arrangement poses significant risks, as Sina.com, the Chinese version of Twitter and the first company to employ such structure, states in its annual report to the U.S. Securities and Exchange Commission, Form 20-F filing. “Because PRC regulations restrict our ability to provide Internet content and MVAS [mobile value-added services] directly in China, we are dependent on our VIEs, in which we have little equity ownership interest, and must rely on contractual arrangements to operate these businesses. These contractual arrangements may not be as effective in providing control over these entities as direct control.”
In addition to bifurcating ownership and control, China’s tacit but unstated approval of the VIE poses the risk that Chinese authorities may unwind these complex contractual webs at some future date. As Sina.com acknowledges: “We cannot be sure that the PRC government would view our operating arrangements to be in compliance with PRC licensing, registration and other regulatory requirements . . . If we are determined not to be in compliance, the PRC government could levy fines, revoke our business and operating licenses, require us to discontinue or restrict our operations, restrict our ability to collect payments, block our website…”
VIE’s Here To Stay…At Least For A While.
Obviously, a wholesale rejection of the VIE structure by PRC authorities would cause more damage than a drop in Sina’s share price. Such action would decimate some of China’s flagship companies, block future access to foreign capital and roil markets around the world. Since 2000 almost 100 Chinese companies have utilized the VIE structure to list on U.S. Stock Exchange, and while this method may snake its way through the labyrinth of Chinese regulations, it can hardly be considered a secret. Therefore, most commentators agree that while the theoretical risk exists that Chinese authorities may one day deem VIE’s illegal, the economic and political consequences of such action make such risk remote.
While MOFCOM’s recent mention of the VIE-structure has not caused a wholesale re-reading of the tealeaves surrounding the validity of such transactions, it again highlights underlying risks to investor and need for regulatory transparency and clarity. As last year’s very public spat between Yahoo and the Chinese-internet company Alibaba surrounding the transfer of the lucrative electronic payment subsidiary Alipay illustrated, the supposed contractual assignment of management authority is rife for controversy. In this case, threatened regulatory action against Alibaba’s VIE structure provided founder Jack Ma with his stated motive for transferring the revenue-generating subsidiary without the consent of, or even notice to, foreign equity holders. The Alibaba example thus highlights dangers associated with opaque regulatory rulings and possible divergent incentives between those holding the license and those providing the capital.
Rather than revoking existing licenses, Chinese regulators could gradually and quietly squeeze VIE investors by disfavoring such companies when reauthorizing licenses or imposing additional restrictions anytime M&A deals involving such companies require MOFCOM review under China’s Anti-Monopoly law. The opaque and “ad hoc” nature of such reviews could allow the slow dismantling of the VIE system in the absence of stated government policy.
That said, MOFCOM’s brief mention of the VIE structure should not be read as the first blow to the VIE structure or a dramatic shift in official policy. Instead, it simply serves as a reminder that even the most sophisticated transaction structures remain vulnerable to regulatory shifts – whether publicly stated or privately enacted.
Commentators on both sides of the Pacific continue to clamor for regulatory transparency and clarity. However, as China sees its stratospheric growth rates slip, the markets may succeed where the academics and lawyers have failed. The allure associated with holding equity in a company contractually removed from the underlying assets may not seem quite as enticing when GDP rates fell to more pedestrian levels. The PRC government will face a tough choice on this and a range of issues as the legalities of a commercial economy crash against the expectations of international capital. The next generation of leadership assuming control in the coming weeks will be forced to either loosen control on foreign investment and eliminate the need for structural tricks or watch such investments find alternative destinations offering similar returns without the regulatory risks and requirements.
In the short term, however, those advising clients seeking initial access to China’s sensitive sector will still be required to scribble a sketch of the VIE structure for new clients, and U.S. shareholders may feel the impact of market gyrations the next time a Chinese government ministry mentions a variable interest entity.