VIE structure – a long untold story

January 2014 | EXPERT BRIEFING | BANKING & FINANCE

financierworldwide.com

It is hard to imagine how a term originally used by the United States Financial Accounting Standards Board following the Enron scandal has found popularity on the other side of the Pacific Ocean, and become a recurring topic of discussion among financial and legal professionals for over a decade. This is what happened to the term ‘Variable Interest Entity’, or VIE, which refers to an entity controlled by the investor not by ordinary ownership but through a series of controlling agreements, so that the investor is allow to consolidate such entity into its financial statements.

Also commonly known as the ‘Sina-model’, the first prominent use of VIEs in the People’s Republic of China (PRC) was by Sina.com to help it list on the NASDAQ in 2000. Although there are variants, the VIE structure essentially enables an offshore public company to transfer funds, exercise voting rights and call options, and obtain revenue from a PRC domestic company (usually operating in business sectors restricting or prohibiting foreign investment) owned by PRC citizens through a contractual arrangement between a subsidiary set up by the offshore company and the domestic company. Sina.com’s success with its overseas IPO was soon followed by hundreds of other PRC companies in TMT, as well as media, advertising, education and other sectors, hoping to raise funds via overseas exchanges that presented entry challenges for foreign investment. The latest companies to seek this route were Lightinthebox and Qunar.com. This is one of the underlying forces driving the internet boom in the PRC.

Two main reasons leading to the emerging popularity of VIEs in the PRC are the difficulty in accessing offshore capital markets and restrictions on foreign investment. Unlike in the United States, Europe or even Hong Kong, the capital market in mainland PRC has yet to reach maturity. Companies that need to access offshore capital have to turn to overseas capital markets for help. However, under the PRC laws, to directly list aboard requires approval from the PRC authorities and the standards are so high that they virtually render most private companies ineligible for approval. As a result, in the early days only major state-owned enterprises such as China Unicom were allowed to raise funds overseas through a virtual control structure (which is not like the currently widely adopted Sina-model), and private companies were excluded from accessing foreign funds in the pre-Sina era.

The difficulty in accessing offshore capital is further aggravated by the regulatory control over foreign investment on certain business sectors, especially in TMT, as well as media, advertising, education and other sectors. In those sectors, foreign investment is either prohibited or restricted (which meansthe possibility ofobtainingapprovalsfrom the authoritiesis minor or unlikely).

Then, in the early 1990s, the Sina-model was invented by certain market pioneers and intermediaries. In essence, this structure is a compromise between international recognition (especially by established foreign securities exchanges) and implied acceptance to some extent by the PRC regulatory authorities, which enables founders in such companies to realise control of a domestic licensed operator through their overseas special purpose entities. As an ancillary result, it also creates possibilities for investment from foreign institutional investors to realise investment stakes in foreign entities on an offshore level.

All of these problems appear to be solved by the separation of control and operation in the VIE structure. On the control side, the business is ‘owned’ by an offshore holding company which is usually to be listed abroad, and the listing approval would not apply because the offshore company is not a PRC entity. On the operational side, the prohibited or restricted business remains in the hands of a pure PRC domestic company. Although the offshore company has contractual control that mimics ownership rights in every possible way – through a set of tightly integrated contracts, over the domestic company operating the prohibited or restricted businesssothat it could consolidate in the domestic company – such control does not involve a change of the domestic company’s legal ownership under PRC law, thus circumventing restrictions on foreign investment. This dual nature arrangement offers a tightrope for PRC companies with offshore IPO and capital needs to reach overseas funds without falling into the mud of obtaining governmental approval or losing the operating licence of their business for purely structural reasons.

Since the VIE structure was originally designed to avoid the approval of authorities or bypass restrictions under PRC laws, one cannot expect that the authorities will always turn a blind eye to such practice. In fact, the laws contain rules that could potentially be used to challenge the VIE structure, at least in specific sectors such as telecoms and online gaming. Back in 2006, the former Ministry of Information Technology, the PRC telecom authority, issued a notice requiring all PRC telecom companies to obtain its approval and other authorities’ approvals under the laws before listing on overseas exchanges. Then, a direct regulatory attack on the use of VIEs in online gaming businesses came in 2009 from the former General Administration of Press and Publication, the publishing authority. In recent years, every new special regulatory review implemented by the authorities – for instance, the national security review and antitrust review – seems to put VIE under tighter scrutiny, with the general rules on foreign investment, foreign exchange and tax always standing by to weigh in. The public spat over Alipay in 2011 provides another lesson to investors that even a new licence requirement could potentially become a new round of regulatory testing on VIEs.

With the statutory weapons (though in a primeval form) available to hand, the next question is when and how the authorities will mount their attack against VIEs.

In 2011, an unconfirmed anonymous research report implicating the China Security Regulatory Commission’s position on overseas IPOs of internet companies with a VIE structure created turmoil in the market, although it turned out to be a market rumour. In the same year, the Hebei provincial government stepped up to block the VIE arrangement adopted by Buddha Steel for offering bonds in the United States, stating that the arrangement contravened PRC regulations on foreign investment. Despite different interpretations by many, the PRC Ministry of Commerce expressly prohibited Walmart from operating Yihaodian’s existing value-added telecom business through a VIE in its antitrust approval.

Putting everything together, it is not hard to see a trend that the authorities are no longer willing to accept the VIE structure the way they did several years ago. Currently, the PRC Ministry of Industry and Information Technology is overhauling the country’s telecom regulations, notably the new Telecom Classification Catalogue. It is also believed to be considering reforms of current policies related to market access for foreign capital in the telecoms sector. While this presents a big leap forward, it is likely to be accompanied by more specific rules on VIEs, which are adopted more often in telecoms businesses thaninany others industries. It remains to be seen whether such reform will unite the previously sporadic actions of different authorities into a joint effort by all relevant authorities to curb the use of VIEs in the telecoms sector.

Another inherent risks in the VIE structure lies with the enforceability of the controlling agreements, which are the foundation of any VIE structure. These agreements have long been claimed as a major factor contributing to the uncertainty of VIEs because the controlling agreements may be held invalid and unenforceable under the PRC laws due to their nature of trying to circumvent regulatory requirements. Such fears of foreign investors have been somehow made real by two prominent rulings from the arbitration institution and PRC Supreme Court in 2012. These two cases relate to different business sectors, one in online gaming businesses with VIE structures and the other involving the investment made by Chinachem Group in China Minsheng Bank through an entrustment investment arrangement. The controlling agreements were used in both cases to control the operation of, or the investment in, the restricted or prohibited business. The arbitration institution and the Supreme Court both nullified the controlling agreements on the same ground that these agreements conceal the illegal purpose of allowing foreign investment to enter into the restricted or prohibited business in lawful forms. These two cases cast a cloud over the uncertainty of VIEs, as well as their variations, and show how unstable the VIE structure could become even in the absence of any external challenge from the authorities.

Looking forward, the inherit risks of VIEs are likely to escalate along with the evolution of PRC regulatory policy. In particular, the PRC founders, as well as international operators, need to think twice before using VIEs to directly tap into a restricted or prohibited business area in the PRC. Even for VIEs used in overseas listings, special attention should be made to carefully balance the interests of foreign investors and Chinese investors to avoid any dispute over controlling agreements going to arbitration or court. On the other hand, it is an undeniable fact that so many companies representing substantial market share in PRC TMT, media, private education, and other sectors have used VIEs to list on an overseas exchange. Global investors’ interests seem to add substantial weight to the scale. Also, as the VIE structure was originally designed to obtain consolidation overseas, once established, it will be very difficult to unravel and restructure it into a pure domestic structure to meet the domestic listing requirements. As such, the authorities’ attempt (if any) to get VIEs back home will not easily succeed. For those PRC companies who want to copy or create structures similar to VIEs, there will be a grey area for the foreseeable future, before any regulatory walls are established.

Fang Zhou is a partner and Brett Zhang is an associate at Jun He Law Offices. Mr Zhou can be contacted on +86 10 85 191 300O or by email: zhoufang@junhe.com.Mr Zhang can be contacted on +86 10 85 191 300O or by email Zhangyue_brett@junhe.com.

Fang Zhou and Brett Zhang

Jun He Law Offices