Chinese regulators call for clampdown on VIE investment structures

Lawyers at four different firms told Reuters that they had seen the report, dated August 17, and warned that, if the issue is pursued by the State Council, it could have grave consequences for private equity firms investing in China from offshore. The lawyers say the CSRC is pushing for the Ministry of Commerce to take the lead in regulating VIE structures, with all new structures requiring ministry approval before being set up. However, they are not expected to force existing VIEs to dismantle.

Concerns were first raised about the sustainability of VIEs when Jack Ma, founder of Alibaba Group, transferred ownership of third-party payment service Alipay from Alibaba to a domestic firm of which he is the majority shareholder. In doing so, he removed Alipay's exposure to the VIE that secures Yahoo and Softbank's financial interest in the parent company.

Ma was essentially responding to a regulatory ruling that all participants in the third-party payment industry would have to apply for licenses, and that those with foreign investors would be subject to separate review. The regulators also indicated that foreign control over these companies will not be tolerated, either directly or indirectly through VIEs.

Foreign private equity firms usually invest in a Chinese company's offshore entity, which in turn operate in the mainland via a wholly foreign-owned enterprise (WFOE), with profits transferred back as dividend payments. However, direct foreign ownership is not permitted in China's internet industry so a structure was created in parallel to the WFOE under VIE rules. The structure is owned by Chinese nationals, which means it is allowed to hold the relevant business licenses but does little else. The relationship between the WFOE and the parallel company is based on five legal agreements that are intended to secure the former's economic interest in the latter.

When the government sought to shut out VIEs from third-party payment services the obvious concern was whether other industries would ultimately be caught up in the clampdown.

VIEs have long been deemed as acceptable in the internet sector, and the third-party payment providers only ran into trouble because it was decided that their activities encroached on the banking space. It was unclear what sectors popular with venture capital and private equity investors - education or biotech, for example - might be considered too sensitive for foreign participation through VIEs.

While the purported CSRC's report doesn't say that VIEs will be outlawed, its very existence would suggest that the fallout from the third-party payment situations is wider than originally anticipated. When AVCJ first covered the issue in July, lawyers indicated that they were already working on alternative structures - coexisting with VIEs or backing them up - that are intended to operate independently of the regulators and lock in investors' economic position.

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• Topics
• Greater China
• Regulation
• Venture
• CSRC