China VIEs: An end to uncertainty?

Variable interest entity (VIE) structures are a feature of many of the 132 VC-backed Chinese companies that have gone public in the US since 2000. Originally devised to work around restrictions on partial foreign ownership of assets held by internet portal Sina, VIEs are widely-used yet clouded by uncertainty.

The legal status of the structure - actually a series of contractual agreements - has never been clear. It was feared that Chinese authorities might cease turning a blind eye and ban VIEs, wiping out billions in investments. Last week, though, the mists began to lift. The Ministry of Commerce (MofCom) issued a draft rule that would legalize and regulate foreign investments using these structures.

"It is a great development," says Ning Zhang, senior counsel at O'Melveny & Myers (OMM). "Under the new rule, MofCom will likely grandfather in all existing VIEs and foreign investors may use a VIE structure controlled by a Chinese national to invest in restricted businesses."

He sees this as a stepping stone to wider deregulation of the foreign investment catalogue. Overseas majority ownership was recently permitted in all facet s of e-commerce and similar moves are expected in education and healthcare. There will still be a need for VIEs but they are likely to be less complex.

The status quo

Under the current rules, foreign investors cannot have full exposure to Chinese companies that operate in "negative list" industries, such as the internet, education and telecom.

A VC invests in such companies via an offshore special vehicle, which holds onshore assets through a wholly foreign-owned enterprise (WFOE). Restricted assets, such as a website operating license, are held in a parallel structure owned by one or more Chinese nationals, usually a company founder. A VIE secures the WFOE's interest in the parallel structure.

The problem to date has been MofCom's refusal to officially acknowledge this aspect of foreign investment. "Its position has always been, ‘I know this structure but I don't like it. I won't recognize it and you shouldn't push me, otherwise I would say it is illegal," one lawyer says.

The draft Foreign Investment Law will consolidate three existing laws on foreign investment enterprises (FIE), equity joint ventures and contractual joint ventures. Officials will assess whether ultimate control of a VIE lies with Chinese nationals or foreign investors. If the former, the company will be classified as a domestic business. If the latter, any existing restrictions on overseas participation in the target industry would void the investment.

Most industry participants agree that VC-backed companies are unlikely affected by these changes - VIEs are usually controlled by Chinese nationals and most of the VCs come in as minority investors in start-ups.

However, Thomas Chou, partner and co-head of Morrison & Foerster's China PE practice, notes that the new rule could potentially give domestic management leverage to reduce the scope of protective provisions offered to foreign VCs. The definition of "control" includes acquiring voting rights that can exert a material impact on corporate resolutions, or the ability to exert decisive influence on the operations, finance, personnel or technology of the business.

"I am already visualizing negotiations in which the founders of a value-added telecoms company argue that such limits on protective provisions are not only necessary for operational efficiency, but also in order to comply with foreign investment restrictions," Chou says.

In the meantime, there may also be consequences for multinational companies that invest in restricted industries.

"Multinationals that use a VIE structure stand to lose because they would likely not be able to show that Chinese individuals or entities have actual control over their businesses in China," says Rocky Lee, Asia managing partner at Cadwalader. "I don't think the new rules will really hurt the market because most VCs take a minority stake in companies but it can hurt the VC investors from an exit perspective because arguably only a Chinese buyer can acquire the business."

Risks remain

The upshot of the draft law is that control of China's overseas-listed internet companies will remain in Chinese hands. Foreign investors have control over existing VIE structures may be required to divest during the three-year period following promulgation of the law. The investors would then apply to MofCom for a license to participate in restricted industries and this might be conditional on business lines being sold off, limits to the scope of operations, or requirements for a minimum number of domestic employees.

"The draft Foreign Investment Law has taken a page from the Anti-Monopoly Law playbook and proposes a similar approach in reviewing foreign investment in restricted industries," Morrison & Foerster's Chou says. "PE investors will need to be prepared to re-assess the value drivers of the investment if such conditions are imposed, and have contractual mechanisms in place to terminate the investment without penalty, if the conditions imposed render their original investment assumptions invalid."

The China Securities Regulatory Commission (CSRC), which is in charge of onshore and offshore listings, will also be a key player in the enforcement of the new regulations.

It is unclear what the agency's stance on VIEs might be, particularly given a number of Chinese firms in restricted industries have been delisting from US bourses in past few years and may list onshore. The CSRC also has the authority to regulate overseas listing of China-based businesses using VIEs and other offshore structures although it has not exercised that power since 2003.

"If an offshore entity using a VIE structure wants to list onshore, it should follow regulations issued by the CSRC, but the CSRC has yet to issue regulations," says OMM's Zhang. "It would also be interesting to see how the draft law impacts China's existing cross-border M&A regulations and the CSRC's attitude towards overseas listings of China businesses using offshore structures."

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