In the past, many technology companies in China have done business through Variable Interest Entities (VIE) in order to gain access to foreign capital and to help expand their business. A few months ago, the dispute over the ownership of Alipay, a leading on-line payment service provider in China that decided to cancel all of their VIE agreements, has not only created debates about business ethics in China but more importantly has brought up questions as to why China’s regulatory authorities are stepping up scrutiny of the VIE structure.
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http://www.lexology.com/library/detail.aspx?g=a9d30374-f27f-4be7-84b8-2a3772ee84cf
).
Definition of VIE
The VIE (Variable Interest Entity) structure is a corporate structure which includes a series of contractual arrangements to enable foreign investors to obtain a degree of control over, as well as a substantial economic interest in Chinese companies without having to directly own their shares, below is a typical VIE structure:
Key elements of VIE:
SPV
. Under a VIE structure, domestic owners and foreign investors will jointly set up a SPV (Special Purpose Vehicle) for the purpose of capital operation. Any financial arrangement or public offering can be realized on SPV level.
Operating entity
. Operating entity is a company which has all necessary licenses to run its business in China and more importantly, is the source of benefits and losses under a VIE structure. In most cases, domestic owners of operating entity are its founders.
WFOE
. To build up connections with the operating entity and to avoid potential needs to deal with China’s government, the offshore SPV will set a wholly foreign-owned enterprise (WFOE) under PRC laws. A WFOE can sometimes also conduct a portion of operating entity’s business in China.
Legal agreements
. The concept that underpins VIE is that any control or economic benefit is obtained through legal agreements rather than share ownership. From the accounting perspective, a SPV could consolidate the operating entity by using contractual arrangements, the following agreements can be typically found under most VIE structures:
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Loan agreement
. The domestic owners borrow funds from WFOE to capitalize the operating entity. This agreement usually forms the main underlying obligation for the following equity pledge agreement.
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Equity pledge agreement
. The domestic owners pledge their shares in the operating entity to the WFOE as collateral, to secure the full performance of domestic owners’ obligation under loan agreement and other agreements. Under PRC laws, this agreement needs to be duly registered with relevant authority.
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Call option agreement
. With its discretion, the WFOE has the right to acquire all the operating entity’s shares from the domestic owners, and the payment price can be offset against the loan provided by the WFOE. From a practical viewpoint, this option cannot be exercised until some point in the future China’s regulatory authorities allow the foreign share ownership in the operating entity.
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Power of attorney
. The domestic owners grant a power of attorney to the WFOE, which means the WFOE is justified to exercise all shareholder rights in the operating entity.
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Consulting service agreement
. The operating entity agrees to use the WFOE as its service provider and pays its service fee. It is through this way that the WFOE transfers profits of the operating entity to itself, ultimately the SPV and all of its equity owners.
Another explanation about VIE structure, available at:
http://www.askventure.com/what-is-a-variable-interest-entity-vie-structure-for-foreign-investment-in-china-prc/
Why China’s Regulatory Authorities Are Challenging the VIE Structure?
Today, the VIE structure faces substantial uncertainty in China because regulatory authorities are challenging its legitimacy under PRC laws and regulations. Undoubtedly, an earthquake will be caused in the capital market if VIE agreements are held invalid, since it is widely used in many offshore-listed Chinese companies, especially in the internet sector. The questions presents itself: Why does it appear that China’s regulatory authorities are re-examining and changing their attitudes about VIE structures? The answer can be found by looking into the history of VIE in China.
Dating back to 2000, the VIE structure first became known to the public in Sina’s IPO, which is why the VIE structure is also commonly referred to as the “Sina model.” At this time, the VIE structure was a popular alternative to certain businesses for the following reasons:
(1) Systematical obstacles—like harsh IPO rules and lack of venture capital—prevented private sectors—especially emerging industries from raising money in China’s capital market.
(2) Sector-oriented regulation limited foreign investment in certain sectors. Ideally, if the operating entity could be a WFOE then the complex VIE is no longer needed (that is why the call option agreement would exist), which, however, is not permitted because the operating entity belongs to a prohibited sector. Generally speaking, foreign investment is classified into three levels according to different sectors, “encouraged,” “restricted” and “prohibited”—for some sectors, the foreign ownership of equity is either completely prohibited or restricted to a small proportion after an unpredictably long time approval process.
Take Sina for example, in China, ICP (Internet Content Provider) license will only be chartered to a domestically funded company. However, this license is indispensable for an internet company which holds a portal website as its core asset like Sina.
Another interesting analysis on this structure is available at the following web-site:
http://china.legalbusinessonline.com/firm-profiles/the-demise-of-the-vie-structure-and-the-emergence-of-the-mjcc-structure/109706
Under these circumstances, VIE provided an alternative solution for capital-hungry entrepreneurs and eager foreign investors, especially venture capitals and private equity funds, who hold great capital for economic return.
Obviously China’s government was aware of VIE, because many large and famous companies used this corporate structure. And if the Chinese government wanted, they could have shut it down which by process of negation means that while VIE structure might not have been a preferred investment vehicle it was accepted. During that time, (1) regulatory authorities had realized that small enterprises in the internet sector needed capital, but they could not get it onshore because of systematical obstacles and sector-oriented regulation, as discussed above; (2) the internet sector did not cause too much concern for regulatory authorities. As a result, they tacitly accepted the use of VIE structure in the internet sector.
In several years after Sina’s IPO, more companies like Sohu, Xiecheng, Tecent and Baidu, most in the internet sector, have accomplished offshore financing and listing through the VIE structure. All these companies were successful, and their success further justified the use of the VIE structure.
To conclude, VIE was just a product of time, a technical method that provides regulatory authorities an “excuse” to naturally accept internet enterprises’ offshore financing and listing—on which regulatory authorities do not have any material disagreement no matter if the VIE exists or not—without amending laws or regulations. Moreover, since VIE is still an arguable issue, this unfinished controversy gives regulatory authorities more leverage in regulating these companies.
Now, it is time to use that leverage. For the following reasons, China’s regulatory authorities are now taking steps against VIE structure:
(1)
National security concern
. Compared to the first several years of twenty-first century, time has changed. Unlike ten years ago, internet regulation now becomes a politically sensitive and national security-related issue for China’s government, and the fact that almost every influential internet company is controlled by foreign investors through the VIE structure makes regulatory authorities deeply insecure.
(2)
Public policy concern
. Regulatory authorities cannot tolerate VIE becomes a manipulated tool that helps companies transfer their assets and profits offshore and even deliberately circumvent PRC laws and regulations. VIE started in the internet sector, than moved to other sectors like media (Focus Media, IPO in 2005) and education (New Oriental, IPO in 2006). However, the use of VIE seems has gone beyond control from then on. In 2009, China Qinfa went public in Hong Kong with a VIE structure, which outraged regulatory authorities: (1) Unlike those emerging light-asset companies, Qinfa is a traditional heavy-asset company which engages in coal operation business; (2) Qinfa circumvented Chinese M&A rules,
[1]
foreign currency exchange regulations and industry-admission policy. This shows, as mentioned above, while VIE serves as a comfortable “excuse” for regulatory authorities to acquiesce the offshore financing and listing of emerging light-asset companies, it does not mean that VIE is acceptable in any other sector, especially those traditional heavy-asset industries like Qinfa.
(3)
Systematical obstacles disappear
. The growth of China’s capital market has been remarkable over the past decade. One the one hand, VC/PE industry has boomed in recent years and private sectors now have diverse channels to raise capital onshore, from early-stage venture capital to ultimate public offering. On the other hand, Shenzhen Stock Exchange has set up ChiNext in 2009, where qualified small and growing enterprises’ shares can be publicly traded. Rules of listing on ChinNext are more flexible than traditional IPO rules and moreover, regulatory authorities encourage and support those leading companies in emerging industries to go listing in the A-share market.
However, despite all the dissatisfactions on VIE, China’s government is not likely to clear existing VIE structures in offshore listing companies in the near future because the government has to consider its reputation in the international community and other political factors. According to a report purportedly issued by the CSRC (China Securities Regulatory Commission)
[2]
the use of VIE may have to be approved by regulatory authorities in the future and relevant legislation in this regard is already being pushed forward; however, those offshore listing companies which have used the VIE structure may be safe harbored.
In this entry I introduced the VIE because it seems that this structure is still popular among investors willing to enter the Chinese market circumnavigating determined prohibitions. However, before the Chinese legislator is going to impede or to declare this form against the law, this could represent a short cut to reach this immense market.
Cristiano Rizzi
(Some of my entries are extracted from my work titled M&A and Takeovers in China, so if you are interested in this topic, please visit:
http://www.kluwerlaw.com/Catalogue/titleinfo.htm?ProdID=9041140484
).
[1]
Provisions for the Acquisition of Domestic Enterprises by Foreign Investors
, enacted in 2006.
[2]
See http://www.eeo.com.cn/2011/0928/212678.shtml, please note this report is not officially verified.