To achieve the initial public offering ("IPO"), there are two options for Chinese companies, onshore listing (also known as A-share listing) and offshore listing (also known as red-chip listing). Since the conditions and qualifications for A-share listing are usually a little higher and the procedure is more time-consuming than for the offshore listing, Chinese companies which cannot meet the A-share listing’s requirements or which need to complete IPO rapidly, usually would prefer the red-chip listing. For the red-chip listing, there are two commonly-used structures for Chinese companies: the straight-forward offshore listing structure and the VIE structure. In addition, for the purpose of attracting foreign investors and for circumventing restrictions on foreign direct investment, during the Pre-IPO restructuring, the VIE structure is also widely used by Chinese companies and foreign companies alike.
In 2011, after a series of public events, the variable interest entity ("VIE") structure re-attracted a lot of attention and concerns from the PRC authorities, entrepreneurs, investors and other market participants. This essay will describe the circumstances in which the VIE structure was created, how it has been used and the changes in the regulatory environment which might affect the feasibility of utilizing the VIE structure.
The VIE structure is also commonly referred to as the Sina-model structure, since it was first used by Sina in 2000. In China, the foreign direct investment market is not totally open to foreign investors. According to the Provisions on Guiding the Orientation of Foreign Investment, promulgated in 2002, and the Foreign Investment Industrial Guidance Catalogue revised in 2007, we understand that the industries are classified into four categories, namely, the encouraged, permitted, restricted and prohibited. With respect to the encouraged and permitted industries, there are few restrictions on foreign investment, which means that foreign investors may usually make investments freely in those industries. As to those restricted industries, higher conditions or qualifications or stricter requirements are provided for foreign investors. Foreign investors are not permitted to invest in prohibited industries at all. Those companies which adopted the VIE structure, in a sense, usually face restrictions on foreign investors, and for the purpose of attracting foreign venture capital or private equity financing in the early stages and completing offshore listings, the VIE structure was finally created by certain imaginative individuals in an effort to circumvent certain legal restrictions which they encountered in China.
In recent years, more than one hundred Chinese companies have adopted the VIE structure for their offshore listings, including internet companies such as Alibaba, Tencent, Baidu, Sina, Tudou, etc.; private education companies such as New Oriental, Global Education & Technology Group and AMBOW Education, etc.; media companies such as Focus Media, Vision China Meida and Bona, etc.; retail companies and companies in other industries. The typical VIE structure is set up as illustrated in the following diagram:
As indicated in the diagram above, foreign investors and PRC individuals establish SPV1 in Cayman; then SPV1 sets up a wholly-owned SPV2 in Hong Kong; and then SPV2 establishes the wholly foreign-owned enterprise ("WFOE") in the PRC. The domestic company usually is the one which owns licenses or approvals for the business. However, due to restrictions on foreign investment, the WFOE cannot obtain licenses or approvals from the PRC authorities to operate in the desired industry. Through a set of contractual arrangements among the WFOE, PRC individuals (usually PRC individuals are the companies’ founders) and the domestic company, the WFOE may be able to actually control the domestic company as if it directly owned the equity interests in such domestic company. Thus SPV1 may consolidate the financials of the domestic company into the group’s overall financial statements, which is permitted and accepted by the US General Accepted Accounting Principles.
In practice, the contractual arrangements include:
(i) the Consulting and Service Agreement entered into by and between the WFOE and the domestic company, which provides that the WFOE shall provide certain services (for example, the consulting or strategic services and technical services) to the domestic company for a fee, typically determined by the WFOE with the intended result of shifting the domestic company’s profits to the WFOE;
(ii) the Asset License Agreement entered into by and between the WFOE and the domestic company, under which the WFOE licenses certain assets including intellectual properties to the WFOE for royalty fees;
(iii) the Voting Rights Agreement or Proxy entered into by and among the WFOE, PRC individuals and the domestic company, in which the domestic company’s shareholder–PRC individuals authorize the WFOE to exercise their shareholders rights in the domestic company, including voting rights, inspection/information rights, signing rights and election rights, etc.;
(iv) the Call Option Agreement entered into by and among the WFOE, PRC individuals and the domestic company, in which PRC individuals grant the WFOE an option to purchase all or a portion of their equity interests in the domestic company at a lowest possible price permitted by PRC law;
(v) the Equity Pledge Agreement entered into by and among the WFOE, PRC individuals and the domestic company, through which the PRC individuals pledge their equity interests in the domestic company to the WFOE as a guarantee of the performance of their and the domestic company’s obligations under other agreements among the three (3) parties in the VIE structure; and
(vi) the Loan Agreement entered into by and between the WFOE and PRC individuals, in which the WFOE extends a loan to PRC individuals to use for capitalization of the domestic company.
The cash flow goes like this: SPV1 will fund the SPV2. SPV2 will make a capital contribution to the WFOE. The WFOE will extend a loan to the PRC individuals, who will in turn establish and finance the PRC domestic company. When the PRC domestic company makes a profit, it will distribute a dividend to the PRC individuals. The PRC individuals will make a repayment of the loan to the WFOE. The WFOE will use the proceeds of the loan together with other funds to be discussed below to make a dividend distribution offshore to SPV2, which will in turn make a dividend distribution to SPV1. In addition, through the contractual arrangements between the WFOE and the PRC domestic company, the domestic company will also make certain payments to the WFOE for provision of services. This payment will be part of the dividend to be distributed by the WFOE offshore, thus completing the chain of cash flow.
At the beginning, the VIE structure was used primarily for asset-light companies, such as internet companies, advertising companies, software companies, education companies and media companies, etc. However, after several years’ development, the asset-heavy companies also began to choose VIE structures for their financing or offshore listing and the typical example was China Qinfa Group Limited. Recently, the VIE structure has been increasingly used by asset-heavy companies.
During the last decade, with various investors’ efforts, the VIE structure has become more and more familiar to foreign investors, Chinese companies and the PRC authorities, and has been widely used in foreign investments in China, especially in the restricted or prohibited industries to foreign investors. However, for foreign investors, the potential risks existing in the VIE structure and uncertainties in respect of government policies are just like the Sword of Damocles over their heads. We will analyze the risks associated with the VIE structure in the following section.
2.1 Risks associated with the VIE structure
From series of contractual arrangements elaborately designed by investors, companies and other market participants, it is not hard to find that the VIE structure is crafted to remove any risk of the WFOE losing control of the domestic company or its assets. Due to the reluctance of the parties from disclosing the entire structure of the transaction, the enforcement of such contractual arrangements is likely to be difficult in China. Moreover, even if the contractual arrangements are finally enforced under PRC law, the damages to the company will be significant for the investors. After all, to some extent, the contractual arrangements cannot be compared with the direct ownership of the domestic company through equity investment.
For instance, if all parties to the contractual arrangements perform their obligations, everything is fine. However, if, for example, the PRC individuals or the domestic company decide not to perform their obligations under the contracts, the WFOE may have a difficult time to maintain control over the PRC domestic company. Consequently, we have known some limited but significant cases in which the offshore holding companies lost control over the domestic companies. The result is typically difficult, expensive and time-consuming dispute resolution process, which may lead to some kind of settlement or, alternatively, the foreign investor giving up on the PRC domestic company and their presence in China.
Most of time, we only notice there have been more than one hundred Chinese companies which successfully achieved listing overseas. On the other hand, we tend to pay little attention to such failed cases in which the domestic foreign investors even lost control over the domestic companies. However, in any case, the potential risk still exists for each market participant and is worthy of consideration by foreign investors at the stage of designing the transaction structure.
In the listing process of Sina, when one Sina’s founder was removed from Sina, the VIE structure was affected by such change of senior officers or shareholders of domestic companies. Although the adverse effect was successfully eliminated and the VIE structure was retained at last, the instability from the structure is still a high profile case in the VIE’s history. Another case is Agria Corporation, a Chinese seed producer which completed its IPO on NASDAQ in 2007, and which also faced the risk of losing control of the domestic company and such risk was eventually settled through compensation in equity and cash to the founder of domestic company (he was also the former director and the legal representative of the domestic company) who claimed the ownership of the offshore parent company.
Sina and Agria Corporation both faced the risk of losing VIE structure, but fortunately, after hard negotiation, such risk was successfully removed and the VIE structure was retained eventually. Certainly, there are also not so exciting examples for foreign investors. One is GigaMedia and the other is Alipay.
GigaMedia is a listed company on NASDAQ, which owns online games business in China through the VIE structure. In 2010, GigaMedia announced it was involved in the dispute with its former founder of the domestic company, who was removed from the domestic company but refused to return the company seal, financial chops and other documentation to GigaMedia. As a result, such former founder in fact still controls the domestic company. Even though there are a set of contractual arrangements, GigaMedia has no choice except to bring a series of legal actions against such former founder inside and outside of China. Furthermore, even though GigaMedia may regain the ownership and control of the domestic company, it is undeniable that such event will bring adverse effect on its business in China and its actual control of such domestic company. Additionally, GigaMedia has already had to announce that it would deconsolidate the financials of domestic company subject to the resolution of such dispute.
Alipay is another classic case which may be repeated by foreign investors and other market participants over and over again. The VIE structure was set up between Alibaba Group and Alipay. Alibaba Group’s shareholders were Yahoo, Softbank, Jack Ma and other PRC individuals. In 2011, Jack Ma, the founder of Alipay successfully severed such VIE structure between Alibaba Group and Alipay, and committed to make certain compensation to Yahoo and Softbank in the future. From the announcement by Jack Ma, the reason of unwinding the VIE structure was to obtain the Payment Business License from the PRC authorities, because only those domestic companies which had the qualifications could apply for the Payment Business License and the VIE structure would not be accepted by the PRC authorities. Alipay eventually set off a big bomb in the Chinese private equity market. As a result, many investors began to re-examine the VIE structure.
From the above cases, it is not difficult to find that the VIE structure is not as stable as some have imagined, to say the least. The founder, senior management or shareholder of the domestic company play a very important role in the VIE structure. Once there are changes to such positions involving interests, potential risks of the VIE structure will appear. The VIE structure helped over one hundred Chinese companies complete the offshore listings, but we should never forget such potential risks when we discuss the successful cases.
2.2 Risks from governmental policies
Why did Chinese companies, foreign investors and other market participants create the VIE structure? They were not unaware of the potential risks of the VIE structure, but they still adopted it, because they had no other choices when faced with the restrictions on foreign investment in China. In fact, most companies using the VIE structure have attracted foreign financings, but at the same time most of them face restrictions on foreign investment. After obtaining supports from foreign funds or other foreign investors, Chinese internet companies got rapid and great development and some internet giants such as Baidu, Alibaba and Tencent, etc., have grown up in the last decade. Of course, in those cases, Chinese companies avoided the restrictions on foreign investment and all relevant the PRC authorities’ approvals by using the VIE structures.
Sina might have chosen to use the VIE structure in 2000, to some extent, because it obtained the tacit consent from the PRC authorities. Over past years, the PRC authorities never formally confirmed the validity of the VIE structure under PRC law. As a general rule, the PRC authorities typically do not like the idea of foreign investors using indirect ways to get around legal restrictions on foreign investment in the first place; however, in order to attract foreign investment in technology focused industries such as telecommunications and internet, the PRC authorities have tended to acquiesce the usage of the VIE structure in China. That is beginning to change, because while the PRC authorities still welcome foreign investment, they have begun to be more concerned about "hot" money flowing into China through less than above-board means. As a result, the scale has tipped from welcoming foreign investment to higher scrutiny of the legality of the transaction structure. With prevalence of the VIE structures, some subsequent regulations or cases imply or reveal the PRC authorities’ attitude which is not so positive at least at present.
The Circular on Strengthening the Administration of Foreign Investment in Value-added Telecommunications Services ("Circular") promulgated by the Ministry of Industry and Information Technology ("MIIT") on 13 July 2006 was the first attempt to explicitly circumscribe the use of the VIE structure. In the Circular, it is provided that a telecommunications enterprise within the territory of China may not lease, shift or sell any license for telecommunications business in any form, or provide resources, places and facilities or any other conditions for any foreign investor to engage in any illegal telecommunications operation by any means within the territory of China. Meanwhile, certain key assets including trademarks, domain names and servers shall be held by the value-added telecommunications service provider or its shareholder which holds the value-added telecommunication service license. This Circular states that the PRC authorities do not welcome the VIE structure in the value-added telecommunications service area. This Circular also requires that the telecommunications enterprise which plans to list oversea shall first get the approval from MIIT.
(b) Online Games Notice
The Notice on Further Strengthening of the Administration of Pre-examination and Approval of Online Games and the Examination and Approval of Imported Online Games ("Online Games Notice") promulgated on 28 September 2009, provides that foreign investors are not permitted to invest in online games operating businesses in China via the WFOE, equity joint venture, or contractual joint venture, and it also expressly prohibits foreign investors from gaining control over or participating in domestic online games operators by indirect means, such as setting up other joint ventures, signing relevant agreements or providing technical supports. We are not aware of whether any listed companies utilizing the VIE structure were penalized or required to take apart the VIE structure.
From the regulatory perspective, the Circular and Online Games Notice are both only regulations other than laws; however, such regulations at least send a signal on use of the VIE structure. Meanwhile, most experts on VIE still believe that the PRC authorities are unlikely to prohibit all VIE structures.
(c) National Security Review
On 3 February 2011, the State Council released the Notice on Establishing National Security Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ("Notice"). To specify the implementation procedures of the national security review, later, on 4 March 2011, the Ministry of Commerce ("MOFCOM") promulgated the Interim Rules on Issues Related to the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( "Interim Rules"), which is replaced by the Rules on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( "Rules") on 1 September 2011.
Article 9 of the Rules re-attracts concerns from the public, which provides that with respect to merger and acquisition ("M&A") of the domestic enterprise by foreign investors, whether the M&A transaction falls within the scope of national security review shall be judged from the substantive contents and actual influences of the transaction; and foreign investors shall not avoid national security review through any means, including without limitation commissioned shareholdings, trusts, multi-level investments, leases, loans, contractual control, overseas transactions, etc.
The "contractual control" mentioned in the Rules obviously refers to the VIE structure. However, after reviewing the Notice and Rules, we may find that not all M&A deals will be subject to a national security review. The national security review process will apply only if the target domestic enterprise is involved in a business that concerns either national defense security issues ("National Defense Security Businesses") or national economic security issues ("National Economic Security Businesses"). National Defense Security Businesses include military industry enterprises and supporting enterprises, enterprises adjacent to major and sensitive military facilities, and other entities relevant to the national security of China. National Economic Security Businesses include enterprises involving major agricultural products, major natural resources and energy industries, important infrastructure projects, transportation services, key technologies, as well as major equipments that are related to national security. It is worth noting that in relation to M&A deals involving National Economic Security Businesses, a national security review process may only be triggered if the foreign investor intends to acquire actual control of the target domestic company.
In addition, the M&A in the Notice refers to the following circumstances:
(i) Foreign investors purchase equity interests of domestic non-foreign invested enterprises or subscribe for capital increase of domestic non-foreign invested enterprises, which convert such domestic enterprises into foreign invested enterprises.
(ii) Foreign investors purchase equity interests of domestic foreign invested enterprises owned by Chinese shareholders, or subscribe for capital increase of domestic foreign invested enterprises.
(iii) Foreign investors establish foreign invested enterprises and purchase assets of domestic enterprises via agreements by such foreign invested enterprises and then operate these assets, or purchase equity interests of domestic enterprises by such foreign invested enterprises; and
(iv) Foreign investors directly purchase assets of domestic enterprises and establish foreign invested enterprises through such assets to operate such assets.
Combining the Notice and Rules, we may conclude that the VIE structure has attracted increased attention from the PRC authorities, and such regulations only indicate that the PRC authorities have the intention to restrict the use of the VIE structure in certain industries. From existing PRC laws and regulations, it is hard to get a conclusion that the VIE structure will be prohibited in all areas.
It is also worth considering whether the existing VIE structures before promulgation of the Rules will be unwound or will face penalty. Since there are no more supporting materials from practical cases, at least until now, we are not aware of any companies with existing VIE structure facing risks of penalty or risk of unwinding the VIE structure. However, based on our experience, it is likely that previously established VIE structures may be left untouched. In addition, investment into such pre-existing VIE structures on an offshore level might not attract the attention or objection from the PRC authorities. However, foreign investors should examine all facts and review all relevant laws and regulations before making a decision to create a new VIE structure in certain industries on a case by case basis.
The promulgation of the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors ("M&A Rules") on 8 August 2006 by six (6) PRC departments, provides that the domestic companies, enterprises or natural persons shall, when they merger and acquire related domestic companies through companies legally established or controlled by them in foreign countries, report to MOFCOM for approval and the persons concerned may not evade the above requirements by re-investment of the foreign-invested enterprises or by other means. The M&A Rules leaves a road for related M&A, i.e. to obtain the approval from MOFCOM. However, during the five (5) years after the promulgation of the M&A Rules, there is no case where the approval was successfully obtained.
It is clear that since the issuance of the M&A Rules, more and more Chinese companies have adopted the VIE structure. In the early stage, the VIE structure was almost only used on the asset-light companies. However, after 2006, those asset-heavy companies also chose to utilize the VIE structure. It is believed that one of the reasons for the increasing use of the VIE structure is that the VIE structure may avoid obtaining the approval from MOFCOM. In fact, it is unimaginable and unreasonable that such asset-heavy companies may move enormous assets out of China only by several agreements without any governmental approval or other legal procedures. The PRC authorities may also be on the alert for the abuse of VIE structure in asset-heavy industries. There are some cases which adopted the VIE structure in the asset-heavy industries and successfully listed overseas, but unfortunately we also understand there are cases which have been rejected at IPO just for using the VIE structure in the asset-heavy industries.
In early 2011, Buddha Steel withdrew its IPO in USA, citing that the company was advised by local governmental authorities in Hebei Province that its VIE structure contravened the current Chinese management policies related to foreign-invested enterprises. On the one hand, this case might simply reflect the local government’s attitude towards specific companies or industries, not towards the VIE structure itself. On the other hand, it reveals that different local governments may hold different views regarding the VIE structure.
Above all, no matter from the legislation perspective or on a practical level, it is clear that the VIE structure faces the risks of uncertainty on policies from the PRC authorities.
In summary, the VIE structure has brought the prosperity to the Chinese internet market, and the VIE structure also had potential risks due to governmental polices in the past ten years or so since its appearance.
With respect to the risks from the structure, from the above analysis we may find that the certain persons in the domestic companies usually play a critical role in the VIE structure, and we all understand it is very important for the WFOE or offshore companies to avoid the risks from such persons. To better maintain the stability of the VIE structure, the following options may be adopted:
(i) Diversify the shareholding of the domestic company. If no shareholder alone or in conjunction with other shareholders, over whom he/she may bring influences, may control the domestic company, at least, it may help to reduce the risk of losing control of the domestic company. The perfect arrangement would be that each shareholder alone or in conjunction with other related shareholders holds less than 33% equity interests of the domestic company.
(ii) Carefully appoint the directors and the legal representative of the domestic company. In the GigaMedia case, the former legal representative refused to return the chops and documentations of the domestic company. In order to avoid such similar events from occurring again, when appointing directors and the legal representative, the WFOE or offshore companies should carefully consider the proper persons who will represent the interests of the WFOE or offshore companies.
(iii) Balance the interests between the persons controlling the domestic companies and those representing the offshore companies. Once the persons who control the domestic companies may get reasonable or greater returns from the offshore companies, the risk on severing the VIE structure by them will be reduced accordingly.
In respect of the risks from governmental polices, before establishing the VIE structure, the companies should ensure that the VIE structures are in compliance with PRC law and may be enforceable in the future. Considering the limited cases on national security review or other polices in practice, we would suggest that the companies should communicate with the PRC authorities first, obtain professional advice on a case by case basis, and then make a decision whether to utilize the VIE structure or how to use it properly.