For years, the conventional wisdom has been that if you are a foreigner looking to invest in certain segments of China’s economy, a variable-interest entity (VIE) might be the best bet. But after investors felt they were burnt by Alibaba’s restructuring, which effectively brought the profitable e-pay business back onshore, there are now more voices in opposition to the use of VIE structures. Simmons & Simmons senior counsel Michael Hickman talks about the investment approach.
Why have people used the VIE structure in the past?
In China, the VIE structure can provide a framework to gain access to industries in which direct foreign investment is restricted or prohibited, and it has been used in other industries as well.
So it’s a way around the law?
Not directly. The structure has been in use for some time, and has generally been seen as a grey area. There’s nothing that expressly prohibits VIEs.
Okay, what is it exactly?
In essence, the use of a VIE allows a foreign investor, through a non-Chinese entity, to exert contractual control over a Chinese operating entity sufficient to permit the results of that operating entity to be consolidated into the financial statements of the non-Chinese entity.
That sounds good for the foreign investor, but how does it benefit the Chinese company?
It provides funding solutions to many Chinese companies. Proponents of the VIE structure correctly point out that many privately held companies in China, including those in industries that are not capital intensive such as internet-based businesses, do not have access to growth capital in China. Access to domestic and international capital markets is tightly controlled, and private enterprises of any sort are hard-pressed to obtain permission to access public capital. Bank loans are also not typically available to Chinese entrepreneurs, and the private risk capital market is embryonic.
How does it work?
Typically, the VIE structure involves the creation of a wholly-owned subsidiary in China, wholly-owned by a non-Chinese parent. That subsidiary, in turn, enters into a suite of contracts with a Chinese company with the necessary Chinese operating licenses to engage in the target business. These contracts usually involve, among others, a services contract, a trademark or branding agreement, and other contracts tying up the equity in the licensed Chinese entity, such as a pledge of equity and an option to buy the equity of the Chinese operating company if and when permitted by law. These agreements, taken as a whole, have the effect of transferring control over, and a substantial economic interest in, the underlying Chinese business, which is otherwise restricted or closed to direct foreign investment.
Has it been used often?
This deal structure has been employed for a number of years, by Sina.com and other high-profile companies who enjoy access to the international capital markets. In terms of US issuers whose operating businesses are located exclusively in China, reports indicate that well over 6o% of those issuers are operating through the VIE structure.
But Alibaba is an example of it not quite working. Is that an isolated incident?
Reports of VIE structures going wrong cover the steel industry, online gaming and e-pay businesses. The steel industry precedent is Buddha Steel. According to its filings with the US SEC, Buddha Steel withdrew its registration statement after being informed by provincial authorities that its use of a VIE structure violated public policy. To date, no written documentation from the provincial authorities has been filed with the US SEC, so it is difficult to assess the extent or basis of this “public policy”.
The online gaming concern is GigaMedia. One of their VIE businesses in China, based in Shanghai, has been effectively wrested from their control. Despite the various contracts shifting control and a substantial economic interest in the business to the non-Chinese issuer, GigaMedia has had to de-consolidate the results of those Shanghai operations. The experience of GigaMedia is perhaps a road map to the fragility, in China, of a VIE structure. With contracts arguably breached by the Chinese founders of a successful business, GigaMedia has today found itself without effective recourse to assert meaningful control. It is telling that these developments, related to the weakness of the VIE structure in general, also followed specific regulatory measures implying that indirect foreign control would no longer be tolerated. The GigaMedia case may have been influenced by rules from the General Administration of Press and Publication, and a variety of rules covering various telecommunications, internet and internet gaming activities.
So what should investors do?
If faced with an opportunity to invest in a growing and potentially booming business in China that due to regulatory constraints may only use a VIE structure, you need to carefully assess the risks.
The VIE structure, at its core, relies on contractual arrangements. As is the case with any contract, one cannot effectively prevent a breach. In China, if the Chinese domestic operating company simply stops complying with its contractual obligations, the persons who control it are usually in a position to assert day-to-day control over the Chinese operating entities. The key indicia of authority and control include the company chop and its original business license, and these are kept on site.
With these in hand, and relying on the fact that he or she is the shareholder of record, the Chinese shareholder of the VIE entity, notwithstanding the various contracts, remains in de facto control of the business.
In at least one case of which we are aware, not only did the shareholder take control of the operating entities, but he was also able to wrest de facto control of the relevant WFOE from the foreign investor.
To mitigate this risk, one should create and consistently follow procedures and controls that make it marginally more difficult for the domestic business and its shareholders to wield unilaterally the important indicia of corporate authority.
What else should you do?
Consider the sector you’re investing in — if others in the industry use the VIE, it may signal that it’s a more acceptable route to take. Also, align your interests with the Chinese company. The foundation of a reliable VIE structure seems to be the extent to which the interests of the various parties are aligned, and can be expected to remain aligned. If the interests of the Chinese stakeholders appear to depart from the foreign investors, the chances of seeing the VIE structure unravel in China increase accordingly. If additional cases of this occur along the lines of the GigaMedia experience, and the foreign investors consistently find themselves without effective recourse, the ‘cost’ of going rogue would likely be perceived as insubstantial.