#guestpost - China: VIEs Alive and Well
Draft Foreign Investment Law Reboot
The latest Draft Foreign Investment Law will be discussed at the upcoming plenary session of the National People’s Congress on 5 March, 2019. It has been over 4 years since the original was released for public comment.
This new version has been much more warmly received than its predecessor as it underscores the Chinese government’s intention to further open up its markets to foreign businesses and also addresses issues raised by other countries, such as forced technology transfers. There is no doubt a political backdrop to the revisions – a looming trade war coupled with slowbalization (i.e. a retreat from globalization) means that China has become a, perhaps unlikely, champion of trade and investment liberalization.
The key issues addressed in the draft law include prohibition against forcing technology transfers; providing equal treatment and market access to foreign companies (except for certain sectors specified on a negative list) but also reserving China’s right to retaliate against companies from countries which discriminate against Chinese investors.
However, it is instructive that the very first article of this draft law articulates its intended purpose to further open up the Chinese economy and actively boost foreign investment.
The new draft underscores the move from permitted foreign investment needing to be listed to a negative list (i.e. restricted or prohibited sectors that are specifically mentioned). The use of negative lists was first implemented in the regulatory “test labs” of various free trade zones in China. If a foreign invested company is operating in a sector not listed on the negative list then the establishment procedure was expedited. In many cases there was no longer a need to require an approval but only complete a filing.
Two other interesting provisions in this new draft include granting foreign companies equal treatment and participation in government procurement activities and also specifically reiterating that foreign invested companies are allowed to conduct onshore China financing via IPOs or other securities offerings. Foreign companies have often faced discrimination in terms of government procurement as various state owned entities and institutions issue guidelines that limited suppliers to selected companies or requirements to fulfill which almost inevitably meant only a domestic enterprise could be selected.
VIEs: New Draft Foreign Investment Law versus the Original Draft
The first iteration of the Draft Foreign Investment Law was announced for public comment on 19 January 2015. It was intended to consolidate the various regulations on foreign investment in China into one overarching piece of legislation.
There was one section that was particularly concerning to foreign investors operating in restricted sectors – the introduction of the “de facto controller” concept. Under this concept, the determinant as to whether an investor is domestic or foreign would depend upon its actual controller rather than its location of incorporation or domicile. This de facto controller approach appeared to be squarely aimed at combatting Variable Interest Entities (“VIEs”). Had it actually been put into effect foreign companies using a VIE structure to invest in restricted or prohibited sectors in China may have faced enhanced scrutiny.
VIEs are domestically incorporated entities held by nominees and controlled by the foreign entity by means of contractual arrangements. Under a VIE structure, the “controlled” domestic company obtains the requisite licenses to operate the business. The contractual arrangements typically include exclusive service agreements which allow the finances of both entities to be consolidated under GAAP accounting rules.
VIE structures are used by both foreign investors who wish to circumvent restrictions on operating in China in restricted or prohibited sectors (notably telecommunications, education and media) as well as Chinese companies pursuing foreign financing or a listing on an offshore equities exchange. In many cases the sector is not prohibited but merely restricted and a number of foreign investors see the theoretical risk of enforcement of a VIE as far lower than the implementation risk of a joint venture with a competitor.
It has long been considered that the VIE structure is a “grey” area of Chinese law as it has never been tacitly approved by the PRC authorities and there have been some cases where the domestic company decided to not fulfill its obligations under the contractual arrangement and when taken to court it was ruled that such contractual arrangements were unenforceable as they were intended to circumvent PRC regulatory requirements.
Upon release of the first draft in 2015, many commentators were up in arms and claimed it spelled the end of the VIE structure in China. However, we believed at the time this outrage was overblown and overstated (as mentioned in our previous article). Furthermore, we saw a silver lining in that this was the first time the PRC authorities had validated the contractual arrangements which supported the VIE structure.
Now as we expected, the VIE structure seems here to stay. The “de facto controller” concept and all relevant provisions that caused the consternation are no longer included in this new Draft Foreign Investment Law. Although it has left room for Chinese regulators to have further thoughts in view of future development, this new draft does not include any negative passages towards the VIE structure; that is, the VIE structure will at least remain the “grey” area of Chinese law upon the passage of this draft.
Echoing this new draft, the Hong Kong Stock Exchange has specifically revised its guidance on listed issuers and continued to permit that VIE structures may be used to the extent necessary to address any limits on foreign ownership stipulated by relevant PRC laws and regulations. Further, it will update the guidance accordingly in case of changes of the Draft Foreign Investment Law.
To VIE or Not VIE?
We believe the PRC government is taking a more accepting approach towards the VIE structure. In addition to the removal of reference to “de facto controller” and other limitations in the new Draft Foreign Investment Law, there have already been steps taken by various PRC governmental authorities addressing the VIE structure that may not go as far as endorsement, but at least tacit acceptance.
In July 2016, the PRC Supreme Court entered a judgment on the very first case involving a typical VIE structure in compulsory education. The Court did not specifically address the legitimacy of VIE structure – it neither affirmed nor denied – but it suggested the Ministry of Education duly supervise the business to ensure foreign investors did not engage in actual operations for compulsory education. The core legitimacy issue was left to the consideration of the regulatory authorities. It should be noted that foreign investment in compulsory education is highly sensitive.
Foreign exchange regulatory authorities
In October 2005, the State Administration of Foreign Exchange (SAFE) published a circular providing that if a Chinese person/entity establishes a foreign invested company in China to control domestic assets through contractual arrangements it would constitute a round-trip investment and be subject to supervision by SAFE.
The 2005 circular was later repealed by another policy published by SAFE in July 2014, which made no reference to contractual arrangement or other similar wording. It seems that foreign exchange authorities were trying to avoid being drawn into a discussion of VIE structures.
As outlined above China’s education authorities have explicitly weighed in on VIE structures.
In August 2018, China’s Ministry of Justice released a second draft regulation on private schools (not yet effective), providing that foreign-invested companies and social organizations de facto controlled by foreign entities are prohibited from exercising de facto control over private school that engage in compulsory schooling in China. This requirement is in line with the China’s 2018 foreign investment negative list which specifically prohibits foreign investors from investing in China’s private schools for compulsory education.
In addition, the Chinese government has set rules in November 2018 stating that private funds cannot use VIEs structures to control state-owned or group-owned kindergartens and not-for-profit kindergartens.
While the said regulations and rules do cause concerns to foreign investors regarding Chinese government position on VIEs, this may, however, indicate that absent an express prohibition, foreign entities are not being restricted in other sectors through a VIE structure.
Securities regulatory authorities
As most of the lower-level authorities have kept discreetly silent for an extended period of time, the latest statement from the State Council has greatly increased confidence in the durability of VIE structures.
According to an opinion published by the China Securities Regulatory Commissions (CSRC) and subsequently forwarded by the office of State Council in March 2018, “Red Chip” innovative entities are permitted to list in China, even if they have VIE structures. “Red Chip” companies refer to those who are registered (or even listed) overseas while are eventually controlled by China entities and have its main business in China. Currently, CSRC only requests that the innovative/pilot entities disclose such VIE arrangement in the prospectus, explain the potential risks to the public investors, and update the implementation status in annual reports.
Following the above opinion, CSRC has released several detailed rules which reiterate its positive attitude towards innovative entities with VIE structures. Shenzhen and Shanghai Stock Exchange subsequently followed the said rules. Furthermore, Shanghai Stock Exchange is planning to set up a new board especially for innovative companies according to a regulation published on 28 Jan 2019. These will undoubtedly include Red Chip companies that have VIE arrangements
This development is encouraging as it may address the de facto controller issue, without affecting foreign invested entities. Initially after the issuance of the 2015 version of the Draft Foreign Investment Law it was thought that the intention of the de facto controller provisions was to validate Chinese controlled companies which had taken foreign investment as the ultimate controlling entity would still be Chinese and would therefore allow the China based entity to still be considered a domestic entity even though it had foreign investment. However, on the flip side, if the ultimate controlling entity of a domestic entity which utilizes a nominee shareholder, as is the case with VIE structures, then such entity would be classified as a foreign invested entity and regulated as such. The new CSRC opinion appears to allow for VIE structures ultimately controlled by Chinese entities to be considered domestic entities without applying the same standards to foreign controlled entities that use a nominee shareholder structure.
From a foreign-controlled VIE perspective the original Draft Foreign Investment Law was colloquially dubbed by a number of hysterical commentators as “the VIE killer”. However, as its successor has dropped any reference to VIEs we believe it should be business as usual. China’s regulatory position on VIEs may still evolve but we do not believe there will be U-turn given the VIEs have existed for about 20 years in China – many of China’s education, media and telecommunications companies listed offshore operate under VIE structures.
From the standpoint of foreign investors, the key concern in a VIE structure is the enforceability of the contractual arrangements – these are core. Indeed, almost all issues relating to VIEs have been that the nominee shareholder behaves badly not actions instigated by the authorities. Typically, foreign companies pick as the nominee shareholders someone connected to their business in China (e.g. local management; distributor etc.). Although this is understandable it is probably the highest risk approach. Better to select someone dependable and (crucially) independent of the business as your nominee shareholder.
We expect as China continues to open its market and the market becomes increasingly attractive where foreign investors facing restrictions will opt for “clever” VIE models. “Clever” will mean that the foreign investor will weigh whether it is practically feasible for a VIE; if it has found the right nominee shareholder and bespoke contractual arrangements and operational controls so risk is mitigated.