Yesterday, co-blogger Steve Dickinson wrote a post essentially excoriating VIEs. That post went live early this morning. A few hours before our post went live, Bill Bishop (who knows as much about China’s tech industry as any human being alive) wrote a post essentially saying that those who are trashing VIEs are engaging in scare tactics and that there is little cause for worry.

Bishop makes his very powerful counter-argument on his Digi-Cha blog, in a post entitled, “Bloomberg Keeps VIE Fears Alive: China Companies Evading Rule With U.S. Listings Stump Regulators” [link no longer exists]. Bishop contends that “so many powerful interests have financial stakes in VIEs that it would be career suicide or worse for a Chinese bureaucrat to destroy this structure on a wholesale basis.” We do not disagree with this statement, but we do not think it deals with the two main issues. One, the government has come out with regulations making very clear that such structures are illegal. On top of that, and as we have said all along, these regulations probably should not have even been necessary because VIEs were almost certainly already illegal under a proper reading of the various applicable laws. Having said this, however, we fully recognize that the Chinese government has in the past come out and said something was illegal and then done nothing about it. See, for instance, “China Rules Skype Illegal. Tell Me Something New,” where we predicted that the government’s making Skype “illegal” would have no real impact.

But with VIEs it is different and Bishop does not address our main point (note again that his post came before ours).

Whether or not existing VIEs are shut down (and at this stage we tend to agree with Bishop that they generally very likely will not be), the reality is that they have now been deemed illegal and that cannot help but have a major and game-changing impact on them. As mentioned above, VIEs are a structure that allows foreign companies to control the Chinese entity via various contracts. Now that those various contracts have been declared illegal, it will be difficult/impossible to enforce those contracts in Chinese courts. In this VIE structures, many of the contracts involve foreign countries and foreign country enforcement so their illegality in China may be minimized to that extent. However, even outside China, the party seeking to avoid enforcement of a contract will, in many cases, still be able to argue against enforcement based on China’s having made the structure illegal.

In many ways, what is happening to VIEs is no different from what we have called “fake Joint Ventures” and on which we wrote in the post, “Fake China Joint Ventures: Why You Calling Me, I’m Not The Guy:

In that post, I very loosely transcribed into one conversation a number of conversations I had been having with people wanting to set up contractual arrangements to avoid China’s expensive and difficult joint venture laws:

Caller: I’ve got this great website and it is exactly what China wants/needs. And I’ve been working on developing it with some Chinese tech friends of mine and we want to take it legal so we can start getting VC (venture capital) funding for it. Here’s our plan. Now I know that the old/truly legal/expected/usual way to do this is for me to form my own company and then form a joint venture with my Chinese partners, but I also know that will cost a lot of money. So our plan is for the Chinese company to own the website and then we will have an oral agreement (or a written agreement) that I really own half of it.

Me: Listen, my firm has been contacted at least twenty times after these situations have gone bad and I am aware of at least another twenty times where the same thing has happened, and let me tell you, these arrangements (it is NOT proper to call these joint ventures) virtually always end the same way. They end with the Chinese company booting you out completely and leaving you with no recourse. Protecting foreign companies in legitimate joint ventures is difficult enough, but it is pretty much impossible under the scenario you are describing. We had a guy who paid us a lot of money once for us to do everything we could to try to get “his” multi-million dollar business back. Guess what, we could not even come close to getting it back. Every Chinese lawyer we talked to about suing to get it back told us we had no chance of winning at all. I mean, just listen to the argument we would need to make to the judge:

Your honor, my client knew that China’s laws are very clear on what foreign companies must do to operate legally in China, but he thought these very clear laws should not apply to him because, well because he is an American tech company and he was just too smart/too poor to bother to comply with the very clear laws. So instead, he had this great method for completely circumventing China’s very clear laws. His idea was to not form a company, but rather, have his Chinese friends form the company and he would have a little side deal with that company. Well, that side deal has now gone bad and my client wants you to go against China’s very clear public policy on how foreign business is to be done in China and enforce this unwritten side deal.

What do you think of that argument?

Caller: (long pause) I understand things could go wrong with that kind of arrangement, but would you be willing to draft the contract between me and the Chinese company?

Me: No. I can’t do that. I can’t draft a contract that I know will never work. I just can’t. Give me a call if you ever want to do this legally, in a way where you actually have a chance of profiting from your work down the road.

For more on this, check out “China SMEs, Own If You Want To Own.” To get a feel for how difficult it can be even with a fully legal joint venture, check out this article by Steve Dickinson in China Brief, entitled, “Avoiding Mistakes in Chinese Joint Ventures.” and this Wall Street Journal article I wrote, entitled, “Joint Venture Jeopardy.

Update: In, “Private Equity, Venture Capital and ‘Fake’ China Joint Ventures,” China Hearsay very nicely maps out the way these deals are typically done (using an offshore holding company) and notes that you might have legal recourse in the rare instances where your Chinese partner has “huge assets offshore” in a country in which you can sue and win:

You can tie up the Chinese founders in 100 different contractual knots, but unless those founders have huge assets offshore (real assets, not equity in the holding company) that you can go after in a dispute, they can always tell you to piss off and kick your ass out of the business.

All I can say is that I have never and I will never invest in a company based on so thin a reed.

FULL DISCLOSURE: Our firm long ago made the decision to work with those companies and individuals with claims based on the arrangements set forth above, as opposed to representing those wanting to enter into such arrangements.

THIS JUST IN: Stan Abrams over at China Hearsay is out with a post, entitled, “A Post-Holiday Update on VIE Chatter,” that essentially says what this post says, which is that the dividing line between Bishop and us is that Bishop is analyzing what the government is likely to do with existing VIES while we are analyzing the risks involved in having a corporate structure based on unenforceable contracts. Stan completely nails it when he says he thinks the differences between us and Bishop stem largely from the angle from which we are looking at the VIE issues:

Anyway, I have nothing new to say, but I did want to point out a couple of new things for you VIE groupies to read. First is a lengthy Bloomberg overview of the issue. It’s generic, and therefore a decent place to start if you’re looking for a jumping-off point to the topic. Second and third are two opinion pieces, by Bill Bishop (DigiCha) and Steve Dickinson (China Law Blog), who sort of set themselves up on opposing sides of the issue.

It was interesting reading these two blog posts, since both authors are wicked smart, experts in their respective fields, and very opinionated (not that there’s anything wrong with that).

Stan then describes Bishop’s post as putting forth “The sky is not falling” position and Steve’s post as “VIEs are complete rubbish and should be avoided like the plague.” Stan then notes how the positions appear very different, but maybe not so:

So, at first glance, two very different views, and I bet they would get into a serious argument if the opportunity arose. But I actually think that their fundamental conclusions are both right but are merely coming at the issue from two very different perspectives. Bill is a Internet and finance guy, and is looking at the market, firms’ access to capital, and what the government is likely to do.

Steve, on the other hand, is a corporate lawyer. He is looking at potential risk, at what might go wrong, and what is/is not a technical violation of the law.

When Bill says that we shouldn’t worry about the government going after Chinese listed firms in the U.S. that use the VIE structure, I think he’s right. All the inside chatter on that issue seems to indicate that the government will grandfather in those companies even if it adopts a new enforcement strategy.

And when Steve says that VIEs are rubbish, he’s of course right. These things are illegal in that their purpose is to deliberately skirt foreign investment restrictions. I don’t actually agree with him on what the M&A rules mean (I think it’s too early to tell), but I definitely agree with his overall legal opinion.

Stan then goes on to say essentially what I say above, which is that the story is not the shutting down of VIEs, it is the inherent risks they present by being based on illegal contracts:

All this being said, if I have one bone to pick with recent commentary on this subject it’s that it emphasizes the latest regulatory goings-on without paying attention to the real risk story with respect to VIEs. The most likely source of problems with these companies has nothing to do with the government, but rather with unenforceable contracts and unstable shareholding structures. Perhaps this is one of those things to which Bill was referring when he said that there are other reasons to be cautious about investing in China. (I should also point out that Steve regularly writes about these sorts of legal issues as well.)

I completely agree.

UPDATE: Fredrik Öqvist over at the China Finance Blog did an excellent post today, entitled, Consolidating Recent Opinions on VIEs, in which he seeks to synthesize all the posts that have been written on VIEs in the last few days by me, by Steve Dickinson, by Stan Abrams, and by Bill Bishop. Fredrik concludes his post with his own take on VIEs:

Here’s where I think the real issue lies, but I don’t think it’s entirely confined to future deals and PE/VC investors. This could for all intents and purposes have a deeply negative impact for listed companies as well.

In order to consolidate VIEs one has to show that the listed company not only receives the economic benefits and takes the economic risks of the venture, a second condition is to show that the VIE is in fact controlled by the listed company. If the contracts, which are put in place to establish this control, are indeed deemed illegal and unenforceable, fulfilling the second part of the consolidation requirement becomes decidedly more difficult.

I agree.

  • Dan, thanks for the post, no offense taken. Having set up and invested in several VIEs,and had friends deal with disputes over their VIEs, I am very aware of the issues around validity of contracts, and some of the steps that more cautious investors can take to mitigate, at least up to now, some of the more egregious risks.
    Given the choice of participating through a VIE or not participating at all, many have obviously chosen to accept VIEs, and in fact the legal disputes around them have been fewer than many would expect. I wonder if VIEs or JVs in China have proportionally had more legal problems?
    A couple of questions. Have the VIE structures officially been deemed illegal? From an article today
    http://finance.sina.com.cn/chuangye/ipo/20111009/233610587219.shtml
    8月26日,商务部发布了《商务部实施外国投资者并购境内企业安全审查制度的规定》(下称《并购审查规定》),明确指出外资并购境内企业不得以VIE模式等方式规避安全审查,将VIE纳入监管范围。
    that same article mentions several other previous regulatory efforts around VIEs, none of which really stuck:
    2006年,信息产业部确曾下发《关于加强外商投资经营增值电信业务管理的通知》,规定“境内电信公司不得以任何形式向外国投资者变相租借、转让、倒卖电信业务经营许可”。业内认为,这正是监管部门对外国投资者借助VIE等规避方式的一种否定。然而,该通知终又因打击面过广而从未得到彻底实行。
       但这并不表明监管层就此放松警惕。当2009年中国秦发上市,将“协议控制”从行业上再迈出一大步的时候,其上市承销券商和律师被监管层“约谈”。与以往采取VIE的互联网等公司不同,中国秦发是典型的重资产企业,而且经营的是煤炭等资源性产品。
       此后,多家准备步中国秦发后尘的类似企业探知监管层态度,望而却步。因此,尽管一直以来中国法律对VIE并无明确禁止性文件,业界仍小心翼翼遵循一些已默认的“潜规则”,如VIE结构的企业应为轻资产且业绩良好等。但即使是这样的公司,也并不知道监管绳索何时会收紧。
    Second, have VIE contracts always been successfully enforced in Chinese courts to date? How many cases have there been?
    And to be clear, my comments about lawyers using scare tactics to market was not directed at you guys, and in fact came from comments by lawyers I know at some of the big US firms in Beijing who find some of the press comments by colleagues a bit overblown.

  • Peter Schloss

    Interesting discussion as always on China Law Blog. One thing I have not seen you or any of your commentators discussing with regard to VIEs is the accounting issue that investors face, which is equally important as the legal issue. As you know, the VIE structure is not only a mechanism by which foreign ownership restrictions are avoided, but also a mechanism which has allowed entities that are not subsidiaries under PRC law (and US, Cayman and BVI Law for that matter) to be consolidated under US GAAP for income statement purposes pursuant to Fin. 46. Accordingly, there are really two issues at hand here: (1) the legality of the VIE structure under PRC law and whether the lack of a “clean” PRC legal opinion will impede VIEs from being listed on foreign stock exchanges, and (2) whether the SEC will continue to allow consolidation of VIE financials under Fin. 46 if the VIE structure continues to be questioned under PRC law. Without the ability to consolidate the financial performance of the operating entity that is actually controlled by PRC citizens (because of the VIE structure) the VIE structure is meaningless.

  • Hua Qiao

    @ Peter Schloss
    Peter, you read my mind. It is not clear to me what the accounting community will do as a result of the now clear bright line in China law. How do you issue a clean audit opinion where the structure is based on unenforceable contracts?

  • David

    It’s the financial accountability that has killed VIEs not so much the legal arguments. They were always dodgy and most sensible firms in China stepped away from advising clients down that route. They were talked up by PE guys keen to get a deal done, that’s all they ever were. Smoke & Mirrors.

  • Always amusing to find that it’s possible to agree with all comments on all sides of a rather divisive issue — as they say: “This Is China.”
    I understood, as Dan implies in the original post, that this regulatory change was like many past “announcements” of regulatory changes in tricky situations, which have tended to follow roughly these steps:
    1. officialdom begins to notice some noise around a potentially controversial issue (i.e.: Jack Ma’s purported thievery), but makes no official statements
    2. rumors and prognostication grow louder, and regulators make subtle inquiries in the background
    3. windbag publishes an editorial in Chinese press, with the tacit approval of officialdom, leading key players to frantically search for crystal balls
    4. regulators announce “change” of some sort, but leave gaping holes in the logic/execution, which drives everyone involved into a state of utter frenzy
    5. after an unspecified period, regulators assess the reactions from key parties, and then either make additional adjustments, or abandon the whole venture / start over.
    6. maybe a “final” change is proposed and accepted, or maybe everyone continues to muddle through
    … or something along these lines.
    Is this one of these situations, and are we not mired somewhere in the middle of this progression?

  • Twofish

    Harris: One, the government has come out with regulations making very clear that such structures are illegal.
    No they haven’t. MOFCOM has issued a regulation which restricts the creation of new VIE’s. It’s far from clear that it makes these structures illegal.
    Dickinson: Even if the Chinese regulators doe not take this drastic step, it is now clear that the contractual arrangements on which the various VIEs are based are in clear violation of Chinese law. This renders the contracts unenforceable and makes existing VIE structures essentially meaningless.
    Absolutely not true.
    MOFCOM doesn’t have the authority to invalidate contracts that are already written. In order to invalidate the contracts, you’d need a a series of ruling from the courts. It’s possible that the courts will agree with MOFCOM, and invalidate the contracts. On the other hand courts are often more sympathetic to local governments than MOFCOM, so it’s quite possible that they won’t. Even if they do, it will take about a year or two before you have a series of decisions that invalidate contracts, and it’s not likely to be a sudden thing.

  • Dan

    Bill, I have always believed that VIE contracts were illegal because they sought to do exactly what China had forbidden: put foreign companies into industries in which they were not allowed (other than as joint ventures). MOFCOM’s recent regulations were (to me anyway) simply a confirmation. I am not aware of anyone having sued on a VIE contract in a Chinese court and I doubt we will see that for some time, if ever. The real point though is that Chinese companies now have tremendous leverage over their foreign partners because everyone now knows that the foreigner who sues is going to have little chance to prevail. The other real point is that (as noted by other commenters), MOFCOM’s new pronouncements are going to make it very difficult for foreign companies to claim in their mandatory reports that they still own companies in China as though nothing ever happened. It is going to be very interesting indeed to see what we get in those reports down the road.

  • Twofish

    Bishop: A couple of questions. Have the VIE structures officially been deemed illegal?
    Define illegal. Also define “official”
    They are inconsistent with the MOFCOMM guidelines on permitted foreign investment. On the other hand, MII and local governments have issued business licenses for them, and courts not shut them down or generally invalidated any contracts.
    One thing about China is that you have a ton of officials and a ton of laws and regulations, and so when you have a situation when one set of officials and regulations are acting counter to another set of laws and officials, you end up with a mess. One thought experiment you can do is to imagine what would happen if a company in China set up a “long live Tibetan independence” website. They’d be shut down in thirty minutes. The fact that we are even arguing about this tells you that we are not in that situation.
    There are also different consequences. For example, the absolute worst thing that can happen to someone investing in a VIE is that they lose all of their money. There is no legal basis that I can see for pressing criminal charges against someone that invests in a VIE. Also, there is the issue of “moral stigma.” There is no moral stigma that I can see associated with investing in a VIE.
    So asking “is this legal?” is the wrong question. The right questions, are “will I end up in jail?” “is this moral and ethical?” “how much money to I stand to lose?” “how much warning to I have if things start to fall apart?”
    About contract enforceability. How a contract holds up in court is not the only (or even the main) mechanism for enforceability. The reason VIE’s are popular in certain fields is that tend to be used in businesses which require large sources of new funding. This means that if you renege on a contract, your funder is not going to court. They’ll just stop writing the checks, and then the company collapses. In the case of VIE’s, the VIE structure is usually essential for the Chinese company to get funding from the stock markets, and if the managers “take the money and run” they’ve just killed the golden goose. The other thing about PE firms is that they plan on cashing out. If the VIE explodes after they cash out, then it’s not the PE firms problem.
    About risk. VIE’s are also popular among PE firms. Yes, it’s possible that the Chinese government will shut it down, but that’s only one of dozens of ways that the company could fold, and one thing that you have to remember about PE firms is that most of the businesses they invest in, do in fact, go under. It’s the one in ten business that succeeds that makes up for the nine in ten that fail, and so telling a PE firm that they could lose all of their money in China brings up a “yes we know that already. We can lose money in China, and statistically we probably will.”
    This means that for a PE firm the big question whether “we are likely to lose all of our investment” versus “the Chinese government will issue arrest warrants for us” and no one has suggested that the second is even possible.

  • Twofish

    One very good summary of the legal status of VIE’s is if you go to any SEC filing for a Chinese internet company. On the “what could possibly go wrong” section of the SEC filing, you’ll typically see about five pages of PRC legal risks inside of 20 pages of general risks, and there is an exhaustive catalog of “regulations that could be used against us.”
    One reason people seem to think that the Chinese government is going to allow VIE’s is that often you’ll find a regulation saying “we don’t want you to X” followed by another regulation saying, “we really, really, really don’t want you to X under condition Y, and you will get into a lot of trouble if you do X under condition Y.” At which point, you don’t do X under condition Y, and you can sort of guess that doing X without condition Y isn’t that bad.
    The other thing is that “banning VIE’s” in US GAAP is harder than it sounds. The reason that VIE’s came into existence in the first place was because of Enron. Enron was able to use accounting rules to hide a lot of stuff outside of the company. So the accountants got together that wrote some rules that says that if certain conditions are satisfied that a company *MUST* put external assets and liabilities on the balance sheet of the main company. This is to keep clever accountants from hiding things off the balance sheet.
    But since highly paid accountants are clever people, someone else figured out that you can intentionally make those conditions happen at which point a US company *must* declare the assets/liabilities of an overseas subsidiary, and that’s a good thing if you want to list a Chinese company on a US exchange.

  • Twofish

    Bishop: Second, have VIE contracts always been successfully enforced in Chinese courts to date? How many cases have there been?
    I don’t know of any situations in which a Chinese court has refused to enforce a contract for a VIE, nor do I see any obvious grounds for refusing to enforce the contract.
    Article 7 In concluding and performing a contract, the parties shall comply with the laws and administrative regulations, respect social ethics, and shall not disrupt the social and economic order or impair the public interests.
    However, if the VIE entity in China has a valid business license and valid licenses from the various ministries involved, it’s very hard to argue that said party was not complying with the law. Sure the Chinese government can shut you down one day if they stop likely VIE’s, but they can also shut you down one day for one of a billion other reasons.
    Also there are some legal arguments you can use to get a court to enforce a contract even if the state invalidates the VIE. Someone negotiates a contract with you knowing full well that the state will invalidate the VIE. The state invalidates the VIE, and they person in China takes your money. At that point you can sue them on the grounds of breaching the duties of good faith and fairness in negotiating a contract they know to be invalid, and for planning on taking your money.
    (And before anyone points out that there is no duty of good faith and fairness in prior to the formation of the contract. That’s US and English contract law. Chinese contract law is different.)
    It’s also possible to write a contract that has contingencies. If the Chinese government does something (i.e. revokes the business license) then what happens? It’s also pretty standard in some fields to write a contract that covers a situation that is clearly not allowed not, but may be in the future (i.e. we own X% of the JV, and everyone agrees that the ownership will increase to Y% if regulations allow it).
    One other thing about reading Chinese law. The first thing that you need to look at is who writes the law and regulation and who it is directed to. If the SPC issued an interpretation stating that contracts that formed a VIE were invalid and that lower courts should not enforce them, that’s one thing, but we have here a regulation from the Ministry of Commerce saying that the ownership structure is not grounds for avoiding a national security review (well DUH!!!) which is hardly the end of VIE’s.
    If you are planning to start an internet company that is controlled by the CIA with the aim of sending military secrets to the US, well a VIE is not going to protect you, but that’s not what we are talking about here.
    If anything regulations like this make people think that VIE’s are going to stick around for a while. This is only one of many, many regulations that say that VIE’s are not going to be tolerated under certain conditions, but the fact that the regulations say that VIE’s are not going to be tolerated under certain conditions (i.e. you can’t use them to circumvent a national security review) suggests that implicitly the government tolerating them in other conditions.

  • Twofish

    Articles 9 and 10 of the “Regulations of the Ministry of Commerce on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors” reads as follows:
    Article 9
    In regard to M&A of domestic enterprises by foreign investors, an M&A transaction shall be
    determined whether it falls within the scope of M&A security review from its material contents
    and actual impact; foreign investors may not in any way materially circumvent the M&A
    security review by means including, without limitation, nominee shareholders, trusts, multi-level
    reinvestment, leases, loans, control by agreement or offshore transaction.
    Article 10
    With regard to an M&A of a domestic enterprise by a foreign investor that has not been
    submitted to the Ministerial Panel for review or which upon review has been deemed by the
    Ministerial Panel not to impact national security, if it thereafter falls within the scope of security
    review specified in the Notice of the General Office of the State Council Concerning the
    Establishment of the Security Review System for Mergers and Acquisitions of Domestic
    Enterprises by Foreign Investors due to adjustment to the M&A transaction, modification of
    relevant agreements or documents, alteration of operating activities or other changes (including
    changes in the offshore actual controlling party), the parties concerned shall suspend the relevant transaction and activities, and the foreign investor shall file an application with the Ministry ofm Commerce for M&A security review in accordance with these Regulations
    It’s basically a modified copy of the US regulations setting up CFIUS. The one big difference between this and the US regulations is that in the US, The Treasury Department is the lead agency whereas in China it’s MOFCOMM. There are reasons for this.
    I do not think that it outright makes VIE’s illegal (and even if it did, the regulation would be invalid as MOFCOMM does not have authority to do so). The language of the text says that the ownership structure does not exempt a company from security review. It’s also important to note that the security review will not be done by MOFCOMM. This regulation merely designates MOFCOMM as the agency that accepts the paperwork.
    So wouldn’t the security review revoke VIE’s? Possible, but not likely. First of all, if it did do so, it would have nothing to do with this regulation. Second, in the case of VIE’s, you’ve already got a business license from MIIT so someone likes you. Third, if you are in a situation where the PLA, Ministry of State Security, or Ministry of Public Security wants to block your business, you really have more things to worry about.

  • LH

    Seems to me that Dan is (rightly) emphasizing the fact that it will be difficult to enforce the contractual rights of the foreign party in a VIE.
    It seems to me that there is another concern, which might be even bigger in some industries than contract enforcement, namely that the government now has a simple mechanism for shutting down selected VIEs that it is uncomfortable with (on any grounds). In other words, it no longer needs a specific contractual or statutory grounds for doing something like the Alipay transfer; it has a catch-all in the illegality of VIEs. My guess is that what the Chinese government will do is allow VIEs that they don’t object to to continue to operate (and they won’t care whether they can enforce their contracts or not, that’s the VIE partners’ problem), and cherry-pick offending ones and shut them down.
    -LH

  • Richard Sze

    Its not the best argued point of law by Steve or Dan on this occasion. There’s too much ambiguity as Twofish has pointed out, and MOFCOM has NOT declared VIEs illegal.

  • Guys, Bill Bishop does NOT make a “powerful counter-argument.”
    “Bishop contends that “so many powerful interests have financial stakes in VIEs that it would be career suicide or worse for a Chinese bureaucrat to destroy this structure on a wholesale basis.””
    This is what is known to any first semester student of Logic, Rhetoric, or Philosophy as an example of the logical fallacy of argumentum ad verecundiam (argument from authority).
    It is just that type of thinking that has caused so many Westerners to fall victim to con after con in China.
    Bishop makes the same error in reasoning that so many others have, and will continue to commit. Of course, none of us are immune from logical fallacies. It is, indeed, very hard to work to overcome them, but surely necessary.

  • @buyerstrike
    how many chinese officials do you think took a first semester class of western Logic, Rhetoric, or Philosophy? your logic is not the same as their logic, I promise you
    i love your blog and know you have been right on a lot of short calls. There are many reasons to be short specific china names, my point is that this VIE issue is not the biggest reason, and it is a mistake to think that an entire class of companies will be killed over it.
    @twofish makes several very important points. wish i knew who he/she is
    btw, i followed this post with another one at digicha

  • Tim

    @Bill, Although I don’t see how ‘argument from authority’ is relevant to your assertions; your argument that logic is different depending on the person confounds logic with reasoning.
    In any event, I agree with you that a dramatic reversal on the current state of VIE’s would be the equivalent of career suicide.

  • Twofish

    BuyerStrike!: This is what is known to any first semester student of Logic, Rhetoric, or Philosophy as an example of the logical fallacy of argumentum ad verecundiam (argument from authority).
    This sort of logic is extremely important in “real world law.” The problem with “real world law” is that invariably the explicit language of the law is subject to interpretation, and a lot of how the law is interpreted depends on interest groups. This isn’t merely a Chinese issue. If a case goes before the US Supreme Court, I can pretty much guarantee that Sonia Sotomayor and Clarence Thomas will interpret the law in different ways. Without knowing anything about the legal logic, I can also pretty much figure out what the final conclusion will be. It’s fun reading Supreme Court decisions, because you know that the judge wants to reach a certain conclusion, and they have to go through logical steps to get to that conclusion.
    The reason that politics matter is that language is complex, and intepreting the law is sometimes more akin to trying to interpret a poem than it is to trying to do an exercise in mathematical logic.
    Also in this particular situation, I have heard it repeatedly stated that VIE’s are clearly illegal under Chinese law, and this simply is not true, and I have not seen anyone provide a *LEGAL* argument as to why this is true. The closest thing that I’ve heard is that VIE’s circumvent the “spirit of the law”. Well it so happens with Chinese law, that sometimes the spirit of the law is important and sometimes the letter of the law is important. There are certain specific words that Chinese legislators and regulators put into the law and regulations to state what their intent is, and in this particular situation they haven’t stated an intent to apply VIE to the spirit of the law.
    I also think that what may be happening is that US lawyers are using US legal interpretation rules to interpret Chinese law, which leads to a lot of problems. American law is often written “metaphorically” which is to say that US law explicitly mentions a specific situation, and you are expected to figure out a general rule from those specific situations. A good example of this is the First Amendment which says “Congress shall pass no law….” but really means that “no one in the government should do this…” The typical US lawyer curriculum is for the student to read large numbers of specific cases, and figure out a general rule.
    However, Chinese law (and for that matter German law which is the basis of Chinese law) just doesn’t work that way, and you will get into trouble if you read a Chinese regulation as if it was a regulation written in the United States. When there is a general rule it will be stated as a general rule. If you read in a Chinese regulation “Congress shall pass no law…” it means Congress can’t, but anyone else can. If the regulators means something else, they’ll use different language.
    Article 9 of MOFCOMM regulations says that you cannot circumvent a security review by changing the ownership structure and that means that you cannot circumvent a security review by changing the ownership structure, but it says nothing about other licensing requirements.

  • Twofish

    LH: It seems to me that there is another concern, which might be even bigger in some industries than contract enforcement, namely that the government now has a simple mechanism for shutting down selected VIEs that it is uncomfortable with (on any grounds).
    No need to get that complicated. In the case of internet content providers, the Telecommunications Law and associated regulations gives the MIIT the power to grant business licenses, and they can withdraw them for very vague reasons. The reason that I very strongly disagree with the idea that VIE’s are illegal is that to run a business in China, you need the approvals of a lot of different parts of government, and VIE’s have gotten those approvals.
    Dan: Bill, I have always believed that VIE contracts were illegal because they sought to do exactly what China had forbidden: put foreign companies into industries in which they were not allowed (other than as joint ventures).
    Show me that regulation, since I don’t think it exists. The closest thing is the Catalog of Foreign Investment and you can probably write a good ten page law review article on the legal status of that document.
    I know of no situation in which a VIE has been used to allow investment into an industry in which the authorities have explicitly *prohibited* foreign investment. VIE’s are used in situations in the “restricted” sector, and in the case of internet media, the restriction is that the holder of the license must be a PRC national.
    If the authorities didn’t want to do this, then why are they issuing operating licenses for the companies to operate? These companies are hardly operating “under the radar.” In the filings to the SEC that are quite open about their financing, and there are several examples in which the MIIT has issued operating licenses to VIE internet telecoms very recently.
    Dan: The real point though is that Chinese companies now have tremendous leverage over their foreign partners because everyone now knows that the foreigner who sues is going to have little chance to prevail.
    Lawyers need to understand that lawsuits sometimes don’t matter.
    If the company tries to seize assets, they the foreign partners kill their access to foreign capital markets. The whole point of a VIE is so that internet company can raise money in NYC, London, and HK, and if you kill the VIE, then that money goes away. Also, I strongly suspect that the contracts are written so that much of the operating cash is parked overseas so that if the VIE stabs the investors, then the investors will grab the cash that is outside of China, and kill the company.
    In any event, lawsuits often are of extremely limited importance in capital markets because of things like the “business judgment rule.” If you buy stock in a company, and the management pays themselves huge salaries and runs the company into the ground, you aren’t going to get your money back via a lawsuit, because more than likely they can claim bad business decisions.
    Even if the management is totally fraudulent (i.e. Madoff), the best you can get is revenge. You aren’t going to get your cash back. Yes there are risks in investing in a Chinese VIE, but the legal risks are minor in comparison to the dozens of other risks that you have.
    Dan: MOFCOM’s new pronouncements are going to make it very difficult for foreign companies to claim in their mandatory reports that they still own companies in China as though nothing ever happened.
    No it doesn’t. MOFCOM changes nothing about GAAP. Remember that VIE rules exist because Enron ended up having a lot of debts by having contracts with companies it didn’t legally own.
    Also SEC filings by PRC companies raising money in the US already have six or seven pages of tiny print that spell out in detail all of the possible things that could legally go wrong. Adding one or two sentences doesn’t change the picture much. I sometimes think that mandatory disclosure rules are a cute way of escaping legal responsibility because people end up putting a ton of stuff in documents that no one really reads anyway. If you not are scared away by what’s in the SEC filings already, the new MOFCOM regulation isn’t going to make any difference. It’s just one more entry in the very long list of “this is how the Chinese government could kill us if they wanted to” things that are already there.
    One point that is important that any Chinese company that lists overseas should be looked at with suspicion. There are a few good companies. There is a lot of junk. There needs to be a lot of suspicion. One reason to be suspicious is that if the companies were such a great deal then why isn’t the Chinese government letting them list in Shanghai or Shenzhen?

  • LH

    Twofish writes: “No need to get that complicated. In the case of internet content providers, the Telecommunications Law and associated regulations gives the MIIT the power to grant business licenses, and they can withdraw them for very vague reasons. ”
    Right, but in this case there is no business license for the foreign side of the company, and the gov’t might not want at all to dissolve the Chinese company. Invalidating the VIE agreement itself is a simple way of nationalizing the company without taking it down. In the Alipay case for example there was no desire to withdraw licenses (afaik). It was simply the foreign “control” that the gov’t sought to remove, and rather than by transfer of assets it could be done simply by declaring the invalidity of the VIE structure.
    Twofish writes: “The whole point of a VIE is so that internet company can raise money in NYC, London, and HK, and if you kill the VIE, then that money goes away.”
    No, there are other purposes to the VIE. The most obvious from the foreign investor’s point of view is the ability to profit from a market that is prohibited to them by law. And exerting control over the firm for that purpose is the intent behind the VIE structure. The way you write, it is as if all the benefit of a VIE accrues to the Chinese side but I don’t think this is at all the case.
    -LH

  • Peter Schloss

    While I am thoroughly enjoying the somewhat Socratic debate on logic versus reasoning, the points raised are actually moot, or somewhat irrelevant. The real issue at hand is this: Until there becomes clarity on the veracity of the contracts used in the typical China VIE structure it is doubtful that there is any auditor willing to issue an opinion stating that the domestic entity’s (which is the operating entity) financial results can be consolidated under Fin 46 (and/or ARB 51). I have had informal discussions with Beijing based partners of big 4 accounting firms on this issue and there is no disagreement amongst them on this point.

  • Twofish

    LH: Right, but in this case there is no business license for the foreign side of the company, and the gov’t might not want at all to dissolve the Chinese company. Invalidating the VIE agreement itself is a simple way of nationalizing the company without taking it down.
    It’s not so simple. First of all, if the VIE is invalid the control over the Chinese assets go over to the Chinese owners, which is different from nationalization. Second, it’s possible to write the contract in a way so that something “bad” happens if the contract is invalidated. Third, invalidating contracts is something that requires a lot of “bureaucratic inertia.” It’s something like bombing Los Angeles. Yes the Chinese government could do it and it would do it if it’s interests were seriously threatened, but it’s nothing that I’d expect to see happen tomorrow, and it’s really not likely to happen without some advance warning.
    Finally, the most common situation with high-profile companies is that the Chinese managers control both the domestic company and the overseas “shell company”, so that the contracts are written between the managers and themselves. The funders write contracts with the overseas company and that’s *better* than dealing directly with the Chinese company, because that means that the contracts are US/HK/BVI contracts and the money is overseas.
    LH: It was simply the foreign “control” that the gov’t sought to remove, and rather than by transfer of assets it could be done simply by declaring the invalidity of the VIE structure.
    Nothing “simple” about it. The problem with invalidating VIE contracts is that there is no simple way of invalidating a particular contract without invalidating *all* such contracts, and there are a lot of situations in which the government wants to keep a VIE. In the high profile VIE’s, Chinese managers are in control of *both* the local company and the overseas Delaware corporation.
    Yes the Chinese government is concerned with foreign control, but licensing is better tool than contract law. Thing about licenses is that you can decide what licenses to give and revoke (which incidentally allows for blackmail), whereas with contracts *by design* you can’t invalidate an individual contract without invalidating all similar contracts.
    LH: No, there are other purposes to the VIE. The most obvious from the foreign investor’s point of view is the ability to profit from a market that is prohibited to them by law. And exerting control over the firm for that purpose is the intent behind the VIE structure.
    It’s not against any Chinese law or regulation for a foreign investor to profit from Chinese internet companies.
    Also in a lot of Chinese internet companies, the VIE structure is not at all intended for the foreign company to control the Chinese company. The foreign company is a shell that exists solely for the purpose of raising overseas money, and is controlled by the Chinese managers.
    If a foreign company tried to “control” a Chinese media company in ways that the Chinese government found unacceptable, yes, they would get shut down, but this has nothing to do with VIE’s.
    Scholss: it is doubtful that there is any auditor willing to issue an opinion stating that the domestic entity’s (which is the operating entity) financial results can be consolidated under Fin 46 (and/or ARB 51)
    Except they are doing it. Go into edgar and pull up the SEC filings for your favorite set of VIE’s. What is likely happening is that the accountants are talking to the lawyers, and the lawyers are saying more or less what I’ve been saying here (i.e. the contracts are good).
    Scholss: I have had informal discussions with Beijing based partners of big 4 accounting firms on this issue and there is no disagreement amongst them on this point.
    SEC filings are done by the US office, and there are several recent examples in which auditors have signed off on SEC filings. Companies listed in the US are legally required to filing reports with the SEC. If the major auditors refuse to sign off on the VIE balance sheets, that is big, big, big, big news, but that hasn’t happened yet.
    One problem is that if they restate the VIE balance sheets they would have to go back and retract all of their previous signing statements and that would be big news.
    Also, I can pretty much prove that people don’t think that the new regulations are a big deal, because if they were, you’d have this massive filing of 8-K statements, which hasn’t happened. If the lawyers thought that the new regulations really did kill VIE’s, they’d tell the accountants, at which point the accountants would have to file something with the SEC.

  • Tim

    TwoFish: Also in a lot of Chinese internet companies, the VIE structure is not at all intended for the foreign company to control the Chinese company. The foreign company is a shell that exists solely for the purpose of raising overseas money, and is controlled by the Chinese managers.
    I haven’t seen any stats on this ; but my experience with VIE’s have been the reverse. The FIE holds most if not all of the assets while the locally invested company holds the specific licenses while day to day management is foreign controlled. This is particularly the case with PE’s that are interested in sectors that they cannot establish WFOE’s.

  • LH

    Twofish: It’s not against any Chinese law or regulation for a foreign investor to profit from Chinese internet companies.
    Looks to me like you’re bending over backwards to avoid the most obvious reading and implication of this law, haha.
    The Alipay case was high-profile. It was internet. The nationalization — well, the de-foreignization if you like, but to me it’s a distinction without a difference in most cases — came at the behest of the Chinese government. This was as reported by the Chinese party to the transaction. The grounds given was that foreign ownership in this sector was illegal.
    I see the recent change in the VIE regulation not as a response to accounting scandals on foreign stock exchanges, but rather as a clarification by the Chinese government of its position on cases like Alipay. There was really no need for it to have suffered public embarassment over the matter because the law has been clear all along. But just in case, they made it a little clearer.
    How could anyone who has a partnership in such a protected industry feel comfortable with the notion that the VIE structure is safe and sound, in light of that case and the subsequent strengthening of regulations around the VIE? I certainly would not.
    It’s mistaken, I think, to dismiss this as conspiracy theory or simple-mindedness when it actually happened, and not long ago, and in a high-profile case as you say.
    I hear what you are saying about the unintended consequence of harming reverse-merger shell companies that are trying to raise money on U.S. and other exchanges using a VIE structure to glue their finances to something foreign. I think we can say pretty confidently that these companies are in bad repute overseas these days anyhow. The question is, does the Chinese government approve of them and care if they are sideswiped by this regulation? My guess is that there are mixed feelings on the Chinese side as well; waking up every morning and reading a story in the overseas press about yet another case of accounting fraud involving such a company has to give them pause. The Chinese gov’t may well look at killing the VIE structure as a way to get rid of two bad eggs in a single stroke.
    -LH