One of the things I love about blogging is how I get my stories. This one came to me via a reader who sent me a link on Buddha Steel (more on that later) on the China Accounting Blog, a really good blog of which I had not been aware. This blog in turn led to a killer article by Thomas M. Shoesmith, who heads up Pillsbury’s China practice. More on that later too.

First, I am going to very briefly disucss Variable Interest Entities (VIE) and how they are typically used in China. VIEs are corporate structures usually set up to get around China’s not allowing WFOEs to participate in China’s internet sector. China Accounting Blog does an excellent job explaining a typical VIE in its post entitled, “Explaining VIE Structures.” I urge you to go read that post now.

Now that you understand VIE structures, you should realize that they are, at their core, a work-around that essentially permits foreign companies to do exactly what China’s laws have been set up to prevent them from doing: controlling a company involved in China’s Internet sector (or other sector prohibited to foreigners). Despite this, these VIE structures are quite common. But are they legal?

I have asked this question of countless foreign lawyers who set up VIE structures and their response is typically something along the lines of “they seem to be allowed.” Many years ago, for various reasons, my law firm made the decision not to set up VIE structures.

I am writing about VIE structures now because, according to this Pillsbury “Client Alert,” Buddha Steel, a Chinese company publicly traded in the United States, revealed last week “that the PRC government had disallowed its variable interest entity (VIE) structure.” The Pillsbury Alert states that “it is not clear whether this [Chinese government action] is a highly sector-focused event, part of a broader move by the PRC government against VIE structures—or, as we think most likely, a ‘one-off’ event driven by local facts and circumstances:”

There is probably less here than meets the eye. VIE structures are commonly used by foreign investors in China to obtain a degree of control over, as well as a substantial economic interest in, operations which they are not permitted to own directly. They were first used in the internet sector by companies such as Sina.com, Baidu, Sohu, Netease, and others. Many of these companies are now among the crown jewels of Chinese industry. The use of the structures then spread to other restricted-industry sectors, such as advertising, tourism and education, and eventually into non-restricted sectors as well. No government approval was required to enter into the agreements used to set up these structures, and they did not appear to be prohibited by Chinese law. As time passed, industry players believed the PRC government was at least tacitly approving the use of appropriate VIE arrangements in China.

The Pillsbury alert then talks of two prior occasions when PRC authorities “issued public statements warning foreign investors against the use of VIE structures” but attributes both of those as intending to target specific industry sectors, “not VIE structures as such.”

The Pillsbury alert sees the Buddha Steel action as most likely a “one-off” event:

It is also possible, and in our view more likely, that the action by the local authorities in Hebei was a “one-off” event motivated by facts peculiar to this situation. A true policy shift is more likely to come from the central government in Beijing, as the two previous warnings did, rather than from local or provincial authorities. In addition, the language used by the local authorities does not have the formality we would expect to see from a national policy pronouncement.

That said, it remains a possibility—though we believe it is unlikely—that this is the first tremor of what would be an earth-shaking change in the PRC government’s attitude toward VIE structures generally. If that is the case, it would certainly chill foreign investment in a number of industries, including many high-technology sectors. Given China’s ongoing efforts to drive its economy up the technology curve, and the need for capital in this process, it would seem self-defeating for Beijing to take this step. For that and other reasons, we do not think this is what is happening.

I agree with the conclusion, but for different reasons.

I think Westerners too often use the word “self-defeating” to describe situations where Beijing puts politics over business and I have seen too many instances of that to think that a good reason for this anti-VIE action not to spread. But in the end I agree wtih the Pillsbury Alert because I just do not believe Beijing would essentially announce a national policy of such significance on a deal like this and in the manner employed. Yes, Beijing loves throwing out trial balloons, but not usually like this.

Time will tell….

What do you think? To VIE or not to VIE, that is the question.

UPDATE: Stan Abrams at China Hearsay has come out with a post on this as well, entitled, “Buddha Steel, VIEs and Legal Ethics: Part I, the Internet Years,” which Stan describes as the “Part I of maybe two or three posts.” Stan talks of his unease with these structures:

 You might be thinking, wait a minute, that Cayman Island company had no assets, nothing of value except these service agreements that were questionable when it came to enforcement. How would a company like that get listed ?Good question.

That was the problem I had back then as a young(er) lawyer, and it’s the same one I have today with so-called VIE structures, an issue I’ll get into next time. Suffice it to say that a lot of these companies were not only built with money from Sand Hill Road, but their corporate structures were built on sand also.

I remember many years ago asking Stan if he thought the companies doing VIEs understood their risks and I recall him saying no and my agreeing. That is one of the problems with structures like these. They become so common that their ubiquity is believed to convey safety and when lawyers try to warn of the risks, we are pretty much ignored. 

 

  • Twofish

    The problem with the VIE is that each one is different. With WFOE and JV’s, there is a standard legal form and a standard legal process for creating the standard legal form. The VIE is something that is not precisely defined under Chinese law, and it’s created ad-hoc. That means that every situation is different.
    The good news is that because VIE’s are not specifically defined under Chinese law, you won’t have a situation in which the government just bans them because they would have to define exactly what they are banning. The bad news is that because they are not specifically defined, the Chinese government could ban certain types of contracts or licenses making a specific structure impossible. This creates legal costs, because unlike a WFOE or JV when you could have a lawyer look at the problem and figure out what happens using general principles, you have to hire a lawyer that (expensively) looks at the particular situation.

  • Twofish

    The big danger of the VIE is that the China partner may take everything, at which point you have non-enforceable contracts. You can get around this if the China partner is in constant need of cash, at which point if the China partner renegs, then you just stop the payments, and there is no need to go to court to enforce the contracts.
    However, if you have a situation in which you have to liquidate the enterprise, things will prove quite interesting.
    The other risk is that this only works because of a particularly accounting trick, and if FASB changes the rules, you may have problems.

  • Chris

    The biggest risk is that you can lose the whole investment which you thought was ‘yours’…. and that the whole range of ‘variable interests’ turn out to be non-enforceable in Chinese courts… the local partner/previous ‘owner’ etc walks away with the lot.

  • ddxm88

    looking at this explanation: http://www.chinaaccountingblog.com/weblog/explaining-vie-structures.html
    The Cayman owned WFOE lends to the China partner in the VIE setup. But, is it legal for a WFOE to provide loans to non-related parties (related by ownership, I mean)? Aren’t loans a strictly controlled part of the Chinese financial services market? Or can any WFOE just go around loan money at will (highly doubted)?
    Sorry, this comment is a bit late to the party, hungover.

  • Craig

    VIEs are not strictly held to internet organizations. Andatee Chine Marine Fuel Services(AMCF) is also a VIE and prospects in the blended marine fuels for fishing vessels and the like.