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.