About a month ago, I wrote a post, entitled, “Variable Interest Entities (VIE) In China. What Would The Buddha (Steel) Say?” That post focused on Variable Interest Entitles which are workaround entities set up to allow foreign companies to do in China (through a Chinese domestic company) that which they are technically not supposed to be doing.  

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:”

A few days later, I received the following email from a loyal reader:  

Can I ask you a quick follow-up question regarding the Buddha Steel stories?

You have more experience than me dealing with local/national government issues in China than me. In my mind the real danger with this situation is that it opens things up for local governments to stop these constructions regardless of whether the central government does so or not. 

Do you think it’s likely we’ll see something like this?

I agree that the central government is unlikely to take action against Baidu, Sina etc. but I find it quite plausible that they’ll let local governments implement these types of objections as they please.

I promised a follow up post and here it is.

I used to write quite often of the differences in legal enforcement between China’s local governments and Beijing. Most of the time, these posts would conclude wtih our advising foreign businesses in China to get on good terms with their local governments, but to always still realize that being on good terms with their local governments will not insulate them from facing legal problems if they violate China’s national laws.  

The above advice still holds true, but in the last few years we have noticed increasing enforcement of business laws by local governments and, more importantly, we have seen local governments increasingly enacting their own business laws. We also have confronted local government interpretation of national laws that vary so much from the norm as to render the same laws very different depending on location. We wrote of this in the post, “China ‘Laws’ Are Local And Don’t You Forget It.” We also touched a bit on the localization in our post, “China Government Contracts. Good Luck With That.” In many cases, what are called laws or are viewed as laws are really little more than local customs. These “customs” can have real impacts on business.

It just seems that many local Chinese governments are getting more assertive and independent in their handling of business laws. It also seems that so long as those local governments do not go directly against the laws coming from Beijing, Beijing seems not to care; Beijing seems fine with local governments enacting/enforcing laws that go beyond Beijing’s. However, Beijing does still care about local governments contradicting or failing to enforce Beijing’s laws and you still can get in trouble for violating China’s laws, no matter who locally is insisting there will be “no problems.”

All of this is combining to make staying within the law in China all that much more difficult.  

Are you seeing the same thing out there?

Dan Harris

I am a founder of Harris Bricken, an international law firm with lawyers in Los Angeles, Portland, San Francisco, Seattle, China and Spain.

I mostly represent companies doing business in emerging market countries. It has taken me many years to build my network and it takes constant communication and travel to maintain it. My work has been as varied as securing the release of two improperly held helicopters in Papua New Guinea, setting up a legal framework to move slag from Canada to Poland’s interior, overseeing hundreds of litigation and arbitration matters in Korea, helping someone avoid terrorism charges in Japan, and seizing fish product in China to collect on a debt.

I was named as one of only three Washington State Amazing Lawyers in International Law, I am AV rated by Martindale-Hubbell Law Directory (its highest rating), I am rated 10.0 by AVVO.com (its highest rating), and I am a SuperLawyer.

I am a frequent writer and public speaker on doing business in Asia and I constantly travel between the United States and Asia. I most commonly speak on China law issues and I am the lead writer of the award winning China Law Blog (www.chinalawblog.com). Forbes Magazine, Fortune Magazine, the Wall Street Journal, Investors Business Daily, Business Week, The National Law Journal, The Washington Post, The ABA Journal, The Economist, Newsweek, NPR, The New York Times and Inside Counsel have all interviewed me regarding various aspects of my international law practice.

I am licensed in Washington, Illinois, and Alaska.

In tandem with the international law team at my firm, I focus on setting up/registering companies overseas (via WFOEs, Rep Offices or Joint Ventures), drafting international contracts (NDAs, OEM Agreements, licensing, distribution, etc.), protecting IP (trademarks, trade secrets, copyrights and patents), and overseeing M&A transactions.

  • Chris

    In the Buddha Steel case I understand that the local authorities were acting quite consistently with the Catalog Guiding Foreign Investment in Industry which regulated foreign investment in the sector. The issue with so-called Variable Interest Entities is they are used as workarounds by foreign companies to invest in industries and sectors in which they are clearly either prohibited or restricted. The dangers for the foreign investors is that one either the local partners and managers will one day walk away with the entire business. Whether the contracts, loans etc used by the foreign investors to ‘secure’ their stake in the business are valid or will be enforced by Chinese courts is an interesting question. Whether courts will take the views that the variable mechanisms which are clearly designed to flout the entire foreign investment framework are valid and should be upheld is yet to be tested. Large numbers of foreign investors (usually financial and private equity) are taking ‘stakes’ in what from a Chinese regulatory point of view are companies registered as domestic entities with no record of the foreign investment ever registered or approved in China. Interesting days ahead.

  • Yeah,in China,law always variable,so people feel hard to grasp the spirit of law.they don’t know how to do,they dont know whether their action violate law.

  • Chris

    @ Frank
    In this case, the foreign investors are quite clear that they are ‘violating’ both the spirit and the letter of the law. There is nothing particularly ambiguous about Chinese law in regard to foreign investment. So they adopt an approach that secures them revenue streams from the Chinese entity that does not amount to outright ownership or any form of obvious equity holding. Their ‘ownership’ is never registered in China (which also obviously has tax advantages).
    Back to Dan’s original theme of local governments acting locally… actually in this case they were simply upholding the national regulatory framework. Nothing too unusual about this other than the central authorities have not been too active on this issue.
    Given the fiendishly clever lawyering in most of these ‘investments’, it is quite difficult for Chinese authorities to identify what is what. Only in the Baidu, Sina cases where the ‘listings’ have gone public (in the form of depository receipts held against rather than shares in the Chinese domestic entity), is it possible for these structures to be identified. In most cases, it is close to impossible, as the arrangements are registered only in commercial conracts tightly held by the parties involved, holding companies are registered in the usual tax-evading small islands (BVI etc).
    I see lots of lost equity at the end of the day when the registered local owners choose not to recognize those ‘variable interests’ and walk off with the loot.

  • Twofish

    The thing about VIE’s are that they invariably expected to be temporary. Either the foreign investor expects to cash out within a few years, or there is the expectation that the Chinese government will allow direct foreign investment at which point the VIE converts to something more standard. One thing that has changed is that a decade ago, it was reasonable to assume that a lot of the restrictions on foreign investment would be relaxed, so it was worth taking a risk if it gave you a head start. We are in a different realm, and it’s not obvious that foreign exchange restrictions would be relaxed.
    It’s risky, but the people that invest in this sort of stuff is used to risk. Disallowing VIE’s is one of a thousand things that could go wrong.
    Also, there is risk not only from the Chinese government but also from the US authorities. VIE’s depend on a particular interpretation by FASB, and if the US accountant standards change, there could be issues there.
    One other issue with Chinese law is “what is a law?” Technically, the only laws are things passed by the NPC. There is a whole soup of guidelines, circulars, regulations, and opinions, each of which have varying amounts of legal force.

  • Paul

    Another interesting development is the Yahoo dispute with Alibaba. It appears that Alibaba could not get a license for Alipay with it being an FIE. So they first sold Alipay to a VIE and then it appears they eliminated the VIE agreements, possibly because banking regulators were taking a stricter view than MIIT about foreign control of third party payment processors.
    So, the attack on VIEs may be an industry by industry thing for now.