China continues to bar foreigners from owning companies in those sectors of the economy China considers particularly sensitive from the standpoint of national security. The Internet is one such sector where direct foreign ownership is prohibited. Yet it is well known that virtually the entire Internet sector has been funded by foreign IPOs, making foreign investors the owners of this sensitive sector in violation of the of the law. New regulations recently promulgated by MOFCOM (China’s Ministry of Commerce) appear to have ended this unusual situation.

Foreign companies have managed to “own” companies in China’s Internet sector by using what is known in the United States as a Variable Interest Entity (“VIE”). Under a VIE structure, a Chinese Internet provider is effectively owned by a foreign entity through a complex set of contractual arrangements, rather than through ownership of stock.  The control by the foreign entity is so total and complete that the arrangement is considered the equivalent of ownership under U.S. accounting rules. However, by there being no actual foreign ownership of stock, these VIE structures have managed to operate in China, evading the clear rules restricting foreign ownership.

New Regulations recently issued by MOFCOM appear to spell the end of VIEs. On September 1, the Regulation of the Ministry of Commerce on the National Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (Regulations) became effective. The Regulations provide the long-awaited procedures for national security review for foreign related M&A activity that is required under the recently promulgated PRC Anti-Monopoly Law. To the surprise of many, the Regulations also took direct aim at the VIE procedure.

The provisions are deceptively simple. Article 9 of the Regulations provides that using “contractual controls” to evade the requirements of Chinese law that would otherwise restrict or prohibit foreign investment in a sensitive sector is prohibited. This is a clear prohibition against the use of VIE structures. The whole goal of the use of VIEs is to hide the fact of foreign investment from the Chinese regulators. Thus, it is likely that the use of a VIE will not be caught by national security review at the outset of the investment. To deal with this issue, Article 10 of the Regulations provides that where such contractual controls are used but not reported to the Chinese regulators, the parties involved have the independent duty to immediately terminate the offending conduct. If the parties do not take action on their own, the regulators have the authority to order the immediate termination of the offending investment by whatever means are necessary.

What does this mean for the future of foreign investment in China? Many foreign investors contend that existing VIE structures are sound and that VIE arrangements can safely be used in the future. I disagree.

The following has been occurring of late in the VIE arena:

  • In the Internet sector, IPOs continue to be proposed that rely explicitly on a VIE structure. Such IPOs are clearly under a cloud and are quite properly being delayed or cancelled.
  • Many investors have proposed expanding the VIE structure for foreign IPOs in other restricted sectors of the Chinese economy, such as the telecom and medical services sector. It is now clear that this proposed expanded use of the of the VIE structure in China will not succeed.
  • The new regulations only reaffirm that existing foreign investment in the Internet sector is built on a shaky foundation and the that the Chinese regulators are essentially only one phone call away from steppng in and ordering all of these investments be terminated. 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.

None of this is actually new. These risks have long been known. However, the clarity of the Regulations means it is now nearly impossible to claim that Chinese law on these issues is ambiguous or unclear. Where Chinese law says that ownership by foreigners is restricted or prohibited, the law means what it says.  Foreigners who invest in violation of the law are making a bet that the violation will be ignored. This is extremely unlikely in today’s China. Such bets are sucker’s bets and should avoided at all costs.

We have been speaking out against VIEs for years and just about every time we do so, someone says that if they are illegal, why have so many large law firms, large accounting firms, and large companies gone along with them? The answer is simple. Money. Big money. Really big money. Now, some of these same law firms and accounting firms and companies are denying that anything has changed. And why is that? Again, money. Only this time they are taking positions not so much to make more money going forward, but to avoid losing through lawsuits the money they have already made.

We have written extensively on the perils of VIEs and if you want to read more, I urge you to check out the following:

What do you think?