January 19, 2015 marks the date of the death of the VIE investment structure in China. The death blow was dealt by the PRC State Council itself, the highest authority on such matters in China. Now that the issue is settled, we can all move on to figure out the effects. 

How was the VIE killed? On January 19, the State Council issued a discussion draft of legislation setting out the plan for overhauling the antiquated Chinese foreign investment legal regime. The new system is set out in the PRC Investment Law Discussion Draft (the “Draft”), a massive document in 178 Articles and 11 Chapters. The underlying philosophy of the Draft is explained in the Explanation of the PRC Investment Law (the “Explanation”).

Draft makes clear that the State Council understands how VIEs work and that their sole function is to evade the requirements of Chinese law. The Draft makes clear that such evasion is illegal and will be prohibited upon the effective date of the new investment law.

The new system will work as follows:

  1. The nationality of any business entity will be determined by the place of formation of the entity. The nationality of the shareholders, the directors or the management is not relevant. The only issue is where the company is formed. Thus, a Cayman Island corporation owned and controlled by Chinese citizens is still foreign for purposes of the law. A Chinese company formed by such foreign investors is therefore treated as a foreign owned entity.
  2. The Draft introduces the concept of “effective control”, a principle borrowed directly from the VIE structure. The Draft provides that any Chinese entity effectively controlled by a foreign owned entity will be treated as a foreign entity. This means that if foreign entity participation in a sector of the economy is prohibited, this prohibition extends to Chinese entities effectively controlled by foreign investors.
  3. It is illegal for an entity effectively controlled by a foreign owned entity to operate in sectors of the Chinese economy that are restricted or prohibited to foreign investors. In other words, the restriction or prohibition applies to effectively controlled Chinese companies in exactly the same way that it applies to a foreign owned entity of any kind. Any effectively foreign controlled Chinese entity that enters into a restricted/prohibited sector is in violation of law. The operations will be shut down and penalties will be imposed as provided by law.

As we know, the core of the VIE is structure is that a foreign owned entity (a WFOE) effectively controls a Chinese owned entity through an elaborate series of contracts. Without such effective control, the foreign owner of the VIE is not permitted to consolidate the earnings of the Chinese entity into its books. I have argued in the past that the contracts are void under Chinese law. The State Council takes a different and even more devastating approach. The State Council has said that it will accept that the contracts are legal and enforceable.

All those opinion letters you have received say that. However, since the Chinese entity is effectively controlled by a foreign investor, it is obvious that the Chinese entity is in fact a foreign controlled entity. Therefore, that foreign controlled entity is prohibited from operating in a prohibited or restricted sector.

The effect of the Draft is to kill the VIE structure as an investment vehicle in China for the future. It is important to fully understand the impact. Even if the Draft is never adopted, for the future at least, the VIE structure is dead. The VIE structure is dead because it is now clear that the State Council understands how the VIE structure works as a contractual device and it is clear that the State Council understands that the only reason VIEs exist is to evade the clear requirements of Chinese law. Most importantly, it is also clear that the State Council has firmly concluded this behavior is wrong and it will not be tolerated in the future. So it does not matter whether or not the Draft is adopted in its current form. Whatever happens, the VIE structure is dead.

Now we come to the more interesting and difficult question. A large number of very large companies operate in China’s Internet and telecom sector as VIEs. Baidu, Sina and Alibaba are only a few of the hundreds of VIEs currently operating in China. These VIEs control the China’s Internet, e-commerce and cloud computing sectors. They are the only significantly large privately owned companies in China.

Yet, the remarkable fact is that these highly capitalized, powerful companies are all operating illegally (as we have pointed out many times on this blog). However, all of this illegal activity has been conducted openly and with the tacit acquiescence of the PRC regulatory authorities. As a result, the big issue for now is what is to be done about the existing VIE entities in China that will be rendered illegal if the Draft is adopted in its current form.

The VIEs have seen this coming, and beginning in 2013 Robin Lee of Baidu led the charge in seeking to have then existing VIEs be formally declared legal under Chinese law. Mr. Lee argued that the State Council should declare VIEs legal under Chinese law so long as Chinese citizens control the management of the foreign owned entity. Mr. Lee did not propose that the limitations on foreign participation in the Internet sector be removed. His plea was simply that his particular device be declared legal. After Mr. Lee made his plea, other owners of large Internet and telecom VIEs joined in to propose various “get out of jail free” techniques to leave them in control of an otherwise closed sector.

From a legal standpoint, the proposals of Robin Lee and others put the Chinese government in a very difficult position. If the government accepts the proposals by making a blanket ruling that VIEs are legal, then open violation of Chinese law is tolerated. On the other had, to declare already existing VIEs to be illegal would involve acting against large and successful Chinese companies in critical sectors such as the Internet, e-commerce and telecommunications. However, the issue must nevertheless be confronted. Here is what we know so far on how the regulators intend to proceed:

1. Article 158 of the Draft states that the issue of what to do about existing VIEs will be resolved in accordance with the Explanation.

2. Article 3.2 provides the following “solution”:

  • A principle of “actual control” will be adopted. A Chinese entity under the actual control of foreign investors will be treated as foreign. A foreign entity under the actual control of Chinese investors will be treated as Chinese. How this analysis will be performed is not explained.
  • For existing VIEs, the government will NOT provide a blanket statement that existing VIEs are in compliance with Chinese law. In this sense, the request from Robin Lee and others has been denied.
  • The rule will be as follows. The decision on whether or not to allow effectively foreign controlled Chinese entities to continue to operate will be made on a case by case basis by the PRC government agency with control over the area of concern. The rule is:
    • If a specific permit is needed to operate in a sector, that permit must be obtained.
    • With respect to VIEs, the effectively controlled Chinese entity must go to the regulator in their field and request a special exemption on the grounds that the VIE WFOE and its parent are actually effectively controlled by Chinese investors. If they can make this showing, then they will be allowed to continue to operate.
    • Article 3.2 provides that if the regulator issues a license in this situation, the State Council will not intervene. If a license is granted by the regulator, then registration will be processed (or maintained) in accordance with the grant of such license.

This means that the State Council has punted on the very difficult issue of what to do about existing VIE entities. We can imagine the State Council saying: You guys created the problem by turning a blind eye to this illegal activity. Now you need to figure out what to do. However, by directly citing the “effective control” standard, the State Council has provided the various regulators with an escape from their difficult situation.

The stock response to this situation is that the PRC regulators will “knuckle under” and provide the required licenses to the existing VIE operators. Virtually everyone says: There is no way that the PRC regulators will shut down Baidu, Sina, Alibaba and the other major PRC VIE entities. I believe that this assessment is correct.

There are, however, a number of problems for the regulators if they knuckle under and grant a get out of jail free pass to the existing VIE entities, including the following:

1. It is now been formally acknowledged that the VIE structure is a violation of Chinese law. If the existing VIE entities are permitted to continue to operate, then the PRC regulators will be rewarding open violators of the law. This then weakens or destroys the legitimacy of those regulators. If you do not understand the threat this poses to the PRC regime, please go back and read Max Weber on the issue.

2. Competition within China is the much more important issue. Let’s assume that Baidu and others obtain/maintain their license to operate with foreign funds in a restricted sector in absolute violation of Chinese law. Now consider the situation of other Chinese “entrepreneurs” that want to do exactly the same thing. Now that the escape hatch has been opened for the existing VIEs, a similar work around should be provided for other Chinese entrepreneurs. If this escape mechanism is not provided, then Baidu (Robin Lee) and the other existing VIES will have been granted even more benefits than they even requested.

3.  The solution being proposed is something like the following. The PRC government will use the effective control analysis. If a foreign company is effectively controlled by Chinese investors, then for PRC regulatory purposes, that company will be treated as a Chinese company. This Chinese controlled company will then be permitted by the Chinese authorities to raise funds in the overseas capital markets. Under this approach, a VIE will not be necessary, since the foreign parent will be treated as Chinese for PRC restricted/prohibited industry analysis. There will therefore be no need to rely on the complex and questionably enforceable set of contracts that are central to the VIE structure.

While solving one problem, this approach raises the following other issues:

1. Companies raising funds on foreign markets are doing so as public companies. It is the core of the public company concept that the company is operated on behalf of the shareholders and that the shareholders exercise effective control over the management of the company. Taking away shareholder control in favor of management by Chinese nationals would therefore violate basic principles of public company law and policy. This is the reason that the Hong Kong stock exchange recently refused to host the Baidu IPO. Though it may be legally possible to impose this kind of restriction on nationality of manage on a public company listed in the United States, the restrictions would need to be fully disclosed. If properly disclosed, it is not clear whether such stock offerings would be attractive to investors.

2. Following this approach puts the Chinese government in the business of assessing the affects of complex corporate control structures implemented under the laws of foreign countries. It is not clear that the PRC government has the expertise to make an appropriate analysis of complex corporate structures that would challenge the analytic skills of even the most seasoned corporate lawyers.

3. The fundamental principle behind all of this is that the Chinese want to be able to raise money in foreign markets to fund business sectors closed to participation by foreign businesses. It is not clear whether foreign governments who regulate the capital and trade markets will find this approach to be acceptable.

The situation for now is very messy, but we can conclude the following:

1. VIEs are illegal. We disagree with those who are saying that what is proposed is a two tier, foreign/Chinese system.

2. For the future, if a foreign entity is in fact effectively controlled by Chinese investors, such entities will be treated as Chinese entities for the purpose of application of the negative list restricted/prohibited rules. How this effective control standard will be imposed is not clear. In any event, there will be no need to form a VIE. As illogical as it seems, the WFOE and its parent will be treated as Chinese controlled for PRC regulatory purposes. Thus, as noted, the VIE is well dead.

3. For existing VIEs, they will be given a chance to convert to a model where their WFOE directly holds the required license. That is:

a. The VIE will terminate.

b. The WFOE will have the opportunity to apply for the applicable license directly from the applicable regulator. If granted, that is the end of process. If not granted, then business of the VIE must terminate. Most people don’t think that will happen, but that is just a guess.

In this way, the awkward and unenforceable contractual method (VIE) of control will be eliminated. If possible legally, the WFOE will hold the license directly. This will eliminate the uncertainty over legality and the uncertainty over who owns what. This is good. However, this system then means foreign capital markets and investors will be required to accept the listing of public stock by a company that is in fact controlled not by shareholders but rather by Chinese promoters. In a way, these entities will be a type of “reverse” VIE. It may solve the problem for the Chinese side, it is not clear if it solves the problem for foreign investors in the negative list side of the Chinese market.

What do you think?

And as proof that “we told you so” on VIEs, check out the following:

  • Well, for the time being I remain confused on the VIE´s. This is what I just read from Mark Schaub and Xu Ping, lawyers at KWM:

    According to the Draft FIL, under the VIE structure, if the actual controller is of Chinese nationality, then the relevant domestic company shall be treated as a Chinese investor and, therefore, the entry clearance and the information reporting systems applicable to foreign invested enterprises will not apply. Accordingly, under this situation, the VIE structure may be considered as legitimate. Conversely, if the actual controller is a foreign entity or national, then the domestic companies will be treated as foreign-invested companies, and any operation without entry clearance may be considered as illegal.

    Does not sound very dead, does it?

    • The notion of distinguishing between VIEs by who controls them was PROPOSED by Robin Lee of Baidu and by others. The official explanation from the State Council goes into detail on the different proposals that were made. Then, and most importantly, the State Council explanation states that the State Council rejects that approach in favor of what Steve wrote above. Article 159 of the Draft says that VIEs will be dealt with in accordance with the Explanation. Section 3.3 of the Explanation sets out what I just explained. The Draft does not attempt to deal with the existing VIE issue; only the Explanation does that. If someone can cite to the language of the Draft of the language of the Explanation for their position, we will certainly re-examine what we have written. Do you have any such cites?

      • Lo Kok Kee

        Is it possible to give us the link to the complete text of the draft so we can see the explanation notes too? Reading Chinese text is not a probem here.
        This is the view expressed by King & Wood Mallesons in Mergers & Acquisitions:
        4. Actual controller and potential impact on VIE Structure

        The Draft FIL introduces for the first time the concept of actual controller from the foreign investment perspective, i.e. whether a company is considered as a foreign invested or domestic company is not solely based on the place of registration but focusing on “actual control”. According to the definition of “Chinese Investor”, Chinese nationals and the companies under their control will be classified as Chinese Investors. At the same time, the definition of “control” also references from internationally accepted definition, including control of shares, voting rights or other equity interests of a company, control of the decision-making bodies of the company, or possession of decisive power to influence the management, finance, personnel or technology of the company through contractual, trust or other arrangements. According to the above definitions, the legal validity and the associated risks of variable interest entities (VIE) structure may need to be reassessed.

        VIE is not only a common structure adopted by many Chinese companies listed overseas, it is also sometimes used by foreign investors to invest or operate in areas subject to foreign investment restrictions. The legality of VIE structures and funds transfer under the VIE structure have been the focus of foreign investors for a long time. All major overseas capital market regulators are also assessing the legal and regulatory risks under the structure. According to the Draft FIL, under the VIE structure, if the actual controller is of Chinese nationality, then the relevant domestic company shall be treated as a Chinese investor and, therefore, the entry clearance and the information reporting systems applicable to foreign invested enterprises will not apply. Accordingly, under this situation, the VIE structure may be considered as legitimate. Conversely, if the actual controller is a foreign entity or national, then the domestic companies will be treated as foreign-invested companies, and any operation without entry clearance may be considered as illegal.

        However, for companies that are successfully listed overseas or companies controlled by foreign investors with operations in China using VIE structures prior to the promulgation of the Foreign Investment Law, the Draft FIL does not provide a clear answer as to how they will be perceived if domestic companies fall into the Negative List and such decision is likely to be influenced by the feedback received from the comments solication process. Based on our speculation, because of the influential power of many companies using VIE structures in various industries, the risks that the existing VIE structure is considered as illegal after the promulgation of Foreign Investment Law are relatively low. In the future, the regulators will likely take a very cautious approach and make decisions on a case-by-case basis depending on the actual situation.

  • FOARP

    Dan, congrats on writing a fascinating piece. When foreign companies complain of double-standards, of local companies getting a free pass in breaking the law whilst foreign companies are held to every letter, it is entirely correct to say that foreign companies cannot complain as they knew, or should have known, that what they were doing is illegal. At the same time, this does not mean that the double-standards and flaunting of the law does not exist, and the situation described in this article is a striking example of this..

  • There are some points in your article that I do not understand. Some of these questions may have obvious answers, or may be due to my misreading. If that’s so, I apologize.

    “Let’s say that the regulators limit the Internet sector just to Baidu and the other existing VIEs. This would give them an oligopoly position beyond that sought by their proposals. Mr. Lee and the others argued to protect China from foreign competition. He never argued to prevent other Chinese entrepreneurs from benefitting from the same closed system.”

    I don’t understand your argument that this is anti-competitive against Chinese entrepreneurs rather than foreign companies. Why wouldn’t Chinese entrepreneurs be free to compete, using Chinese companies and capital?

    “The public will likely believe that those with “free passes” secured them via illicit financial arrangements with regulators.”

    What is the evidence for this assertion? I appreciated this article.

    “Most non-Chinese analysts assume that money will be their deciding factor and so they are predicting the “free pass” route. We are not so sure.”

    This implies that Chinese analysts think that the opposite is true. Is that so?

    Thank you for your analysis.

  • FOARP

    Ooops, this is Steve Dickinson piece, not one from dan as I wrote in my previous comment. Kudos to him.

  • Very interesting, but inconsistent with the analysis coming out from major Chinese and foreign law firms. They are saying that the jury is still out on how to implement the new rules for VIEs, and the Robin Li alternatives are put forth as placeholders.

    Can you really see China shutting down Alibaba, Baidu and Tencent? I think this idea of considering these VIEs as domestically controlled and therefore not FIEs is an elegant one.

    • That would be an elegant solution, but how do you get past the fact that the SEC and other stock exchange filings for these VIEs emphasize that the foreigners control them? The State Council even spoke of this in rendering its “decision.” Are we just going to ignore those filings? Paul, I really would love to hear your response to this because I know you know the VIE issue better than pretty much anyone else.

      • The US accounting treatment requires that the Cayman Islands Co and subs control the VIE. If China determines that the Cayman Islands co. is controlled by Chinese, that does not appear to alter the US accounting treatment – the VIE is still controlled by Cayman, and the fact that China considers Cayman controlled by Chinese is not relevant.

        • roanmartigan

          Spot-on. Basically what the proposed solution (not even a proposed rule at this stage, which tells you a lot about the hesitation of the draftsman) is that all Chinese-controlled VIEs become instantly legal, while all foreign-controlled VIEs become illegal. Very well played on MOFCOM’s side, but of course difficult to swallow for foreign investors. The Robin Lis of this world have nothing to do, they can jsut keep their structure and keep benefiting from international finance while Amazon et al. have to change their structure or pack up and go home. In fairness this is not what will happen because there is a fair chance when the rules are adopted the Negative List will be issued simultaneously and e-commerce and various internet services will be liberalised, leaving only a handful of illegal foreign-controlled VIEs. The watershed is really the move from a theory of appearance (all foreign-incorporated companies are foreign) to a theory of actual control (all Chinese-controlled companies are Chinese, even if they are incorporated overseas) since this is true both for VIEs but also M&A and greenfield investment. While this change is not objectionable per se, it definitely gives Chinese investors the best of both worlds: easy access to international finance (by incorporating holding cos overseas), international-class rule of law and corporate vehicles, better tax planning on the one hand and national treatment on the other hand. This also means that round-tripping will be completely relaxed in the near future (I suppose the tax authorities are now comfortable that theywill be able to catch fraudsters thanks to automatic information exchange – good luck with that).

  • wave

    cant they just come to baidu and say well ok here a shutdown notice but if you move back your holding from the caymans to here you get your license back or something ?

  • CDHS, LLC

    With limited specific knowledge and vast general understanding of the underlying principles of VIEs, it is clear that #4 is still what matters at the end of the day, to the masses. This continues to be unknown but the outcome will most certainly be anti-climactic.

    But it is still fun to watch NASCAR for the possibility of a crash.

    Future considerations. What will be the new way?

    From http://lawprofessors.typepad.com/china_law_prof_blog/2015/01/comments-on-chinas-draft-foreign-investment-law.html

    “Finally, a thought about all the energy we are spending on looking at the law. It seems a bit odd to be worrying about what the Draft FIL says about the legality of VIE structures or to say that it somehow makes them illegal. As I argued at the beginning of this discussion, they are already illegal. Hardly anyone denies this. And yet the authorities have permitted them to exist, and indeed to flourish, right under their noses. Back in the 1990s we saw the same thing with the CCF structure: a prohibition on foreign investment that was openly violated through a too-clever-by-half contractual arrangement. That arrangement worked just fine until it didn’t. Then it was resurrected in the form of the VIE structure, which we are now told is being made illegal, or—given that it’s already illegal—at least is not fine any more. Is there any reason to think that the pressures that produced the CCF and VIE structures, despite their being clearly prohibited, won’t survive this new purported prohibition and give us yet another transparent workaround?”

    I am off to plan for my next GFW workaround (half of my day in a world of over capacity. ) I am glad someone is looking out for my best interests in staying productive.

    Then maybe shop for some FTZ real estate… for oh… I don’t know… some discounted leases held by foreign investment firms?

    I can’t help but hope the MNC squeeze is hard and fast.

    I like watching NASCAR. But not for the round and round the track part.

  • plus8star

    It seems the challenge is really with the definition of “control” – shareholding is one aspect, but effective control can be done without majority shares. In any case, it’s going to be interesting to watch.
    Also arguably and even without a Cayman island structure, Alibaba could be foreign “controlled” by Yahoo + Softbank (>50%)?

    PS: typo on Robin Li’s name

  • A quick comment on the statement: “Taking away shareholder control in favor of management by Chinese nationals would therefore violate basic principles of public company law and policy. This is the reason that the Hong Kong stock exchange recently refused to host the Baidu IPO. Though it may be legally possible to impose this kind of restriction on nationality of manage on a public company listed in the United States, the restrictions would need to be fully disclosed. If properly disclosed, it is not clear whether such stock offerings would be attractive to investors.”

    This is similar to an issue we regularly face in Canada. Ottawa has a deal with Washington where US agencies fund R&D in Canada. If the resulting tech is sensitive (mainly CBRN), Ottawa forces the shareholders to move their company to the US and forces ownership to be 51% American. This is the terms of the R&D financing. It is perfectly reasonable to me that Washington wants control of what it pays for, but simultaneously incredibly bizarre to us entrepreneurs and investors that the mandarins (heads of federal civil service departments) quite happily refuse to invest in Canada with Canada $, take US $, and then force jobs and know-how to move to the US over the heads of our shareholders and investors. This is NEVER fully disclosed.

    China “foreign entity”/control structure seems to be a copy of the US model. Admittedly, theirs is an across-the-board policy, not restricted to sensitive tech. Nevertheless, it has never been clear to me whether the deal between Ottawa and Washington is to be fully disclosed to shareholders. It is all very murky; Ottawa’s mandarins refuse to explain their rationale; and China by far gives a better answer. It is clear what China’s rules are.

    David Huer
    Hubble Project Group http://hubbleproject.com/