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By Xu Ping
ariable Interest Entity (VIE) Structure for Foreign
Investment in the PRC May Face Challenges

Although China is one of the world’s top destinations for foreign direct investment, the legal structures through which such investments are carried out
have often been a hot topic of debate. The variable interest entity has long been a popular structure for foreign investors in certain sectors and types of
investments that are subject to China's investment restrictions. VIEs have also been used as a means by which Chinese domestic entities are able to
list overseas on international capital markets. This article explains what a VIE is and how recent developments reported in Chinese media may have a
significant effect on the viability of VIE structures in future investments.

The variable interest entity (“VIE”) has long been
a popular structure for foreign investors in sectors
that are subject to China's investment restrictions.
VIEs have also been used as a means by which
Chinese domestic entities are able to list overseas on
international capital markets.
The first well known VIE structure was that of Sina.com in
its 2000 listing on the NASDAQ. Indeed the VIE structure is
also commonly known as the "Sina Structure". Sina used
a VIE as a workaround structure to avoid restrictions
on foreign direct investment (“FDI”) in the value-added
telecom services sector. Since then, both foreign and
Chinese investors alike have replicated the VIE structure
in many other sectors of China's economy where FDI is
either restricted or prohibited from foreign investment.
In essence, a VIE refers to a structure whereby an
entity established in China that is wholly or partially
foreign owned (the “Controlling Company”) has
de facto control over an operating company (the
“Operating Company”) which holds the necessary
license(s) to operate in an FDI restricted/prohibited
sector. As such sectors are subject to investment
restrictions in China, foreign investors are not able to
directly invest in the Operating Company. Accordingly,
the foreign investors adopt various contractual
arrangements between the Controlling Company and
the Operating Company in order to obtain de facto
control over the operation and management of the
Operating Company. The profits of the Operating
Company would also flow back to the Controlling
Company and ultimately be consolidated with the
finances of the Controlling Company.
For domestic companies, especially companies
in restricted industries that don’t typically have
many physical assets (such as internet or
telecommunications companies), the VIE structure
was widely used to enable companies to obtain
financing from overseas markets through overseas
listings. Gradually, companies in the heavy industries
also started to adopt the VIE structure to list overseas,
as did offshore shell companies that were looking
to circumvent approval requirements stipulated by
China’s M&A Rules1.
From a regulatory perspective, although there is no
clear prohibition against the VIE structure in China,
there has also been no express endorsement of the
VIE structure either. Accordingly, the VIE structure has
always been a gray area in the Chinese legal system.

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Although the VIE structure allows both domestic and
foreign investors to circumvent government reviews
and regulation, this also means that the VIE structure
does not have the backing of the authorities and
therefore possesses inherent defects and potential
legal and regulatory risks.
I. Recent Alibaba Case
The risks and uncertainties facing VIE structures
include: (a) the level of protection of the rights of
beneficial owners in VIE arrangements being far lower
than a direct equity interest in the Operating Company;
(b) the potential conflicts of interest between the legal
shareholders of the Operating Company and the
beneficial owners; and (c) the uncertainty in whether
VIE contractual arrangements are enforceable
between the Controlling Company and the Operating
Company in the event of a dispute.
The recent case of Alibaba, a popular shopping
website which had a successful IPO on the Hong
Kong Stock Exchange in 2007, is a good example
illustrating the potential risks of a VIE structure and the
rationale for possible government intervention in the
future.
Alibaba’s structure is a typical VIE arrangement:
Zhejiang Alibaba, a private company held by Ma Yun
(Jack Ma), acted as an operating company controlled
by Alibaba Group Holding through a VIE arrangement.
No problem arose until Ma Yun decided to complete
a 70% equity transfer of Alipay from Alibaba Group
Holding to Zhejiang Alibaba allegedly without majority
shareholders' approval on the part of the Alibaba
Group (i.e. Yahoo and Softbank). The argument from
Ma Yun was that Alipay would be unable to acquire the
necessary operational license from the People’ Bank
of China if it was held by foreign investors.
The Alibaba matter placed a spotlight on VIE
arrangements and has been widely reported that
the CSRC 2, China's securities regulator, submitted
an internal report to the State Council asking the
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 government to clamp down on this controversial yet
popular corporate structure. This has resulted in even
greater concern on the part of investors and has cast
doubts as to the feasibility of the VIE structure going
forward.
II. The Implication of the Report on the future of the
VIE structure
There has always been a great controversy regarding
the legality of the VIE structure, mainly because (a)
it circumvents the restrictions on foreign investors
making it possible for them to invest in restricted/
prohibited industries in the PRC; (b) it circumvents
approval requirements by the Ministry of Commerce
(“MOFCOM”) in accordance with the M&A Rules,
especially by offshore shell companies making round
trip investments (i.e. where PRC national owned
businesses and assets are owned by an offshore entity
owned by PRC owners); and (c) it may constitute price
transferring and consequently result in tax evasion in
some cases.
The leaked report supposedly analyzes the legality of
the VIE structure as well as the current status of PRC
internet companies listed overseas by using the VIE
structure. More importantly, the report recommends
future overseas listings using a VIE structure should
first obtain MOFCOM and CSRC approval. The
leaked Report, is causing grave concerns for foreign
and domestic investors alike as nothing has been
officially confirmed. Furthermore, there is substantial
uncertainty as to what (if any) requirements will be
introduced.
Notwithstanding the above, it was recently reported by
the Shanghai Securities News that the report, which
was allegedly drafted by a research department of
the CSRC, was created solely for an internal study.
Therefore, it is not an official report submitted to
the State Council and therefore the actual policy
implications, if any, are unclear.
Xu Ping is a partner at King & Wood’s Foreign Direct Investment Group in Beijing
1. Rules on the Merger and Acquisition of Domestic Enterprises by Foreign Investors was promulgated on August 8, 2006,
and was revised in 2009.
2. China Securities Regulatory Commission.
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However, the investors should note that since the
overseas listing of domestic companies by way of VIE
structure has gradually been extended from traditional
light industries to heavy industries involving material
assets (such as infrastructure and natural resources)
and therefore also avoiding PRC government
supervision, the motivation for the PRC government
to regulate the VIE structure has become greater.
Although we expect the government will not launch
a severe clampdown upon the VIE structure in the
short run, it is an issue very likely to be tackled by the
government at some time in the future.
III. Potential effect from NSR system on the VIE
structure
Even though currently there are no laws or regulations
directly regulating the VIE structure, a newly
established National Security Review (“NSR”) system
by the Chinese government may prevent foreign
acquisitions of domestic companies if the purpose is to
evade the government’s security review. This system,
similar to those in many other countries, bestows upon
the government the authority to review and approve a
proposed foreign M&A transaction if it involves one of
several key sectors (i.e. military, key technology and
agricultural products) that have a bearing on China's
national security. However, since these newly enacted
security review regulations are broad and highly
discretionary in practice, whether a foreign investment
which uses a VIE structure in a key industry will
constitute a M&A transaction and consequently be
required to go through NSR procedure is unclear.
The NSR review may be a means by which MOFCOM
may strike down transactions using the VIE structure.
However, as currently no precedent case has
occurred, it is still uncertain whether the NSR system
would be used by the government as a step to bring
foreign investments using VIE structures under their
supervision.
(This article was first published on XBMA.com)