18 Nov 2016 The China VIE Structure is Vulnerable – So Why is it Still Used?
The accounting definition of “variable interest entity” (VIE) means an entity in which an investor holds a controlling interest that is not based on owning the majority of voting rights. To non-accountants, the VIE structure is a business structure that is widely used by Chinese companies in certain “sensitive” or “strategic” business sectors that have restrictions on foreign investment under the 2015 Foreign Investment Industrial Guidance Catalogue, such as telecommunications, e-commerce, and online games. The October, 2016 IPO of ZTO Express, a delivery service company in China, was done using the VIE structure. The VIE structure is currently the only way that foreigners may have an economic interest in businesses in Chinese restricted industries.
The simplest VIE structure includes a foreign holding company which is usually an exempt limited company in the Cayman Islands, a China wholly foreign owned enterprise (WFOE) and a China domestic operating company owned only by Chinese nationals. The founders, foreign investors and other shareholders hold equity in the Caymans holding company, which in turn owns a 100% equity interest in the WFOE. The operating company is a purely China domestic company that is licensed to operate in the restricted industry in China. The key point of the VIE structure is that the WFOE exercises de facto control over the operating company through a series of contractual arrangements entered between the WFOE and the operating company. The SEC filings for the recent ZTO Express IPO contain the current state-of-the-art set of control agreements. The Chinese founders of the domestic company borrow funds from the WFOE and pledge their shares in the operating company as collateral under the loan agreement. The WFOE usually provides technical services to the operating company and is compensated for its services. The financial statements of the Cayman holding company are consolidated with the WFOE and VIE which makes the holding company financeable.
Ownership of the domestic operating company is very important. In some cases, at the outset, the investors are all foreign and the founders of the Cayman holding company are all Chinese nationals so they can also be owners of domestic entity. But most situations aren’t so neat, some investors and founders will be foreign and some domestic. For example, in a recent matter, the founders were both foreign nationals and both domestic and foreign investors were involved. The owner of the domestic operating company is a close relative of one of the founders of the Caymans holding company, someone who is trusted. In addition, however, as a practical matter, to mitigate the risk of a decision independent of the business interests of the holding company, the economic interest of the owner of the operating company was aligned with the owners of the holding company by stock ownership in the Caymans entity.
Since SINA unveiled the VIE structure to public investors during its IPO offering on NASDAQ in 2000, this complex corporate structure has become very popular among Chinese companies who want access to foreign investment. Data shows that more than half of the Chinese companies listed on the NYSE or NASDAQ are using the VIE structure. Although many lawyers and financial industry professionals have warned investors over time that the VIE structure has inherent risks and the validity of the control contracts are at best in a gray area under Chinese law.
Legal and Regulatory Risks
Bear in mind that the VIE structure was designed in the first place to circumvent the Chinese government restrictions on foreign investment in certain industries. The PRC contract law does not address the VIE structure directly, however, it clearly provides that the court may declare a contract void “when a lawful form is used to conceal an unlawful purpose”. That is to say, if the court finds the two parties entered in to the equity pledge agreement with the purpose of unlawfully concealing foreign investment in restricted business, the contract is void despite that Chinese Law recognize equity pledge agreement in general and the agreement was drafted and implemented strictly according to applicable law.
In fact, the risk factors in the prospectus of almost all of the listed companies who use the VIE structure states that “there are substantial uncertainties regarding the interpretation and application of current and future PRC laws and regulations” or similar words. Although many lawyers in China believe that the risk of the Chinese government cracking down on the VIE structure is very low, investors need to understand that their investment is very sensitive to legal and policy changes. The China Securities Regulatory Commission (CSRC) released a report in 2011 expressing its concerns over the use of VIE but has not spoken since on the VIE structure. Other China regulatory agencies, including the Ministry of Commerce and the Central Bank have also questioned the viability of VIE structure in public statements.
The major business risk for the investors is they don’t have access to the assets of the operating company. In a VIE structure, the investors do not own equity interests in the operating company. It is common for them to negotiate a call option agreement (in which the owners agree to sell all of the equity interests in the operating company to the WFOE) but arguably the foreign investors may never exercise the option, because they are barred from owning the operating company under Chinese law. This means the assets of the operating company are unreachable for foreign investors. The large e-commerce companies (SINA, Tencent and Alibaba) dealt with the issue by transferring its service platform – the most valuable asset – into the WFOE to mitigate the risk. The operating company then holds only licenses and certifications, which are prohibited from foreign ownership. This solution is not available in all situations due to legal and other regulations.
Conflict of Interests
The issue of conflict of interests was highlighted by the 2012 dispute between Alibaba and Yahoo. When the Chinese government tightened its regulations over online payment systems, Jack Ma, acting as the Chairman of Alibaba made the decision to transfer the assets of its online payment platform to a private company owned by him. Yahoo and Softbank (who owned, respectively, 43% and 30% of Alibaba) then complained about the transfer, claiming that they were not notified nor approved the transfer. While the dispute was settled, it warns investors that their investment may depend largely on how they would limit the power of the owners of the domestic operating company funders. As indicated above, in addition to implementing good contracts, practical controls for avoiding a conflict include selecting a trusted person for being the owner(s) and aligning the economic interests of the owner with the Cayman holding company.
So why is the VIE structure still used? There is no alternative for countries such as China that restrict foreign direct investment. The 2015 Foreign Investment Industrial Guidance Catalogue did not ease the restrictions in any material way. The ZTO Express VIE structure illustrates the broad interpretation of the scope of restrictions in which a delivery service was deemed “strategic” and not open to foreign ownership. Some believe that the Chinese government would not overturn the VIE structure because many of the large GDP generating companies are involved and the financial chaos that would result. At the end, the investor will make a decision to take the risk or not – just like every other investment, but it is important to understand the structure as well as the risk in making that decision.