January 28, 2015

Are VIEs Finished?

On January 19, 2015, the Chinese Ministry of Commerce (“MOFCOM”) released the draft Foreign Investment Law (the “Draft Law”) for public comment. The public consultation period will end on February 17, 2015, after which the Draft Law (or any modified version) would need to be approved by the State Council and National People’s Congress. The Draft Law has received considerable press in the legal and business press because it proposes to adopt a new system that is significantly different from the current regulations governing foreign investment in China. Some practitioners have gone as far as to predict the end of variable interest entities (or VIEs). Of course, there is no assurance whether a final law will be adopted or what it would look like. However, with the value of Chinese companies with VIEs listed overseas approaching $1 trillion, it is unlikely that the Chinese government would take steps to damage some of the most successful businesses in China that have been instrumental in driving China’s growth. What is clear is that we are in for a period of uncertainty, and investors do not like uncertainty.

1.  Significant Features of the Draft Law

There are several articles that provide detailed analyses of the Draft Law. Generally, the Draft Law has the following significant features:

(a) Currently there are separate laws that regulate foreign invested enterprises (or FIEs), depending on which path the investment takes, such as equity joint ventures, contractual joint ventures, wholly foreign owned enterprises and other structures. The Draft law would repeal these laws and replace them with one unified law regulating foreign investment, regardless of which path the investment takes.

(b) The existing laws require FIEs to obtain prior approval, often via licenses from a range of governmental authorities. Instead, the Draft Law proposes a new model of “limited prior licensing plus comprehensive reporting post-incorporation.”

(c) Foreign investors will enjoy “national treatment” similar to domestic investors in unrestricted sectors. However, FIEs will also be subject to a “negative list” of restricted or prohibited industries.

(d) Significantly, Draft Law defines “foreign investors” broadly to include any persons or entities “controlled” by a foreign investor, and covers control of a domestic entity including by way of contractual arrangements. VIE structures employ this structure, in which a wholly foreign-owned entity (or WFOE) enters into a series of contractual arrangements with a domestic company (the VIE company) and its Chinese shareholders pursuant to which the WFOE receives the results of operations of the domestic company, and is consolidated into the financials of the WFOE and its parent company.

2.  Implications on VIEs Going Forward

Under the current foreign investment rules, foreign investment is determined based on the place of incorporation of the investor. The Draft Law instead focuses on who has control of the domestic company. Under this concept, if a domestic company in a VIE arrangement is owned by Chinese persons, it may nevertheless be deemed to be a foreign investor if it is deemed controlled by a WFOE. “Control” for these purposes can be exercised by:

  • Directly or indirectly holding more than 50% of the shares, voting rights or similar equity interests of another entity.
  • Directly or indirectly holding the power to appoint or nominate more than half of the members of the board of directors or other corporate governance body of another entity.
  • Directly or indirectly holding a voting right which can “significantly influence” the decisions of the corporate governance body of another entity.
  • Having a “decisive influence” on another entity’s operations, financials, and technologies by way of contractual or trust arrangements (such as VIE arrangements).

From our reading of the Draft Law, it appears that some VIEs may be deemed to be foreign investors and others will be domestic, depending on how the factors determining control apply to each VIE. Practitioners believe MOFCOM will use this distinction to separate VIEs used by foreign investors to circumvent restrictions on investment in China, which MOFCOM deems undesirable, from Chinese controlled companies that employ the VIE structure to attract overseas investment (such as the large Chinese technology and internet companies listed overseas). This could lead to increased use of supermajority voting and other structures to ensure long term control of holding company by Chinese founders and management, thereby allowing their VIE companies to be domestic companies.

3.  Implications on Existing VIEs

In the drafting note issued by MOFCOM along with the Draft Law, MOFCOM suggested three ways to deal with existing VIEs operating in restricted or prohibited areas:

(1) The VIE may make a declaration with MOFCOM that it is controlled by a PRC investor and continue its businesses;

(2) The VIE may apply to MOFCOM for a determination that it is controlled by a PRC investor and continue its businesses; or

(3) The VIE may apply for an entry license with MOFCOM, which will make a decision by taking into account the actual controlling person of such VIE and other factors.

Given the size, visibility and national importance of many large overseas-listed Chinese companies with VIEs, most practitioners believe many existing listed and unlisted VIEs will be able to show domestic control and will be treated as domestic investors.