China’s New Foreign Investment Law does NOT Resuscitate VIEs

As regular readers of this blog should know, our China corporate lawyers have a long history of skepticism regarding China VIE structured entities. In 2013, in China VIEs: What Me Worry? we had this to say about them:

China VIEs. In a nutshell, we don’t like them, don’t trust them, and don’t do them. Quite frankly, our malpractice insurance just isn’t high enough for the massive risks we see in these investment vehicles. We believe that when push comes to shove, China’s courts won’t enforce the contractual agreements necessary to support such a structure.

VIEs have for the most part worked just fine and this likely will not change until there is a problem. And that itself is the problem. To make up a Yogi Berra quote, there is no problem with VIEs until there is a problem. Problems arise if the Chinese partners decide they don’t want to follow the contracts any longer because, for example, they already have the money and know-how they were seeking, as has happened several times. When this does happen, the foreign party most likely has no legal recourse. :

Then in 2015, in China VIEs Are Dead. Done. Over. Stick A Fork In Them. we proclaimed China VIEs to be on their last legs:

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”).

The 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 not 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 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.

But there are still those who desperately hang onto any shred of hope for the VIE and some have of late even been claiming they will soon see a revival. In VIEs in the new foreign investment law, Paul Gillis (one of the true China VIE experts) discusses the source of this new “theory”:

Gillis starts out by mentioning how Bloomberg News has an article suggesting that China’s new foreign investment law “lessens concern about a crackdown on VIEs”:

The proposed new foreign investment law is considerably briefer than a similar law that was floated in 2015 but withdrawn. The 2015 version clearly stated that the VIE structure could not be used to circumvent the foreign investment law. That provision has been removed from the 2019 version. The new version is much shorter than the 2015 version and some of the new provisions included are likely designed to reduce trade tensions with the US.

The 2015 version was tough on VIEs, but provided a way out. All overseas listed companies other than state-controlled companies use foreign (typically Cayman Islands incorporated) parent companies. The 2015 proposal said that if a foreign company was ultimately controlled by Chinese then the rule forbidding use of VIEs would not apply. Most, but not all, overseas listed Chinese companies use some form of control structure (most commonly two classes of shares). I believe what that meant was the companies that use control structures to keep Chinese founders in control (like Alibaba, Baidu and most other private Chinese companies) would not be treated as foreign. I believe this meant that not only would VIEs be permissible in these situations, but they might be unnecessary, since the company could directly own businesses in restricted sectors.

The 2015 version was withdrawn. Although it likely fixed the VIE problem for most overseas listed Chinese companies, it did not work for Tencent. Tencent listed in Hong Kong, which at the time did not allow control structures. I believe that is what killed the 2015 version – while it fixed most of the problems, it created an unsurmountable one for Tencent.  Hong Kong now allows control structures for new unicorn listings, but the relaxed rules do not appear to apply to Tencent. The 2015 proposal was a great idea for Alibaba, Baidu and many other U.S. listed companies, but there was no apparent way to apply it to Tencent.

Gillis then writes how the new law does not even mention VIEs, and therefore it merely “continues the status quo, where the government turns a blind eye towards the structure.” We 100% agree.

Gillis then notes how he believes “Chinese regulators would like to fix the VIE problem, since it makes a mockery of the rule of law, but a workaround has proven elusive. These companies are now a big part of China’s economy, and I find it inconceivable that the government is going to shut them down.” We 100% agree with this also.

Gillis then states that “as VIEs mature they are becoming increasingly unworkable because of the difficulty in moving cash into and out of the VIE.” We 100% agree with this too.

China VIEs. Done, done, done and if you see someone claiming otherwise, ask yourself what that claim does for them financially.

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