Legal risks of the VIE Structure

A domestic entity engaging in an overseas listing by way of the VIE Structure is always limited by actual situations associated with PRC laws or other restrictive factors:

a) The National Development and Reform Commission (NDRC) and other related authorities jointly revise and promulgate the Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录) (Catalogue) every five years. Currently, the 2007 edition is valid even though a new draft catalogue was released in April this year. The Catalogue classifies Chinese industries into three types: “encouraged”, “limited” and “prohibited” industries. Other industries not listed in the Catalogue are usually regarded as “permitted”. Regarding the limited and prohibited industries, Chinese administrative authorities usually impose strict restrictions upon the quality of and the equity ratio of foreign investors or ban foreign investment directly, causing domestic entities in those industries to turn to the VIE Structure for pooling funds abroad.

b) Concerning encouraged industries, domestic entities also prefer choosing the VIE Structure due to the strict requirements of mergers and acquisition rules (M&A rules). On August 8 2006, six PRC regulatory agencies, including the Ministry of Commerce (Mofcom), the China Securities Regulatory Commission (CSRC) and four other regulators jointly promulgated the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors (关于外国投资者并购境内企业的规定), a new regulation with respect to the mergers and acquisitions of domestic enterprises by foreign investors that became effective on September 8 2006, and which was revised by Mofcom on June 22 2009.

Subject to the M&A rules, domestic entities engaging in overseas listings by way of equity merger shall be approved by Mofcom and the CSRC. Because of the complicated approval procedures and strict requirements, to date, nearly all entities that applied have failed to receive approvals from both the CSRC and Mofcom. Some domestic entities in the encouraged industries have chosen to utilise the VIE Structure for listing overseas.

c) Due to the insufficient foreign exchange funds of shell companies, they are incapable of making an acquisition of a domestic entity, which also constitutes a reason why this is not an option.

At present, there is no clear provision in any PRC regulations concerning the legality of the VIE Structure and there is no agreement relating to the effect of the VIE Structure among related fields. This article will discuss related issues concerning the effect of the VIE Structure from the view of the administrative authorities.

It is believed that where foreign investors control a domestic entity in a limited or prohibited industry by the VIE Structure, phenomenon related to the avoidance of legal governance does indeed exist. The government is likely to regard this action as illegal and penalties, fines or other modes of punishment may be meted out to the domestic entity and WOFE directly. In respect of the permitted or encouraged industry, though doubts of intention to avoid the M&A rules still exist, a domestic entity adopting the VIE Structure does not violate national industry policy. Therefore, the entity is able to mostly avoid the risk of being regarded as engaging in illegal actions.

In practice, the controlling power of the WOFE and domestic entity is always held by the same management group and, to be exact, by the actual controller himself or herself. Therefore, the seals or chops of the domestic entity and WOFE that are used for the VIE Structure are held by the actual controller at the same time. Since the actual controller has the right to change or terminate VIE contracts at his or her discretion, the stability of the VIE Structure is often spoiled by breaching issues. For a listing company and its affiliated companies, though the number of breaching VIE contracts in bad faith is small, the actual controller, other shareholders and financial consultants holding shares in overseas entities may hold different opinions based on individual interests, which would also lead to the termination of VIE contracts.

An equity pledge agreement is the guarantee of the whole VIE Structure. According to PRC property law, related parties shall enter into written contracts at first, then they shall register with the Administration of Industry and Commerce (AIC). After completion of the foregoing procedure, the pledge of equity can be set up. As a portion of the VIE contracts, the signature and registry with AIC of its equity pledge agreement is very significant for the protection of other VIE contracts, and the safety and stability of the whole listing structure.

In practice, sometimes shareholders of a domestic entity and WOFE have already entered into an equity pledge agreement subject to PRC law, but some local counterparts of the AIC refuse to accept the materials due to a lack of regulation or policy guidelines or precedent cases as references. Sometimes shareholders and the WOFE have to submit false contracts such as loan contracts for the purpose of an equity pledge. At times, shareholders and the WOFE have to give up the equity pledge registry even though an equity pledge agreement is entered into. At other times, even if equity is pledged, the equity pledge agreement may be invalidated by the parties who share common interests. As a result of all these scenarios, the safety of the VIE contracts is damaged.

For the purpose of improving the stability of the VIE Structure and protecting the legal interests of overseas investors, it is suggested that: 1) A Dependent Director should be added to the Board of Directors in the WOFE. In addition, without the prior written consent of the Independent Director, a VIE contract cannot be revised or terminated, which shall be included in the company's articles of association; 2) VIE contracts shall be recorded with the competent AIC for the convenience of review by the public and supervision by the competent AIC; and 3) the competent AIC authority is entitled to standardise and unify administration so as to enhance the business transaction and not to impede it.

Pursuant to Article 11 of the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors, a domestic entity or individual shall submit to Mofcom for approvals concerning the acquisition and merger of a domestic entity or affiliated entity through a Special Purpose Company established or controlled by a domestic entity or individual. The related party shall not try to avoid the foregoing requirements through investment in the domestic entity by foreign investors or by other means. To date there is no further explanation and definition regarding “other means”. It is unclear whether the VIE Structure is included in the said “other means”.

To date, it seems that there are only two departmental stipulations in connection with the limitations on the VIE Structure in China.

a) As of June 13 2006, the Ministry of Information and Industry enacted the Notice Regarding Strengthening Business Management of Operating Value Added Telecommunication Service invested by Foreign Investors (关于加强外商投资经营增值电信业务管理的通知) (Notice), provided that domestic telecom companies are not allowed to lease, transfer, or sell licences relating to the telecom business to foreign investors. Additionally, they may not provide resources, sites, or equipment to foreign investors illegally engaging in telecoms business in China.

b) In 2009, The General Administration of Press and Publication, the National Copyright Administration, the National “Anti-Pornography and Anti-Illegal Publications” Working Group Office jointly promulgated the Notice Regarding Carrying out The Three Provisions by The State Council and related Explanations by the Central Government and Strengthening further the Prior Approval of Internet Games and Approval Management of Importing Internet Games (关于贯彻落实国务院〈“三定”规定〉和中央编办有关解释，进一步加强网络游戏前置审批和进口网络游戏审批管理的通知). This states that foreign investors are not allowed to actually control or participate in a domestic entity business that is related to net games by means of setting up a joint venture company, signing related agreements or offering technical support.

The abovementioned authorities just made special management provisions in respective jurisdictions that are not clearly referring to the VIE Structure. Moreover, the legal effect of two documents can only be policy rather than law.

Since 2000, nearly 100 domestic entities have successfully listed on US stock exchanges by way of the VIE Structure. These include famous Chinese companies such as SINA Corp, Sohu.com, Baidu, E-Commerce China Dangdang, Renren, and as of May 12 2011, Phoenix New Media. Those companies all adopted the VIE Structure to list on American bourses, without having made any applications to the competent administrative authorities for approval at all. The Chinese central government adopted an attitude of “turning a blind eye” and made no response accordingly.

In March 2011, Baosheng Steel was advised by local governmental authorities in Hebei Province that its Control Agreements contravene current Chinese management policies related to foreign-invested enterprises and, as a result, are against public policy. This case simply reflects the local government's attitude towards specific entities or industries, not towards the VIE Structure itself. It reveals that different local governments hold different attitudes regarding the VIE Structure, which does pose a potential legal risk to using the VIE Structure.

Since the PRC government has adopted strict controls over offshore listings, domestic entities have had to select the VIE Structure to be listed overseas, which causes potential legal risks.

It is recommended that the Chinese government should, on one hand, maintain strict limitations on those industries related to the national economy and livelihood of its people, strategic development and safety for the sake of national security, but on the other hand, it should loosen restrictions attached to the permitted or encouraged industries. Practice proves that the PRC regulations aimed at limiting domestic entities from listing on overseas stock exchanges are not as effective as expected. On the contrary, all the restricted stipulations have only put volumes of burden upon domestic entities such as engaging in complicated procedures, trying to meet time-consuming requirements, high costs, and the devaluation of its stock. Instead, the government should protect special structures that use foreign investment appropriately so that a domestic entity attracts and utilises foreign capital to improve and develop itself.

The Chinese government should adopt an open attitude towards selecting foreign capital markets to finance domestic entities that are in compliance with current state industry policy. It should not add insult to injury by imposing strict limitations as per normal, but it should protect and support the compliant domestic entities to receive overseas financing. Furthermore, the government could build up a productive environment of laws and regulations, with the cancellation or revision of outdated regulations and policies. For long-term benefits, it should also support, encourage and develop those domestic entities seek financing and going to list overseas.

Sally Bee, Partner and Wang He, DeHeng Law Offices, Beijing