VIE structures under closer examination

Circular 6 applies to foreign acquisitions of domestic interests in the military sector, including any enterprises that are near key or sensitive military facilities, and other entities related to China's national defence. Circular 6 also regulates foreign investors who acquire control over domestic enterprises in industries deemed to have a significant connection to China's national security, such as agricultural products, energy, resources, infrastructure, transportation services, technology, and heavy equipment manufacturing. Circular 6 gives regulators wide discretion to rescind or add stipulations to a proposed transaction on national security grounds.

Filing requirements

Announcement No. 53 specifies that a foreign investor's transactions, which are required to go through the Security Review, should provide the following documents when filing the official Security Review application to Mofcom:

(a) the “Merger and Acquisition Security Review Application Letter” with a brief summary of the transaction details, and signed by applicant's legal representative or authorised agent;

(b) a notarised and legally certified ID certificate, or registration certificate, of the foreign investor, as well as its capital and credit verification documents;

(c) a description of the foreign investors and their related enterprises (including those exerting de facto control over the foreign investors and/or other parties under the control of the same persons) and their relation to the national government;

(d) a brief description of the target enterprise, including a business summary, articles of association, business licence (copy), audited financial report of the previous year, and organisation chart before and after the merger and acquisition;

(e) the following information about the foreign-invested entity that will be established post-transaction: contract, articles or partnership agreement, list of directors appointed by the shareholders, and a list of the corporate officers that will be hired including the general manager or partner of the enterprise;

(f) in cases where equity is acquired in a transaction, a share transfer agreement or share purchase agreement must be filed by foreign investors and should be supplemented by a shareholder resolution of the target enterprise, shareholder meeting resolutions, and an asset evaluation report;

(g) in cases where assets are acquired in a transaction, a resolution should be filed that indicates the enterprise agrees to the asset sale; this should be supplemented by an asset purchase agreement (including a proposed list of the assets to be purchased, as well as the current status of the asset(s), a summary of the details concerning each side of the agreement, and an asset evaluation report;

(h) introductory details on the foreign investors' post-transaction influence with respect to shareholders resolutions, board resolutions, partnership management, business decisions, financial status, personnel, enterprise technologies etc. that transfer actual control of the business to the foreign investors or overseas related enterprises; and

(i) any other documents required by Mofcom.

Security Review Measures and the VIE structure

Circular 6 emphasises a foreign investor's “control” of the domestic enterprise, and states that actual control can occur if a foreign investor obtains de facto control of a domestic enterprise with regards to its business decisions, financial affairs, personnel, technologies, etc. Article 9 of Announcement No. 53 goes one step further and specifically refers to the control relationship:

“A transaction must be examined in its entirety including its actual impact when assessing whether the transaction is subject to a Security Review. Foreign investors shall not use any methods to materially circumvent the Security Review, including but not limited to the use of, authorisation agreements and trust agreements, multiple layers of re-investment schemes, lease agreements, loan agreements, control agreements, or offshore transactions.”

The specific reference to “authorisation agreements and trust agreements, multiple layers of re-investment schemes, lease agreements, loan agreements, control agreements, or offshore transactions”, indicates that the PRC government is aware of the regular use of the VIE structure and wants to specifically regulate against it in areas sensitive to national security.

The VIE structure has increasingly been acknowledged by the PRC regulating authorities and recent regulations have specifically restricted the use of the VIE structure in certain industries. It is believed that the VIE structure remains valid when structured and used properly, but investors and companies alike should continue to follow regulatory developments and seek competent legal advise when necessary.

Final thoughts

Foreign investors seeking to acquire enterprises or assets in China would be well-advised to prepare for a more complex and prolonged transaction approval process. It would appear that PRC regulators will continue to regulate foreign investment in industries subject to a Security Review.

Investors must query whether or not the Security Review retroactively applies to old transactions. Legal specialists suspect it does not, however further clarification from Mofcom is being awaited.

The analysis of numerous PRC lawyers is that the VIE structure's related contracts are generally enforceable in the PRC. However, a transaction using a VIE structure-related contract is now subject to a heightened level of scrutiny. The use of a VIE structure for the purpose of circumventing industries of national security concern may be invalidated by regulators, and thus any investor's business, legal, and policy analyses should focus on the question of whether or not a particular asset or business in the PRC is of national security concern.

It is believed that the VIE structure remains valid when structured and used properly, but investors and companies alike should continue to follow regulatory development and seek competent legal advice.

Parties are recommended to discuss these issues at the outset of a transaction and negotiate in advance an arrangement for allocating the burden of both risks and costs, should a Security Review terminate or change the terms of a proposed transaction.

Rocky Lee, Cadwalader Wickersham & Taft, Beijing and Hong Kong