How to invest in prohibited or restricted industries

In practice, many Chinese companies under the restricted or prohibited categories have listed on international capital markets through the VIE structure. Sina, the country's online media giant pioneered the trend when it used the structure to list on the NASDAQ in 2000. It appears the relevant government authorities actually support the listing mechanism. They have also made no objections to the VIE structure used by foreign investors for their investments into restricted or prohibited industries. There are two exceptions to the structure: online gaming and national security, as the government tightly restricts VIE investments in these areas.

Exceptions

National security

It is almost impossible for foreign investors to invest in enterprises related to national security. The VIE structure hinges on the domestic company held by the WFOE under a control agreement. Article 9 of the Security Review Provisions states that foreign investors cannot avoid security review during mergers and acquisitions. This includes holding equity in the agent's name, trust, multilevel reinvestment, lease, loan, control agreement and overseas dealings. Therefore, when the holding company establishes the WFOE and it enters into the agreements with the domestic company, it is deemed as an acquisition by foreign investors. These agreements are then subject to security review.

This means that all control agreements between WFOEs and domestic companies are subject to security review. Article 1 of the Provisions states that if the agreements fall within the security review scope specified by the Circular on the Establishment of a System for Security Review of Acquisition of Domestic Enterprises by Foreign Investors (关于建立外国投资者并购境内企业安全审查制度的通知), a security review application must be filed with MOFCOM. The scope of the Circular's security review includes if the domestic enterprise deals in armament or supports other companies relating to national defence security. In addition, if it has close ties to military or sensitive facilities or involves major agricultural products, major energy or resources, major infrastructure, major transportation services, key technologies or major equipment manufacturing, or it relates to national security.

The scope for review is general and often lawyers consult with MOFCOM or its local counterparts to assess whether a specific industry requires an application. The government intentionally keeps the Circular's industries general so it has the greatest jurisdiction over security reviews. If the domestic company falls within the scope of the Circular, foreign investors have to file a security review application with MOFCOM. However, based on experience with MOFCOM, it is very difficult for foreign investors to obtain approval because of restriction policies in place.

Online gaming

A Notice from the General Administration for Press and Publication and the State Copyright Administration provides that no foreign investor may control and participate in the business operation of online gaming in any indirect way such as establishing a joint venture, signing relevant agreements or providing technical services. The actual and indirect participation by foreign investors in the domestic enterprise's online game business operation under the VIE structure is incompliance with the Notice. However, as Chinese government authorities continue to implement the Notice, it is impossible for them to invest in this industry.

Foreign investors under the VIE structure may find their agreements void before Chinese courts as they fail to comply with Chinese law. For example, Ma Yun, president of Alibaba, terminated these structured agreements between Alipay and Alibaba in 2011 because Alipay would have been unable to obtain the payment of its business licence under the VIE structure. Registered owners should ensure the investment agreement stipulates to indemnify for and against any loss and damages arising from the early termination or breach of contract governed by international laws, avoiding legal risks.

The regulators

The China Securities Regulatory Commission (CSRC) has yet to announce its official position on the VIE structure. However, in September 2011, the CSRC's Report Regarding Overseas Listing of Internet Enterprises such as Tudou.com (关于土豆网等互联网企业境外上市的情况汇报) has been widely circulated amongst professionals. The Report proposes to strengthen regulating VIEs by requiring the overseas listing of companies to be approved by MOFCOM and with consent from the CSRC. Even though the CSRC has yet to issue any rules or policies, many see the Report as a starting point to restrict the VIE structure in the future.

After MOFCOM issued the Security Review Provisions, the Hong Kong Stock Exchange (HKEX) imposed strict requirements on listing applicants using the VIE structure when it released its Listing Decision in November 2011. For example, if the domestic company does not engage in prohibited or restricted industries, the Listing Division of HKEX will refer the case to the Listing Committee of HKEX. In order to bypass the legal impediments of the Acquisition of Domestic Enterprises by Foreign Investors Provisions, some Chinese companies not engaged in prohibited or restricted categories also used the VIE structure to apply for a HKEX listing. However, there is a small possibility Chinese companies will be able to obtain approval from HKEX since the updated Listing Decision came into force.

Unlike the HKEX, the US Securities and Exchange Commission (SEC) has not issued new requirements regarding the VIE structure. Some Chinese internet companies, like LaShou.com, AdChina.com and Vipshop.com, have filed applications with the SEC to list on the NASDAQ or New Stock Exchange after MOFCOM's Security Review Provisions. Since the VIE structure violates Chinese laws, the listing applicant is required to disclose the risks, leaving investors to decide if they wish to add the company to its investment portfolio.

Foreign investors can still use the VIE structure to invest in restricted or prohibited industries, other than those engaged in national security of online gaming. However, this window of opportunity is short as many predict the Chinese government will impose greater restrictions on the VIE structure due its violation of Chinese law. Foreign investors should build the VIE structure for their investments as soon as possible.

Brad Shu, Jade & Fountain PRC Lawyers, Beijing