Reconsidering the VIE structure

The holding company owns the WFOE through a series of intermediary holdings. The domestic company and the WFOE enter into a series of structured agreements, including an exclusive equity option, equity pledge, voting proxy and technical licence and service agreements. These agreements allow the domestic company to be indirectly controlled by the holding company and its financial results are consolidated into the WFOE's financial statements, as if it were one of the company's subsidiaries.

Investigation

Beijing-based Brad Shu, a partner at Jade & Fountain PRC Lawyers said: “The SEC might not be questioning the VIE structure, but they are concerned about whether franchises may be consolidated into the company's financial statements.”

Eric Liu, a partner with Han Kun Law Offices in Beijing added: “It is the change in shareholder structure rather than the VIE per se that draws the attention of the SEC.”

This is not the first time the SEC has looked into companies using the VIE structure. In 2011, it launched a series of investigations into Chinese companies, albeit again over financial issues.

Legal issues with VIE

While the VIE structure does not violate Chinese law, it does go against the spirit of it. The purpose of the Industrial Guidance Catalogue is to regulate foreign investment into industries that are allowed, restricted or prohibited.

“There has been no official decision or legislation denying the legality and validity of VIE,” said Liu. “If investors can bypass the Catalogue using the VIE structure while the authority is aware of it, then it is not prohibited,” he added.

There are also questions over whether the structure can effectively protect investors, especially from management's abuse of power at domestic firms. In addition, there are issues with enforceability and validly of the structure's contracts.

But while Chinese law may not protect investors, Liu and Shu contend that foreign law can protect investors during contractual disputes or abuse of power.

Opening foreign investment

In his opinion piece from Caixin, Zhang Jiwei said that perhaps it is time to remove the VIE structure and completely open up China's foreign investment. “The fact that a large amount of foreign investment has poured into these areas has contributed to their development, and probably suggests that we should lift the prohibitions,” he wrote.

Lifting prohibitions will not be easy, argued Shu, as “foreign investment restrictions will be a long-run policy in China”. Even regulating the VIE structure seems impractical “because any official comments will have a profound and lasting impact on the market,” said Liu.

By David Tring