Internet boom demands VIE clarity

The three businesses, together with thousands of others, are spending billions of dollars on M&A, making it imperative the nation set a regulatory standard to achieve consistent merger control and fair industry growth. VIEs, which involve complex arrangements with offshore entities, are often used to bypass China's ban on foreign ownership in sectors reserved for domestic growth, such as TMT.

“The critical issue is that the validity of the VIE structure is uncertain, maybe even challengeable,” said Johnny Zhao of Taylor Wessing.

VIE 101

The structure has been widely used since China's first-generation internet portals conducted IPOs overseas in 2000, a time when there wasn't much of a domestic market for high tech and telecom companies. VIEs allowed them to secure foreign venture capital and private equity financing en route to the IPOs.

The structures are seen as a creative compromise to the 50% restriction on foreign direct investment and have drawn credit for China's internet boom. Other industries have benefited from the workaround as well, with hundreds of private education, media and retail companies using it to tap international capital markets.

The VIE structure involves overseas investors and PRC founders forming an offshore entity that controls an onshore wholly foreign-owned enterprise (WFOE) or foreign-invested enterprise (FIE) in China. The WFOE or FIE controls the management and ownership of a domestic-licensed company which operates in foreign-restricted sectors through service agreements rather than ownership of shares.

But its complexity has spurred calls for clarity. Unregulated, the VIE structure possesses inherent defects that need to be addressed as internet companies increase in size and activity.

Regulatory reluctance

“Until now, no government authorities in China have ever said anything about the VIE structure, especially the Ministry of Commerce (MOFCOM),”' said Jeffrey Ding of Fangda Partners. "Even its antitrust bureau does not want to say anything about it. The current practice surrounding the structure is open to interpretation and nobody wants to get involved, but there is some discretion now that the antitrust bureau may change its stance.”

Although not explicitly expressed in regulations, the structure is of clear concern to MOFCOM authorities. Taylor Wessing's Zhao told China Law & Practice that MOFCOM is not in a position to review VIEs, but an item in the merger filing form requires a party to confirm that that transaction complies with industry policy.

This creates ambiguity and has placed MOFCOM in an awkward position. Though it can indirectly acknowledge and accept the VIE structure during its review process, it cannot assert firm judgments on behalf of all authorities, such as the telecom watchdog Ministry of Industry and Information Technology (MIIT) and the China Securities Regulatory Commission (CSRC).

“The VIE structure is neither legal nor illegal,” said Zhaofeng Zhou, also a Taylor Wessing partner. The longstanding controversy over the structure has led to criticism of the limited powers of MOFCOM's antitrust bureau, but Zhou said that “it just doesn't want to be seen as approving these VIE deals when the structure hasn't even been clearly defined in the first place.”

Competition heightens urgency

The lack of guidance and specific interpretation have taught businesses to structure deals in ways less sensitive to an antitrust review, which some argue has helped leading internet companies develop near monopoly status. Domestic competition has led many players to turn overseas for investment opportunities and partnerships. Such concerns have added to the pressure for regulatory transparency and direction.

“Giving importance to the VIE structure definitely goes up to the State Council level,” said Philip Qu of TransAsia Lawyers. “Direction from the State Council will then lead MOFCOM and the MIIT to draw up the groundwork for regulating VIEs,” he said. The two government bodies are responsible for foreign investment policy in the telecom industry. The CSRC's definition of the operating structure from an equity perspective will also contribute to the overall framework.

A temporary solution

Qu noted that the director general of MOFCOM's antitrust bureau, Shang Ming, might have changed position. He believes that the authorities are seeking an interim solution in which they will set aside the technical VIE component and instead focus on the substance of the business concentration entity.

But until the government gives the go-ahead for the relevant authorities to reach a consensus, enforcement remains an issue and the lack of regulation will continue to work in favour of the expansion of VIEs.

Regulating competition becomes increasingly difficult as the big players, seeking to expand, actually provide opportunities for niche-market newcomers. Many start-ups benefit from venture capital deals, which encourage new products and ideas. At the same time, this allows the big to get bigger. Disputes are becoming more aggressive and frequent in the struggle for dominance. Interpretation and discussion of these cases will help the competition system in China to evolve.

“The new government still respects technological innovation and gives a lot of respect to the new industry and economic growth drivers,” said Qu. “Hopefully with the way it manages the monopolies it can still encourage innovation. This is most important.”

What the leading companies are up to…

The internet industry's pace of competition has quickened with the pressure to tap the growth in mobile phone usage.

After a series of big investments in search engines, logistics developers and restaurant-rating websites, Tencent Holdings is now buying a 15% stake in online retailer JD.com for US$215 million (Rmb1.32 billion) with plans to purchase another 5% after the latter's US IPO. The deal is not subject to antitrust review as Tencent will not have a controlling stake.

The two are looking to challenge Alibaba Group Holdings' dominance in China.

Alibaba has also made several purchases in various software sectors, such as its recent US$804 million (Rmb5 billion) acquisition of video host ChinaVision and its US$586 million (Rmb3.65 billion) investment in 18% of Sina's social media site Weibo. But it has been losing ground to Tencent in mobile usage. More than 80% of all internet users access the web via mobile devices, and Tencent will provide JD.com with a direct portal to the world's largest smartphone market.

As part of the deal, Tencent will integrate JD.com with WeChat, a powerful move that will give JD.com access to the app's half-billion users. If WhatsApp was worth US$19 billion (Rmb118 billion) to Facebook, WeChat's value is at least US$60 billion (Rmb374 billion), according to CLSA, which forecasts the figure will reach US$90 billion (Rmb560 billion) by 2017. Alibaba has two potential acquisition targets if it wants to match up: Naver's LINE or KakaoTalk, although the latter is less likely as Tencent already owns 13.84%.

And then there's Baidu, which has boosted its mobile capabilities to try and catch up with Alibaba and Tencent by purchasing China's largest mobile-app store 91 Wireless for US$1.9 billion (Rmb11.8 billion) last year. It also recently increased its stake in group-buying site Nuomi to 59% and, like the others, it is still on the hunt for more targets.


By Katherine Jo