(By You Yunting) Abstract: The Foreign Investment Law (Draft for Comments) has shifted the standard of a company based upon the actual controller, instead of the shareholder of the company, and regulated that the domestic company must not engage in any industries where operation by foreign investors is prohibited. In case the Draft becomes law, it will cut off the survival basis of VIE structure, so that the VIE company controlled by foreign investors cannot be operated, that the overseas listed company controlled through the VIE structure by Chinese will lose its survival basis of oversea listing, and that the startup companies of VIE structure controlled by Chinese will be forced to abandon the VIE structure.
China Ministry of Commence issued the Foreign Investment Law (Drafts for Comments) (hereinafter the “Draft”) and began its revolution on the approval and management of foreign investment companies. However, the Draft regulated that a domestic company controlled by foreign investors must not engage in any industries where operation by foreign investors is prohibited, which will probably have some serious influence on industries such as internet companies that have already used variable interest entities (hereinafter the “VIE”) structure in gray zone, and might even wipe out the existence space for VIE structure. I am wondering whether the designer of such structure has thought over this problem with full consideration. The following is our analysis.
- What is the VIE structure?
In short, in consideration of state sovereignty consciousness and/or ideology control, Chinese governments prohibited and restricted many industries for foreign investors, for example Telecommunication, Media and Technology (collectively called “TMT”). But the development of these TMT industries needs foreign capital, technology and managerial expertise. Therefore, startups, venture capitalists and professional service personnel (accountants, lawyers and etc.) jointly established a concurrent company structure to evade the Chinese government limits for these TMT industries.
(1) Foreign capital shall first find a liable Chinese citizen in China, and establish a domestic company (or acquire a domestic company) which the above Chinese citizen is the shareholder of. This domestic company can engage in the industries where the operation by foreign investors is prohibited, such as the internet. The application for Internet publishing license, online culture operation and IPTV all requires the qualification of domestic corporations.
(2) Synchronously, foreign capital is used for the registration of a parent company (the “off-shore company”) in Cayman or in the British Virgin Islands. The off-shore company then sets up wholly-owned subsidiaries in Hong Kong, after which a wholly foreign-owned enterprise would be established in mainland China by the Hong Kong subsidiary. (Setting up Hong Kong companies is aimed to tax preference.)
(3) Agreements will be signed between the Hong Kong subsidiary and the domestic company (including its shareholders), specifically including: the Share Pledge Agreement, the Business Operation Agreement, the Share Disposal Agreement, the Exclusive Consulting and Services Agreement, the Loan Agreement and the Spouse Statement.
(4) Through these agreements, the off-shore company registered in Cayman or British Virgin Islands eventually takes control of the domestic company and its shareholders, enabling it to operate the domestic company, distribute and transfer its profits according to the will of the foreign parent company, and finally transfer the profits to the overseas parent company after tax.
- Why does VIE structure have the tacit approval of the government?
Sina Corp. is the first company that managed to be publicly traded in the United States with the help of VIE structure. After then, VIE structure has nearly been the only option when it comes to a way to be listed to on the overseas stock market for the Internet enterprises which are now thriving in China. Given the background of Internet technological advances, VIE agreements have provided an opportunity for foreign capital, techniques and management experiences from foreign countries to constantly enter China, thus giving rise to independent Internet Industry of China. Moreover, this structure has promoted rapid reformations in various industries and governments, domestic and foreign capital of the whole industry, entrepreneurs and netizens have all benefited a lot from it. It is no exaggeration to say that VIE structure has created a win-win pattern.
Under such background, the Chinese government takes an ambiguous standard on VIE structure. The government neither gives up its authority or power to regulate this issue, nor recognizes the legitimacy of VIE structure. At the same time, the government also benefits from the social progress, employment rate and tax revenue brought by the rapid development of the Internet industry associated with the VIE structure, reluctant to denounce it as illegal at the risk of benefit loss and social unrest.
The gray zone, however, is not sustainable in the long run. Compared with social development, regulation or legislation from the government always lags behind. A lot of regulatory space circumvented by VIE structure where foreign capital is prohibited to be involved are unreasonable, which also applies to some ideological issues related to publication and culture. The Chinese government, which hasn’t started any reformations in those industries, has already realized that regulation may hinder social development. However, it cannot give up the power of regulation. These factors together make it even more difficult to apply deregulation in any of these industries. Meanwhile, the information flow caused by the rapid development of the Internet has increased the speed of the exposure and escalation of social contradictions. When social stability is influenced by the Internet, it would be more likely for the Chinese government to take control of the Internet industry. For these reasons, regulation over the VIE structure has been escalated.
- Why does the Draft prevent the VIE structure controlled by foreign capital from circumventing the law?
For the time being, all the VIE corporations can be divided into two categories: one is controlled by Chinese corporations or individuals; the other is controlled by foreign corporations or by individuals. The emergence of the Draft makes it impossible for the latter category to circumvent the law by the VIE structure. The identification criteria for a foreign corporation formerly employed by PRC Law lies in the nationality of its shareholders, which may help domestic companies under the VIE structure to enter the industries that are prohibited by the Chinese government. Nonetheless, two regulations of the Draft force out the space taken advantage by the foreign corporations under the VIE structure to operate business regulated by the government.
Firstly, the identification criteria employed by the Draft have shifted to the standard of the company’s actual controller. It is regulated in paragraph 2, Article 11 that “domestic companies controlled by foreign investors are deemed as foreign investors”. Article 18 regulates that “identification of a corporation lies not only in its share or the right of control of its board of directors and shareholders, but also in the decisive influence by agreements or irrevocable trust on its operation, finance, staffing and technologies.”
Secondly, the Draft also regulates the directory system of term sheet prohibited and restricted for foreign investors in which foreign investors are not allowed to engage in the industries listed in the category. In addition, Article 25 of the Draft specifies that “as long as the foreign investors directly or indirectly hold shares, property shares, voting right or other rights of a domestic company, this domestic company is prohibited from investing in the industry listed in the directory, excluding the stipulations of the State Council.”
Once the Draft becomes law, it would be impossible for the VIE companies controlled by foreign individuals, companies or organizations to operate business in industries listed in the directory. On the other hand, VIE companies controlled by domestic individuals or companies will not be influenced.
- Analysis of the Draft’s influence on several types of corporations
Although it seems that the regulations of VIE structure in the Draft are accurate enough to strike a blow to the VIE companies controlled by foreign investors, it may cause real damage to the market fundamental of VIE structure. If these regulations do become law, the VIE system would be destroyed, leading to the loss of benefit of every participant, including the government.
(1) VIE companies established by foreign entrepreneurs
We have served for some of those VIE companies, where the founders may be foreigners, investors from Hong Kong, Macao and Taiwan, and Chinese-American who are familiar with the trade regulations both in China and overseas. They are looking for gold in the development of Chinese internet and always do a good job. However, in case the Draft becomes law, most of them cannot continue to operate their companies. For the employees in their companies and startups, it will surely be a disaster. This is indeed the case of some listed companies in China. Online video, such as Youku, is a prohibited industry that foreign investors should not engaged in, but its founder Mr. Victor Koo, a Hong Kong citizen, owned more than 40 percent of the shares of its off-share company when Youku went listing, typically considering as an actual controller. The Draft regulates that investments from Hong Kong, Macao, Taiwan, and overseas Chinese shall be accord with this Law. Therefore, if the Draft does become law, Mr. Victor Koo shall give up his shares of Youku.
(2) VIE companies controlled by foreign entrepreneurs
Due to the existence of VIE structure, there is always plan B in the Chinese internet competition that the failure could sell his shares of the off-shore company to overseas companies and individuals. For example, Eachnet.com was sold to eBay, JOYO.com was sold to Amazon, and eLong was sold to Expedia. Moreover, there may be countless other foreign companies which engage in or acquire promising Chinese VIE structure corporations in their growth period. Those VIE companies have a more formal operation than domestic companies with better staff benefits, a healthier business model, and they might do become benchmark firms in the future. In the event that the Draft does become law, it becomes impossible for most of these VIE companies controlled by foreign entrepreneurs to remain in business.
(3) Listed VIE companies controlled by domestic individuals
If the Draft does become law, as for the listed VIE companies controlled by domestic individuals, their existence will present a paradox which may be abandoned by investors. Because overseas share markets have its own rules that, if one has more shares than the controller, one could operate the company through controlling the shareholder meeting and the board of directors. However, the rule of the Draft is that the company uncontrolled by domestic individuals and companies cannot engage in the prohibited industries. If foreign investors hold the control, it is impossible for the company to remain in operation. Such paradox comes into conflict with the original intention of the stock exchange listing, damaging the survival basis of those listed companies. At least, if I was an investor, I might not engage in those listed companies with restricted shareholder rights.
(4) VIE Startups controlled by domestic individuals
Although the Draft may assist domestic entrepreneurs to annihilate some overseas competitors, it will also aggravate the surviving environment. Firstly, as previously stated, foreign capital cannot acquire those startups. Secondly, the listing environment and full trust environment will also be destroyed by the Draft, so that these startups are losing their advantages over VIE structure to attract foreign investors. At the moment, VIE structure will be more burdensome, and they must convert into wholly domestic companies and break up with overseas listing.
As I’m writing here, everyone may understand that, if the Draft becomes law, it will make a space for the VIE companies controlled by domestic companies and domestic individuals but indeed cut off the survival basis for VIE structures. This means, it is impossible for VIE companies controlled by foreign capital to remain in operation, and for VIE companies controlled by domestic companies and individuals to go public abroad, thus VIE startups controlled by domestic individuals may be forced to give up the VIE startups. According to our experience, as Chinese governments are very pragmatic, they will not make massive changes all at once for current systems. Then, the Draft will be substantially revised before becoming law, shutting off VIE companies will not been the case.
However, since this should be the vested policy of the China government over restricting the VIE companies, it is absolutely a possibility that China government will apply such systems as requiring VIE companies controlled by foreign investors to introduce domestic cooperators in terms of three or more years and to change into the operation of joint venture companies. It may also apply other systems, like refusal of approving new VIE companies, disapproval of new operational industries. All in all, VIE companies will not be in outright catastrophe but will have a hard time in the next few years.
Lawyer Contacts
You Yunting：86-21-52134918 youyunting@debund.com/yytbest@gmail.com
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