• Heightened Scrutiny to VIE structures under the New M&A rules
  • November 9, 2011
  • Law Firm: Blank Rome LLP - Philadelphia Office
  • China's Ministry of Commerce ("MOFCOM") issued new provisions concerning the national security review of foreign mergers and acquisitions of domestic enterprises, which became effective on September 1, 2011 ("M&A" rules).

    The M&A rules provide MOFCOM with the power to determine whether an acquisition of a domestic enterprise by a foreign enterprise should be subject to the national security review by considering both "the substance and actual influence" of the acquisition itself. Further, foreign investors cannot circumvent the security review of M&A transactions by structuring around the requirement, such as holding equity via trusts and exercising control through contractual arrangements (i.e. the "variable interest entities"). as It means that any foreign investment can be subject to the security review. Although there is no expressed prohibition against the "variable interest entity" ("VIE") structure in the PRC under the new rules, it is increasingly coming under scrutiny.

    Variable Interest Entities

    In the typical VIE structure, a foreign investor and a PRC legal person would establish an offshore company that owns or controls a wholly foreign-owned enterprise ("WFOE") in the PRC. At the same time, the PRC legal person will form a domestic company to be the operating company and will hold the necessary license(s) for operation, while the WFOE will enter into a series of contracts with that domestic operating company. The foreign investor gains control of the operating company indirectly through contractual arrangements with the operating company—the linchpin of the VIE structure.

    The VIE structure has long been the favoured investment structure of choice for foreign investors to navigate through the grey areas of PRC law on foreign direct investments ("FDI"), particularly where the FDI is either restricted or prohibited under PRC law.

    On the domestic front, the VIE structure has been used by PRC nationals to engage in international financing for their businesses to circumvent Circular 10. Circular 10 explicitly states that central MOFCOM approval is required for PRC-based companies to transfer assets to offshore companies for listings. By using the VIE structure, there is no actual transfer of assets from the PRC-based operating companies with any offshore companies, thus Circular 10 does not apply.

    The use of the VIE structure has been widespread, particularly in the internet and telecommunication companies, including Google and Baidu, the Chinese equivalent of Google. As of April 2011, approximately 42% Chinese companies that are listed in the U.S. have used the VIE structure.

    Risks Associated with the VIE Structure under the New M&A Rule

    Internet Sector

    The recent dispute between Alibaba Group Holding Limited ("Alibaba") and Yahoo Inc. ("Yahoo") demonstrates the risks that foreign investors may face with the VIE structure if PRC authorities enforce the new M&A rule, although the dispute itself did not arise from the latest changes in the M&A rules.

    In the Alibaba-Yahoo dispute, Alibaba spun off its online payment company, Alipay, and transferred it to a purely domestic ownership with no contractual arrangements made with the foreign related entity. Jack Ma, Alibaba's founder and CEO, claims that China's central bank ("PBOC") refused to issue Payment Business Permits to online payment companies that have foreign ownership. It remains disputed whether or not PBOC would have issued the Payment Business Permit, however, this just illustrates a plausible scenario where a PRC authority could ban the use of the VIE structure in certain key sectors.

    Natural Resource Industry

    In March 2011, the Heibei provincial authorities banned Buddha Steel from forming the VIE structure with a locally-based steel plant stating that the structure "contravenes current Chinese management policies related to foreign-invested enterprises and are against public policy." As a result, Buddha withdrew from the process of its IPO listing on NASDAQ.

    Implications for Investors and the Future Viability of the VIE Structure

    Recent developments have raised some uncertainties on the long-term viability of the VIE structure. PRC authorities are unlikely to clamp down on all the businesses that are currently engaging in the VIE structure, particularly those being listed on overseas exchanges.

    However, foreign investors must be cautious when they are looking to make, or have made investments through, the VIE structure. The new M&A rules are clear that the foreign investors cannot evade the PRC government's authorities and scrutiny through the VIE structure anymore. Where the PRC law says that ownership by foreigners is restricted or prohibited, the law means what it says. With the ambiguities being dispelled, in theory, PRC authorities have the discretion to ban transactions using the VIE structure going forward.

    Foreign investors may consider, if possible, particularly in non-restricted sectors, directly setting up a WFOE, which allows direct ownership of the foreign investors for acquiring new businesses in the PRC.

    With the new rules, the market expects authorities to try and strike a balance between imposing the national security review and the consistencies of foreign investment policies; but it remains to be seen how these new rules would impact transactions based on the VIE structure.