China crackdown prompts rethink on VIE structures
China is considering overhauling regulation of foreign investment into the country. It could tighten the screws on foreign ownership of its booming technology sector and steer more Chinese firms toward dual class shareholdings, if it approves a draft law that addresses the use of the variable interest entity (VIE), writes John Loh.
China's Ministry of Commerce published a draft Foreign Investment Law on January 19 that will remain open to public feedback until February 17. It would aim to collapse three existing regulations into a uniform law that should ease foreign investment into China, said lawyers.
“Overall, the draft law will grant foreign investors better and easier access to Chinese markets,” said Barbara Li, a partner in Norton Rose Fulbright’s Beijing office. “However, for industries that are deemed to have national security implications, the government will impose further scrutiny.”
A key issue in the draft law is the VIE structure, which effectively allows foreign entities to wield control over mainland companies via a series of contractual arrangements. It has emerged as a popular avenue for offshore capital raising by Chinese companies — usually through IPOs in the US or Hong Kong, or even private equity. About half of all Chinese high tech and internet companies that are listed overseas have used VIEs, according to Li.
“The VIE was introduced about 10 years ago and is mainly a fundraising tool,” she said. “This was because onshore capital was not easily available at the time to those in the technology sector. Under the legal regime at that time, the regulators also prohibited companies with no track record of profit from going public, which was why many of them flocked to places like the US. They did this using VIEs.”
For the better part of a decade, foreign companies have used VIEs to get round China’s investment curbs on what it considers to be sensitive sectors — like e-commerce, telecommunication, media and technology.
VIEs typically work through setting up an offshore holding company incorporated in the Cayman Islands that owns a Chinese-incorporated subsidiary. The latter then enters into a series of contracts with the onshore operating company that entitle the Chinese subsidiary to the profits of the operating company.
The VIE structure was first created for internet portal Sina’s listing in New York back in 2000. Other famous examples that have followed include Alibaba, which received a $1bn investment in 2005 from Yahoo through a VIE.
In theory, China's technology sector should be closed off to foreign investment as the country keeps a tight rein on its borders, but the authorities have in the past turned a blind eye to the use of VIE by its fast-growing technology firms.
This could be set to change. Once the new rules are issued, Chinese operating companies that are controlled by foreign investors by way of contractual arrangements such as VIEs will be regarded as foreign-invested companies — making them subject to the same foreign ownership restrictions as any other.
China’s laws governing foreign investment had previously been silent on the VIE structure, leading many to question its legality and enforceability. But the draft regulations will recognise the existence of VIE for the first time.
The ministry also plans to introduce a “negative list” that would outline exactly which sectors are off-limits to foreign capital. Although the draft law does not explicitly state what those sectors will be, legal experts widely expect it to include the telecommunication, media and technology categories.
Lawyers say that those who will benefit from the rule changes include Chinese e-commerce firms Alibaba, Baidu and Tencent, all of which enjoy some level of foreign ownership via their public listings, but with management control ultimately in the hands of their Chinese founders.
Their VIEs are unlikely to be put under the microscope and they will be able to operate as usual. However, those with foreign ownership who are unable to prove that control of the company lies with Chinese nationals may be forced to restructure their holdings when the new law takes effect. This includes companies controlled by citizens of Taiwan, Hong Kong and Macau, who are considered foreigners under the draft law.
Kit Kwok, a corporate partner in Shanghai with DLA Piper, believes the new regulatory regime could complicate cross-border corporate takeovers and mergers and acquisitions for those hoping to buy or sell equity in the prohibited categories.
“It will be good for Chinese-controlled companies who intend to remain under Chinese control, but bad for smaller companies looking to exit to foreign investors,” he said. That could also lead to a sell-down or restructuring in the holdings of Chinese companies by their foreign owners before the law comes into effect, lawyers reckon.
Another possible consequence of the draft law is that it could encourage more Chinese owners to adopt the dual class shareholding structure to maintain control of their firm even without owning most of the shares, said Kwok.
That could give the Hong Kong Stock Exchange more impetus to allow the listing of dual class shares, or risk losing out on another Alibaba. The stock exchange stood its ground and turned down a request by the e-commerce firm to pursue a dual class shareholding structure, forcing Alibaba to decamp to the New York Stock Exchange for its $25bn IPO last year.
As for how the draft laws will affect the IPO pipeline, lawyers see a muted impact. “We had little trouble setting up VIE arrangements in the past,” said Mark Chan, a Hong Kong-based partner with Berwin Leighton Paisner. “Though the VIE structure carries many risks, it didn’t stop companies such as Alibaba from using it.”
With the draft regulations set to formalise VIE, Chan believes it will make compliance more clear cut. But on an operational level the changes are unlikely to result in a deluge of deals coming to the market.
“I think this development will help clarify the position on VIEs and definitely give investors some comfort that such structures will be more acceptable to the Chinese government,” Chan said. “While the VIE has become more common, given the rise in companies in the internet and other politically sensitive industries, there is still some stigma attached to the uncertainty over their enforceability.”
Kwok of DLA Piper thinks that with VIEs achieving regulatory certainty for the first time, there could be positive spillover effects on valuations.
“It removes the regulatory overhang,” he said. “That should be good for anyone wanting to list based on a VIE structure or even some of those who are already listed.”
Market participants are likely to have time to prepare for the implementation of the changes. Now midway through public consultation, the proposed laws still have to be submitted to the State Council for review and then to the Standing Committee of the National People’s Congress for final approval to become law, a process that could take about two years.