China Watch – A Foreign Lawyer’s View from the Inside

It’s a new year and I am sure there are some of you who may be interested in my take on the pending King & Wood Mallesons merger, but that will have to wait.  Now that the year-end deal closings and (western) holidays are behind us, it is time to finish off my series of blogs on the VIE structure and cloud computing in China. 

Then I will turn in future blog postings to an overview of the legal market conditions in China which provide the backdrop against which the K&WM (if that is the right acronym) merger perhaps can best be understood.

In my first installment in this (now over-long) series, I made the point that cloud computing in China is just another form of value-added telecoms services (VATS) and since the MIIT, the Chinese telecoms regulator, had effectively closed the front door for foreign investment in the VATS sector, everyone had for some years now been tramping through the side door using the well-worn China-China-Foreign (CCF) or Variable Interest Enterprise (VIE) structures, which are essentially one and the same.

However, given the continuing chatter in China suggesting a re-think of the VIE structure on the part of regulators as outlined in prior blog entries, a re-think of the VIE structure may be timely and appropriate for foreign investors. 

This is particularly the case in respect of the delivery of cloud computing solutions in China.  The market dynamics are different for cloud computing than for typical foreign-funded VATs operations, changing the fundamental deal structuring considerations and drivers.

First of all, we need to assess what you can do and what you cannot do without a VATS license in respect of cloud computing.  The commercial and regulatory structuring opportunities break down generally as follows, irrespective of whether your cloud computing offering involves infrastructure (IaaS), platform (PaaS) or software (SaaS) as a service:

·      If both your servers and the entity acting as your collection point are outside of China (for these purposes, Hong Kong is outside of China), then you do NOT require a China VATS license for the business even if you have China-based customers because you are outside the effective scope of regulatory authority of the MIIT.  However, under this model, you can only collect service fees in USD or some other foreign currency.

·      If either your servers or your collection point (or both) are inside China, then you MUST deliver the cloud computing service through a license VATS operator.  The good news is that this model permits you to collect service fees in RMB.

The offshore model is essentially what Google defaulted to in order to put itself outside of the jurisdiction of the MIIT – it simply moved its servers to Hong Kong. One might think that this is the ideal solution for all cloud offerings in China, but the currency issue is not insignificant.   All China enterprises can remit payments offshore in hard currency, but as this involves exchange control procedures and exchange rate risks, most China-based customers (including many subsidiaries of foreign MNCs) have a strong preference to make payment locally in RMB. 

Consequently, as a practical matter, if you position your cloud computing business solely offshore, you will limit your addressable market in China.  Once you move your point of collection onshore to address this fundamental market demand, then there is a strong regulatory (and often a technical performance) preference to move your servers onshore as well, so your cloud computing service offering will be doubly subject to the jurisdiction of the MIIT.  Since foreign companies are effectively blocked from getting their own VATS license in China, this means that as a practical matter you will need a local partner with a VATS operating license.

But not all cloud computing business models are the same, and you will need to decide on your business model in order to identify the potential pool of business partners.  There are two principal options:

1.    You can provide the cloud services via a big-name branded partner in China which already has a VATS license (such as a big basic telco operator like China Telecom), where the partner is the face to the customer and you are in the background (we will call this “Channel 1”).

2.    Alternatively, you can deal directly with the customer and use a cooperative/captive partner with a VATS license solely as the delivery channel for regulatory purposes (which we will call “Channel 2”).

There are some variations on the above models, and you can mix and match to cover more market segments.  Channel 1 is more of an approach to the SME market, while Channel 2 is more appropriate for large MNC/SOE/POE key accounts.  In Channel 1, you are the sub-contractor and your partner is the prime, while in Channel 2, you are the prime and the partner is the sub-contractor.

Each of these arrangements presents some different issues and opportunities, but neither really requires a full-blown traditional VIE structure – unless you opt to have your nominees set up a greenfield VATS operator to provide the base connectivity for your cloud offering.  But there are several disincentives to setting up your own greenfield VATS operator.  One is that, as we have discussed in this series of blogs, if you indirectly own the VATS operator entity, you will need to tie it up with a comprehensive set of “vertical” as well as “horizontal” VIE controls, which may give rise to some regulatory heartburn and risk.  There is also a time to market concern – it takes time to set up the greenfield entity and obtain the license.  If you have a partner which already has a VATS operating license, you are good to launch once the commercial agreements are in place.

But there is an even more fundamental disincentive in the form of the minimum capital requirements for the greenfield VATS operator.  A single-province VATS operating license requires minimum capital of RMB 1 million, while a multi-province (national) VATS license requires minimum capitalization of RMB 10 million.  Given that the VATS license is simply the delivery platform for the cloud computing business and not the core of the offering, this differential in capitalization is not inconsequential. 

It is not entirely clear how to determine whether you have a single-province or multi-province VATS business since VATS operations are, by definition, “virtual” in nature.  It is tempting to take the view that if you only set up your VATS operating entity in one province, you only need a single-province license since you will deliver the service elsewhere only virtually, but that is not how it usually shakes out in practice.  If you are going to have customers across all parts of China, then as a practical matter your VATS operator will need a multi-province license, and if you are using a nominee shareholder greenfield entity as the VATS operator, you will need to fund the RMB 10 million minimum capital.  This creates a whole host of related technical issues that serve to increase the pressure points in the already somewhat fragile VIE structure, not the least of which is how will you fund this amount to your nominees –it’s a bit much to do so as an employee advance against future salary!

Returning to the business model options outlined above, in Channel 1 you won’t be considering a greenfield nominee structure in any event.  Under the Channel 1 option, you are leveraging off of the brand, customer base and the fee collection capability of the major domestic telco or portal operator.  You might have your brand put forward by the partner under a “powered by XYZ cloud computing technology” banner, but that entails a peer-to-peer licensing arrangement, not a full set of “vertical” or even “horizontal” controls typical for a VIE structure.  If you are one of the big cloud computing players, or if you require higher levels of controls over the technical solution and content delivery, you can hold title to the servers dedicated to your cloud business and simply co-locate them in the Channel 1 partner’s facility.  You can even provide technical management services for the jointly provided cloud offering.  All of this is more of the nature of a peer-to-peer technical cooperation – it is clearly not a VIE deal structure.

Even for a non-greenfield Channel 2 structure, you do not need to own the VATS license (directly or indirectly); you just need to ensure that you have a properly licensed VATS operating partner who can deliver your cloud computer offering to your customer in China and collect the service fees locally in RMB.  Your China cloud business consists of your content and applications delivered to your customers in China – the licensed VATS operator partner merely provides the regulatory compliant delivery conduit. 

To make this Channel 2 model work, you will need to consider putting in place certain “horizontal” controls, all of which are consistent with a prime-sub or peer-to-peer technical/commercial cooperation and which fall short of a true VIE structure.  For example:

·      As with the Channel 1 arrangement above, you may consider co-locating your servers at the partner’s site and providing technical management services for the operations.

·      Similarly, while the Channel 2 partner will need to provide the VATS connectivity services in its own name, the dedicated web interface can reference that the core content and technology is sourced from you.

·      Since it is your brand and reputation on the line, your partner can “outsource” the QOS aspects of the business to your wholly foreign-owned enterprise (WFOE) subsidiary in China. Alternatively, the VATS operator partner can carve out a separate team to manage this cloud business cooperation under the direct management of your WFOE personnel.

·      So long as you reference that the service is being delivered by the licensed VATS operator partner, your own WFOE sales people can in most cases own the customer interface directly – this falls under the permitted category of resale of VATS, which does not require any separate license or approval from the MIIT.

·      You will need to impose controls over the VATS operator partner’s dedicated bank account into which the service fees for your cloud offering are to be paid.  If you want to take a more aggressive position, you can provide that your WFOE will enter into a broader bundled services agreement with the customer with a transparent subcontract of the VATS portion to the local partner, in which case your WFOE would collect the overall fees and hive off the agreed portion attributable to the VATS partner, thereby avoiding all payment risks relating to the local partner.

While there are many elements above that are similar or identical to the “horizontal” controls in a true VIE structure, the absence of the “vertical” controls reduces the related regulatory risks substantially.  Under this arrangement, you are not controlling the ownership of the licensed VATS operator – you are entering into a peer-to-peer commercial cooperation which entails some level of negative controls to ensure the protection of your legitimate economic interests.  Also, unlike a greenfield operation set up by your nominees, you are dealing with a pre-existing VATS operator with a business track record. 

While as part of this cooperation arrangement you understandably will exercise significant controls over the aspects of the operations which relate to and directly affect your cloud offering, perhaps even taking all or part of the partner’s operations “captive” for these purposes, this is a business decision which the partner has made freely and independently on the basis of a commercial judgment that its interests will be best served by doing so.  This is fundamentally different from the typical work-around in which the VIE structure is employed and as such should be much less susceptible to second-guessing by the MIIT. 

There are still commercial risks inherent in tying yourself so closely to a single VATS operator partner.  There are generally only two situations where your partner relationship can go pear-shaped in China: 1) you are not making money, and 2) you are making money.   If you are too successful, the VATS operator partner may be tempted to hold your business hostage in an effort to negotiate better terms.  This perhaps can be addressed by using a dual- or multi-vendor solution: by entering into two parallel arrangements with licensed VATS operator partners, you reduce the risk that one can turn the spigot off and kill your cloud business in China.  Of course, this also has its own costs in the form of parallel negotiations and partner relationship management.  In the end it is a simple cost-benefit analysis.

So that (at last) brings us to the end of this series of blogs on cloud computing and the VIE structure generally.  To sum up, in too many cases foreign investors have either shunned the VIE structure because it does not conform to their preconceived notions of corporate structuring norms or have uncritically accepted the VIE structure because their advisors told them that this was universal market practice in their industry sector.

Both reactions have a basis in logic and fact, but the use of the VIE structure requires clear-eyed analysis and sensible business and legal judgment in the context of the particular commercial transaction, and as such the best decisions regarding the use of the VIE structure tend to fall in between the all-to-common extremes of visceral rejection or unthinking embrace.  And for cloud computing, it is my judgment that you don’t need the VIE structure, as such, at all

Robert Lewis is a US lawyer qualified in California who has lived and worked in China for nearly 20 years.  He has been rated as one of the top TMT and M&A lawyers in China for the past decade and was one of the first senior foreign lawyers to move from a large international law firm to a local Chinese law firm in 2010.