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

17 October 2011

Unfortunately, that round hole is effectively plugged up by the policies of the MIIT, China’s telecom regulatory authority, which has as a practical matter refused to issue licenses to Sino-foreign JV VATS operating companies, so virtually no one can come through the front door as promised in China’s WTO commitments. 

As a result, everyone is going through a well-trodden side door, through the work-around known as the Variable Interest Entity (VIE) structure, which is used in a wide range of industry sectors in which foreign investment is subject to certain limitations.

The VIE model has a somewhat suspect provenance and a checkered past.  It always seems to be on the knife’s edge, and 2011 in particular has not been a great year for the VIE structure.  It has taken more than a few hits but somehow just keeps on ticking. 

For the uninitiated, the VIE structure (sometimes known as the nominee shareholder structure or the China-China-Foreign or CCF structure) is comprised of the following key component parts:

1.    An OpCo which holds the relevant operating permits.  This OpCo typically is 100% owned by Chinese shareholders, and the relevant business is conducted by and in the name of this OpCo.

2.    A wholly foreign-owned enterprise (WFOE) is set up by an offshore SPV owned by the foreign party.  In some cases, particularly where they are looking to an eventual offshore IPO, the OpCo shareholders/founders also have a stake in the offshore SPV.

The basic premise is that the OpCo operates as a shell.  The WFOE provides a suite of technical consulting services, in consideration of which all net operating revenues of OpCo are passed through to the WFOE in the form of a service fee.  The net result is that the WFOE is in fact operating the business through the OpCo, providing a neat work around the regulatory restrictions on foreign investment in whatever industry sector it may be.

The foreign owners of the WFOE obviously have some legitimate anxieties about the lack of direct control over the OpCo and so put in place a range of indirect controls in the form of share pledges and call options together with proxies and POAs at the shareholders and board levels (what I call “vertical controls”) as well as negative and affirmative covenants in the technical consulting services agreement covering matters such as segregated dual-signature bank accounts, minimum QOS standards, systems design and operational management requirements, on-site training and supervision, management outsourcing arrangements, etc. (what I call“horizontal controls”).

The elephant in the room is that the relevant regulators could step back, look at the structure in the entirety, collapse it down to its essentials and declare it to be in violation of the applicable foreign investment restrictions and close it down.  So far they have not done so, but they still keep chipping away bit by bit just to keep everyone guessing whether or when they might eventually decide to swoop in and shut these VIE structures down completely.

The first problems with this structure arose in the late 1990s in the early days of the Unicom investment structures, when the VIE structure went by the China-China-Foreign name.  Unicom remains the poster child for the CCF or VIE structure and the Unicom story is still the most prominent cautionary tale in respect thereof.  Unicom raised more than US$1 billion from foreign telecom operators and investors in 40 regional and provincial mobile networks.  But when Unicom was ready to launch its IPO its advisors realized that it did not have clean title to its network assets, so Unicom decided that these CCF structures were illegal after all and backed out of all them.  Since they were on shaky legal ground, the foreign investors couldn’t mount much of a defense.  Most investors got their money back, but they paid a lot in legal fees on the way in and on the way out, and all left with a bad taste in their mouths.   

Remarkably, in the aftermath of the Unicom debacle, the CCF model did not die, but in fact became the structure that telecom regulators seemed to encourage for foreign investment in the internet sector.  Chinese internet stars such as sina.com and sohu.com use this structure to launch their own IPOs in New York, with the apparent blessing of the Chinese government.  Foreign investors in the value-added telecoms space followed suit in droves, and thus after no more than a year, the CCF structure was reborn as the VIE structure and dominated this industry sector.

Things went along swimmingly for a while, but more problems soon arose.  The next hit came in 2006 when the MIIT issued notices requiring VATS operators to own the domain name and trademarks used in the VATS business and banning domestic VATS operators from leasing or transferring their licenses and operational resources to foreign parties.  In 2009, a similar notice about no foreign indirect participation in online games operations was issued.  In each case, this put a chill in the market for about 3 months and then everyone decided to ignore or work around these restrictions in practice.   Moreover, neither provide much interference for VIE structures in the non-telecoms space.

But this year there has been a steady drumbeat of efforts to chip away at the VIE structure more generally:

·    In the early part of the year, the Supreme Peoples’Court issued a guidance opinion to the effect that nominee shareholder and beneficial ownership arrangements are enforceable if they do not contravene Article 52 of the PRC Contract Law.  That sounds positive until you read Article 52, which provides, inter alia, that a contract is invalid if the parties intend to conceal an illegal purpose under the guise of a legitimate transaction (anyone smell a“work around”around here?).

·    In March, Buddha Steel withdrew its proposed US$38 million offering that was to propel the RTO company onto the NASDAQ exchange and also advised investors not to rely on its financial statements after Hebei officials found its VIE agreements to be invalid.

·    GigaMedia has been in the news this last summer in connection with the ugly collapse of its VIE structure in China when the legal owner of the OpCo shares in its VIE structure reportedly ran off with both the OpCo entity and the WFOE in violation of the VIE agreements.  GigaMedia reportedly has brought a lawsuit in China to enforce the VIE agreements (you know your VIE deal is in trouble if you have to go to court), and then the not-so-nominee shareholder turned around and sued GigaMedia in a US court seeking US$40m in damages, claiming the VIE structure was an illegal sham (so just when GigaMedia thought things couldn’t get any worse, they did).

·    The new National Security Review (NSR) rules (similar to CFIUS review in the US) specifically provide that a foreign investor cannot use contractual arrangements to circumvent NSR in “key sectors”(which, as is the norm in China, is not defined, so it means whatever they want it to mean, which, after all, is their intention).

·    Finally, recent news reports indicate that the China Securities Regulatory Commission is pushing the PRC Ministry of Commerce to investigate VIE structures and may be trying to position itself to be the gate-keeper for offshore IPOs using this VIE structure.

So what does this all mean and what should foreign parties do about all this?  And what does this have to do with “cloud computing”in China? Since I am already well over my word limit for this blog entry, you will just have to wait for my next posting!   

Robert Lewis, International Managing Partner, Zhong Lun Law Firm, Beijing

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.