Foreign investors in China using the Variable Interest Entity structure
11 November 2011
As noted in my earlier blog postings, foreign investors in China using the Variable Interest Entity (VIE) structure have experienced some anxiety in recent months, perhaps unnecessarily (still TBD), over a string of potentially bad news for VIE deals on the regulatory front. But the bigger risk in a VIE structure is and always has been partner risk – i.e. can you trust your nominee shareholder?
China Watch – A Foreign Lawyer’s View from the Inside
As GigaMedia found out (see prior blog entries), if your nominee shareholder/partner holds the chops to the VIE entities, he or she has tremendous leverage, and if your relationship goes sour, you will be on the outside looking in. Unfortunately, depending on how you structured the deal, your money will already have been injected into the WFOE and/or Opco, which under Chinese law and practice is like a black hole – once your money goes in (as capital) it never comes back out. OK, that it a bit of hyperbole – you can get your money out but you have three not-so-great choices:
· either have to sell your equity to someone else (but if you want out because your local partner has run off with the license, chop and/or the bank account, who are you going to find who wants to step in and take your place either for full value or even for a steep discount?);
· you can try to remit the money out as service fees, but that is a phantom exchange (i.e. there are no actual services), which may be harder to justify where the amounts are large and this is potentially subject to tax withholding in any event; or
· more likely, you have to blow up the whole structure, somehow get the money back in the WFOE and then liquidate the WFOE so you can repatriate your capital investment without taking a major tax hit.
None of this is easy, but as I expect GigaMedia is discovering, bringing a lawsuit to enforce your beneficial rights to the shares in OpCo is not exactly a great solution either – it costs time and money and you run the risk that the local court will read the recent Supreme People’s Court guidance opinion which states, in a backhanded way, that you cannot enforce a nominee shareholding arrangement which is designed to circumvent restrictions under law (again, see prior blog entry). And in the GigaMedia case, they now find themselves on the other end of a retaliation lawsuit in the US.
The only effective way to minimize (not eliminate) partner risk in a VIE structure is to select a local partner you trust completely and then document the deal in a way that makes it almost impossible for them to breach that trust, i.e. you need to treat them like you in fact do not trust them as far as you can throw them. You need to identify each potential risk event and set things up in advance so that you can make sure they can’t run off with “your” business. There are a lot of “do’s” and “don’ts” that are not always well addressed in the up-front structuring stage when everyone is feeling happy and hopeful and may be a bit too embarrassed to suggest that they in fact don’t (or at least shouldn’t) trust each other. Here’s a sample list of things to do and not to do in a VIE deal to ameliorate potential partner risk:
1. Achieve sufficient alignment of interests.
2. Make sure there is no incentive to run off with the license, the chop or the bank account.
3. Take the keys to the car out of their hands to the fullest extent possible.
4. Set up the documents so you can cut them off at any time without going to court.
5. And the number one rule – don’t use a VIE structure if you don’t need to.
Let’s talk about these one by one. Due to space limitations, we will cover items 1-3 in this blog, and then move on to points 4 and 5 plus some case studies in the next posting.
Point one – alignment of interests. Another way to put this is that you need to ensure the loyalty of your nominee shareholder to you, the business and the deal structure. If this does loyalty not exist, then you run the very real risk that your partner/nominee shareholder is going to claim, as in the case of GigaMedia, that the VIE structure is illegal. In fact, at this point, it is probably more likely that your nominee will challenge the legality of the VIE structure than that your regulator will do so. This is not to say that your regulator will not do so; it is just to underscore that when your interests and those of your nominee fall out of alignment, then you can almost guarantee that this will happen. When the loyalty of your nominee evaporates, and you leave too many levers in the hands of your nominee, your only real option is to buy off the defaulting nominee to secure the cooperation they were supposed to give originally in the absence of what in essence is blackmail. So you need a structure which will reinforce and even reward the loyalty that already exists at the front end of the deal.
In a greenfield VIE, your nominee shareholders typically will be employees of your WFOE or one of your other group companies, and ideally they will be among your best employees, who see a potential long-term future with your company. Their continued employment and remuneration with the WFOE or other affiliate should be tied in part to their continuing to play ball as nominee shareholders. Similarly, once they are no longer your employees (either due to voluntary resignation or involuntary termination, either connected to their performance as nominee shareholders or otherwise), you need to be able to swap them out as nominee shareholders without missing a beat (which ties into point 4). In short, you need to have some leverage or relationship outside of the OpCo entity which incentivizes the employee/nominee shareholder to keep in line.
In a pre-IPO investment VIE structure, the local OpCo founders typically will co-invest in the offshore SPV parent of the WFOE, hold director and often management positions in the WFOE and also remain as the shareholders of the OpCo. Since the SPV is the future listco, and all parties have the same shared objective to go public, it would seem that there is a sufficient alignment of interests to keep the nominee shareholders in line. In most cases that may be true, but it breaks down in enough cases that you still need to use all the other tools in the tool-kit to ensure there are adequate management controls in place all the way down the corporate structure so that the founders/management can keep the business growing but maintain appropriate corporate discipline to protect the interests of the financial investors. (Note to financial investors: if you are a minority shareholder at the offshore SPV level but are the sole or principal source of cash injected into the WFOE, then you should not cede control of the finances of the WFOE to the local founders even though they hold the majority.)
This ties in with points two and three – reducing or eliminating any incentive or ability on the part of the nominee shareholders to run off with your money and “your” business. Let’s start with the incentives, which really should be dis-incentives. To reduce or eliminate any temptation on the part of the nominee to take the money or the business and run off, you need to implement proper cash management and relationship management arrangements. In a greenfield VIE, your nominees probably should not be signatories on the bank accounts, and you should do a regular sweep of the accounts to bring the cash from the OpCo to the WFOE, where presumably you have full, direct, unimpeded control of the accounts.
Similarly, in a greenfield VIE you need to keep your nominees out of the loop with customers and suppliers so their loyalties are all tied to you and not the nominees – in other words, it really is your business and your nominees cannot take it anywhere. Of course, your nominees can still make your life miserable by wresting control of the OpCo away from you, but that is where point three comes into play – taking the keys out of their hands.
There are several potential problem areas in a greenfield VIE structure which can be addressed up front with some modest forethought and effort:
· You don’t want the nominee to transfer the shares in the OpCo without your prior consent and approval – so in addition to a negative pledge you can take physical custody of the share certificates (if it is a company limited by shares as opposed to a regular limited liability company, where there are no shares).
· You don’t want the nominee to approve any OpCo shareholder resolutions not approved by you – so in addition to related negative covenants you should have the nominee sign POAs and standing proxies (under Chinese law a POA or proxy can be revoked at any time but you can make revocation of the POA/proxy an event of default, triggering the rights under point 4).
· You don’t want the nominee to adopt any OpCo board resolutions not approved by you – so in addition to related negative covenants you can consider either standing proxies or having the nominees appoint other WFOE or parent company employees who are equally if not more loyal to you as directors (including foreign nationals where permitted) and have these directors vote as directed by your relevant senior management team.
· You don’t want the OpCo to enter into any unauthorized transactions – so in addition to relevant negative covenants you can consider providing that the board will have the OpCo hire your designees as the general manager and CFO (including foreign nationals where permitted), who will control the OpCo company chop and operate the OpCo under your directions.
The dynamics in a non-greenfield pre-IPO VIE deal will be different but the principles will be the same. In each situation you need to take a clear-eyed view of all the potential risk areas and events and make sure that there is not too much de facto veto control in the hands of one or two trusted nominees. Even if you spread out the key elements of control, it is always possible for a group of individuals to conspire together to pool their separate keys and jointly take control of the OpCo in breach of their contractual undertakings, but it is much less likely. And if you create adequate dis-incentives by structuring the arrangements such that they can only kill the business and not kidnap it, then inertia will usually ensure that in most cases no conspiracy is ever hatched. Still, it bears repeating that each deal has its own unique dynamics which will require some unique solutions to balance and protect the legitimate interests of the parties.
This covers matters relating to operating control in a VIE structure. In my next blog, we will address how to put yourself in a position to be able to pull the shares from a non-cooperating nominee and transfer them painlessly to a new, more cooperative nominee (point 4) as well as present some case studies showing how the VIE structure works or doesn’t work in practice. We will also introduce point 5 – i.e. assessing whether you need to use the VIE structure at all – but we will deal with that point more comprehensively in a later blog entry when we come back full circle to apply these principles to cloud computing. Stay tuned.
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.