Foreign investors in China using the VIE structure (part II )
18 November 2011
11 November 2011
23 January 2012
25 October 2011
19 October 2011
22 January 2007
n this installment of our continuing series on managing the risks inherent in the Variable Interest Entity (VIE) structure, which is a common work around structure used in a variety of industry sectors in China, we will look at how to fix a VIE deal that has gone pear shaped, including a discussion of some case studies – one a successful example of an effectively managed swapping out of a defaulting nominee shareholder and a second where the foreign party had to go the long way around to exit a deal that went bad early.
China Watch – A Foreign Lawyer’s View from the Inside
Robert Lewis, International Managing Partner, Zhong Lun Law Firm, Beijing
This is point 4 in the list of key points to keep in mind in the VIE structuring and documentation process set out in my prior blog posting on this topic. To repeat, the 5 points to structuring a VIE deal in China are:
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.
We discussed points 1 through 3 in my prior blog. Now we come to point 4 – putting 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. We start with the technical points and then will move on to the promised case studies.
You can have all the negative covenants and further assurances undertakings you want in your agreements with the nominee, but when it comes down to exercising your rights under those clauses, you cannot rely on the good will of your defaulting nominee. When things go bad in this type of relationship, the nominee usually smells out the inherent weakness in your position and will want to use all the available leverage to improve his or her deal on the way out. So you have to paper the deal as tightly and comprehensively as possible up front so as to pull as much of the leverage over to your side of the table as you can.
The typical elements of this point 4 include:
· A stand-alone power of attorney in English and Chinese which is drafted sufficiently broadly so as to be accepted by any government official to whom an application for approval or registration is to be submitted. You don’t want to have to rely on a weak clause embedded in a longer document that describes the overall nominee arrangement (as that may invite or even force the authorities to look beyond the POA clause itself), and you don’t want to have a POA that lists some but not all of the acts covered – sins of omission are not readily forgiven by Chinese bureaucrats, at least not without appropriate “guanxi”, legitimate or otherwise (and, of course, neither we nor our clients deal in the latter category of improper “guanxi”).
· Undated share transfer documents in proper form signed in blank and held together with the share certificates (if it is a company limited by shares).
· Undated signed resignation letters with full waiver and release of claims.
· Anything else which is needed to effect the transfer of the shares to the new nominees and to keep the business moving forward without having to go back to the defaulting nominee following the breach; this requires a thorough assessment up front of the different structural elements and where the nominee intersects with the intended transition process.
These are not new concepts but the details are too often ignored in VIE deals. And even if you make a good faith effort to cover off all the potential risk events, you cannot always account for the possibility that a certain government official may not accept your POA even if properly drafted. Similarly, related forms will change over time so you may need to require your nominees to update their pre-signed documents from time to time so you always have a fresh set which will have a better chance of being accepted. Finally, you need to hope that your defaulting nominee does not consult competent legal counsel who advises the nominee that they can revoke the POAs if they want to play dirty.
If this all sounds a bit risky on the nominee relationship side, it is. If it sounds a bit document intensive (at least if done right), it is. If it sounds like the level of control that will make you feel more comfortable on the partner risk side of the equation may make your Chinese regulatory authority uncomfortable, it may, but only if they have a mind to turn over the apple cart (see prior blog entries). If this all sounds (relatively) expensive in terms of legal fees, it can be. And, of course, if you simply do a cookie-cutter VIE structure, and copy-paste from someone else’s set of VIE documents, then you have saved a bit of money on legal fees and bought yourself at least double or treble the risk in what is already an inherently risky structure. I have done scores of these VIE-type structures in a dozen different industry sectors, and no two clients have ever made the same choices on the multitude of risk/control points inherent in the structure – some because of the different risk profiles of the clients but mostly because of the unique dynamics of each deal and the relationship between the parties.
GigaMedia is not the only VIE-type deal to go pear shaped. It is actually quite common for nominees to have to be swapped out, either because of voluntary change of employers or because problems have arisen. I have worked several deals where we were able to effect an orderly transition from one nominee to another, some without contention and some where the beneficial owners had sufficient overall leverage through the broader relationship and/or the documentation and other controls to force the issue.
A few years back a well-known international IP consultancy firm had a global partner of the firm who was a local Chinese national who was also the lead nominee shareholder in a captive Beijing-based domestic IP agency that was controlled by the firm using a VIE-type structure. When this local partner started to run the local operation a little too independently (I’m being politic here), the regional management came in to work with our team to prepare all the necessary documents to sweep in, raid the local offices, kick out the nominees and replace them with more loyal designees, and reclaim control over the local entity. Their documentation was not all in order when they came in to see us, and there were some gaps in the structural approach (as it happened, the client had relied on otherwise competent London-based counsel who drafted the documentation under English law concepts which failed to take into account the particular requirements in China). However, the firm did have strong overall leverage over the local nominees by means of the global partnership arrangements, and we were able to help the client retake control in a single day with no significant resistance and (importantly) no outside interference, no bad publicity and no lawsuits.
Not all partner problems in a VIE structure are resolved so quickly or so (relatively) easily. More recently, we acted for a PE fund from the US which made its first (and only) China investment though a pre-IPO VIE structure. They had some of the key elements of control in place, principally through the right to appoint their own general manager in the WFOE, but their GM was asleep at the switch when the nominees started bleeding out the capital through some apparently fraudulent self-dealing transactions. When we were brought into the deal, the client had already discovered the problem, confronted the local partner, and not-so-politely persuaded the partner to refund the money back to the WFOE. That all sounded like they were on the road to a solution except for one thing – how to get the money back out of the WFOE quickly without having to take a haircut.
Unfortunately, this ended up taking more time and costing the client more money than they had hoped because their local partners were shareholders, directors and officers of the WFOE. The local partners also held the WFOE chop, so controlled access to the WFOE bank accounts and thus were able to hold the client’s money hostage even at the WFOE level. Moreover, the only way for the PE fund to get the money out tax free was to terminate and liquidate the WFOE, but that would require the signatures of the local partners on related board resolutions and a raft of application documents. So the only rational approach was to require the local partners to submit resignations and hand over their shares in the offshore SPV parent of the WFOE.
Not surprisingly, the local partners declined to transfer the SPV shares for free or for mere nominal consideration – they had a much more substantial figure in mind for the shares and they knew they held all the cards. It ended up being a classic example of the foreign party having to buy its way in and then buy its way out when things went wrong, but at least the client was able to acquire the SPV shares and control the WFOE liquidation process without needing to go back to the local partner at each step along the way. However, that was only the first stage of the process. They are now still working through the WFOE liquidation procedures, more than a year after acquiring the SPV shares and more than 18 months after signing the initial MOU with the local partners to unwind the deal. Not pleasant, easy, fast or cheap.
The remarkable thing is that there was no real need in that transaction to use a VIE structure in the first place. The operating company was not in an industry sector which was subject to foreign investment restrictions, and they should have been able to make a direct investment rather than a more convoluted indirect VIE investment. These are very savvy guys, but it was their first China deal, so they asked around the PE community and everyone they talked to said that the documentation seemed to be pretty standard for a VIE deal. No one asked whether you needed a VIE structure, and apparently the client’s original counsel (a firm we like and otherwise very much respect) never walked the client through the list of risk issues outlined above. They could have still experienced partner problems even in a direct non-VIE investment structure, but the VIE structure was an unnecessary overlay that added more complications with no additional obvious benefit in this case.
This brings us to point 5 – if you can invest directly, do so, and do not use a VIE structure. But there is an important corollary to this: if you can deal with your local partner not as a nominee shareholder of a captive operating company but as a true strategic partner on an arms-length basis, then that often is also the preferred way to go. If you are a true operating company which finds that part of your business offering in China needs to be delivered through a local license holder in a highly regulated sector that is effectively closed to direct foreign investment, you need to ask yourself whether you can achieve your business objectives without using a full VIE structure and instead use a peer-to-peer, prime-sub, strategic partner cooperation arrangement with a real (as opposed to a greenfield nominee-owned) local license holder.
Using a non-VIE structure may also substantially reduce the level of regulatory risk inherent in the VIE structure, which currently appears to focus in substantial part on the “vertical controls” relating to beneficial ownership and control of the shares of the OpCp. “Horizontal controls” may still give rise to some regulatory risks, but likely not to the same degree, and not so blatantly obviously as the “vertical controls” which are central to a full VIE structure.
This now finally brings us back full circle to cloud computing, and in my next blog posting I will explain how I think the full VIE structure is not necessarily the preferred solution for this new cloud computing technological wave that will sweep across the world and into (and also emanate out from) China. I think that a peer-to-peer, prime-sub, strategic partner cooperation arrangement will also prove to be the better model for a range of other service industries as well, avoiding many of the potential regulatory risks and pitfalls of the now overly commoditized VIE structure. With the increased negative chatter on the regulatory front in respect of the VIE structure, now is the perfect time to rethink the approach, which we will do in my next installment.
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.