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

In my last blog entry I wrote about the recent drumbeat of bad news for VIE (Variable Interest Entity) structures in China.  Now I am going to tell you whether you need to be worried.  OK, you can start worrying – if for no other reason than because in China a good dose of caution generally produces better deal structures.

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

In my last blog entry I wrote about the recent drumbeat of bad news for VIE (Variable Interest Entity) structures in China.  Now I am going to tell you whether you need to be worried.  OK, you can start worrying – if for no other reason than because in China a good dose of caution generally produces better deal structures.

All of the VIE problems outlined in my last posting fall into one of two general risk categories:

·      Regulatory risk, i.e. the risk that the relevant Chinese government regulator may close down the VIE work around structure; and

·      Partner risk, i.e. the risk that your partner who holds the legal shares in the VIE onshore OpCo will go off the reservation as apparently was the case in the GigaMedia VIE debacle.

In this blog post I will start with the regulatory risks and turn to the partner risks in my next blog.

So has the regulatory environment in China actually changed as a result of the recent series of government announcements (e.g., the SPC opinion, the reported CSRC attempts to position itself as gate-keeper for offshore IPOs involving VIE structures, and the new national security review rules) and related administrative actions (i.e. the invalidation of the Buddha Steel VIE by Hebei officials)?  The answer, in short, is “not really.”  Unfortunately, that is not necessarily good news, but neither is it bad news in and of itself.

The official chatter has increased, but the fundamental risk analysis remains unchanged – the VIE structure is inherently at risk because it is a work around to avoid regulatory restrictions which foreign investors find “inconvenient” (which is a term the Chinese owned long before Al Gore co-opted it for his green agenda).  If the Chinese government wants to shut down these VIE structures, it could do so at any time – it doesn’t need any new notices, opinions or policy announcements.

It’s like the whole issue of national security review (NSR) of foreign investment in China.  NSR first came up in the aftermath of the 2005 CNOOC failed bid for Unocal.  In that case, public anxieties in the US about the potential purchase of US oil reserves by what was perceived to be a corporate surrogate for the Chinese government gave rise to a political response which threatened a more comprehensive review under CFIUS.  This, in turn, provided the Unocal board an excuse to turn down the richer all-cash CNOOC bid in favor of the competing (and pre-existing) ChevronTexaco bid.  In China, this was seen as blatant political interference (even though most CFIUS experts agree that the deal would have cleared a formal CFIUS review), and the Chinese response was to adopt hastily drafted national economic security (NES)review provisions in the 2006 Cross-border M&A Rules – the precursor to the newer NSR, which is the Chinese version of CFIUS.

When Chinese business news reporters first started calling me to ask my opinion about the then new NES review rules, I was dumbfounded.  Unlike the US, where the general presumption is that most FDI deals require no approvals (except in highly regulated industries and in cases involving anti-trust or national security issues), in China a foreign investor can’t take step one without a government approval.  China doesn’t need NES review or NSR rules because it can veto any foreign investment deal it wants to for any or no reason.  If it considers a deal to be sensitive, it can pull the plug at any stage. 

The same is true for the VIE structure.  I am confident that in most cases the relevant Chinese regulator is in fact not unaware that the VIE structure is being used as a work around.  That is particularly true for VIE structures supporting offshore IPOs – the structure is laid out in its full splendor in the prospectus.  In other deals, the foreign investor or the Chinese partner will feel compelled to be completely up front with its regulator about the arrangement in order to keep in the regulator’s good graces.  In still other cases, e.g. the internet space, the front door is effectively closed and everyone is stampeding through the VIE side door.  There is very little mystery here to the VIE structure given how common it is, and the regulators can shut down this structure any time they choose to.

But the recent increased chatter notwithstanding, the Chinese government has not opted to shut down VIE structures generally or even in particular industry sectors, in part because from the government’s perspective it is “inconvenient” (which in Chinese usage essentially means it is more trouble than it is worth or the upside benefit is outweighed by the downside risk) and in part because this type of VIE work around is part of a grand tradition of work arounds in China.

The most openly flagrant use of the VIE structure to flout the black letter rules is in the internet space (which includes cloud computing – I promised I’d come back to that), but if the MIIT torpedoes some of the VIE structures doesn’t it also threaten to sink its stars and and others using the same structure?   That would be very “inconvenient”, to say the least, and not very pragmatic.

Just as importantly, if the MIIT shuts the VIE side door, it should expect that pressure to open the front door for foreign investment in the internet/VATS sector – and lay out a welcome mat – should intensify exponentially.  My view has always been that the 50% cap on foreign investment in the internet/VATS space in China makes no sense at all, and the MIIT refusal to even allow such direct capped investment as a practical matter borders on the bizarre, particularly since this overly restrictive policy directly contravenes a plain reading of China’s related WTO commitments and applicable implementing regulations.  Moreover, in a world of increasing tech-media-internet convergence, if foreign investment in hardware, software and related technical services is not subject to foreign investment caps or constraints (as is in fact the case), then foreign investment in most segments of the internet/VATS sector (including cloud computing offerings) should be similarly open (at least so long as it does not call into play prohibited or sensitive media content). 

Another reason for lack of government action is the great chasm between black letter law and actual practice in China, which has traditionally existed and generally suits the government’s purposes.  First and foremost, it is generally recognized that this is the only pragmatic way to get things done in many cases against the backdrop of an incomplete legal framework in certain sectors.  For example, the entire private enterprise miracle that took place first in Guangdong, Zhejiang and Jiangsu provinces and then has spread across almost all of China, required both government officials and local entrepreneurs to wear blinders and ignore all the laws that were being trampled on.  Government officials give the private sector some space and watch to see what happens.  If it turns out OK, they can grandfather it in or even enshrine it as the new officially recognized business model as part of the next round of regulations.  If it goes pear shaped, government officials can step in and bring the hammer down.

So in the end, the fact that there are hundreds and perhaps thousands of examples of VIE structures across China, many of which are highly public in nature, provides some comfort, but does not in and of itself provide the ultimate comfort in numbers as many seem to expect.  The MIIT and other regulators can shut off the VIE valve at any time, in full or in part. 

Many expect in connection with VIE structures that any proscriptive action would be prospective in application, and prior VIE deals would be grandfathered in.  However, Chinese regulators can choose to grandfather in some VIE structures but not others or require all to take rectification actions and fall back to an alternative structure.  For example, regulators may express a preference for true domestic operators which have used VIE structures principally to access foreign capital markets and simply impose a further CSRC review requirement for these (on the basis that this promotes local players), but take a harder line on a pure foreign play using a greenfield operator set up by nominee shareholders who are employees of the WFOE entity (on the grounds that this is a blatant circumvention of the foreign investment restrictions in a given sector). 

Alternatively, Chinese regulators can crack down on the nominee shareholding arrangements and other “vertical controls” as described in my prior blog but take a more relaxed view of “horizontal controls” (on the basis that foreign control of beneficial ownership of shares in a domestic operator is anathema to FDI regulation while “horizontal controls” are just how arms-length cooperative relationships are managed in the real world).  They could even adopt a more liberal approach in one industry and a more restrictive approach in another.  It is all a question of whether Chinese regulators in the given industry are happy with the “blinders on” status quo or whether they see a need to play mix and match with the standard Chinese portfolio of regulatory remedies.  

In the end it is a matter of whether it is more “inconvenient” for the relevant regulators to do something or to do nothing.  The Unicom example is still informative.  Unicom and the telecom regulators at the time were all happy with the original CCF deal structures until it was “inconvenient” for Unicom to keep them intact because Unicom needed clean title to its assets for its IPO. 

So where does the Buddha Steel VIE deal fall in this spectrum?  The answer is it is not quite clear.  Many assume it is a one-off local regulatory response to a specific set of facts.  It could just be bad “guanxi” or bad karma.  We don’t have enough facts, and Chinese regulators don’t need a reason.  But one swallow does not a summer make, so it is too early to declare a regulatory trend just from the Buddha Steel case or the other points in the array of ostensibly bad news for the VIE structure in 2011.

In sum, for each VIE structure, you will need to assess the leverage equation in the context of the particular regulatory scheme and the regulator’s overall enforcement posture.  So long as there is no pressing motivation for the regulator to act, you should be safe, and if the regulator does act, it is still more likely that it will adopt a more pragmatic approach and not disturb existing structures or at least provide a path to rectification.  But you need to take a clear-eyed look at the potential pressure points and build in some flexibility to work around the regulatory response to the original work around while still preserving the intended commercial terms agreed by the parties. 

In China, deal structuring is always an exercise in the art of the possible, not the ideal.  That is never more true than in respect of the VIE structure.  While there are no completely safe harbours, there are saferharbours, some of which I will explore more fully in a coming blog post when we finally come back full circle to cloud computing in China.

But even if you can successfully maneuver around the shifting regulatory landscape, you still have potential partner risk, as in the sad case of GigaMedia.  I will take up this topic in my next blog entry – coming soon.

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.