How China’s Draft Rules May Affect Foreign Investors; Proposed Rules Target Structure Known as Variable Interest Entity

Earlier postings: (1) Proposed Draft Legislation on VIE Structures (Link); (2) US SEC Cautions Companies on Consolidation Analyses Using VIE (Variable Interest Entity) (Link)

How China’s Draft Rules May Affect Foreign Investors; Proposed Rules Target Structure Known as Variable Interest Entity


Jan. 27, 2015 9:33 p.m. ET


HONG KONG—China’s proposed new rules on foreign investment will help the Chinese government re-exert control over the flood of foreign money and interests coming into the country’s booming Internet industry. That is likely to be a boon for Alibaba Group Holding Ltd. and Chinese Internet companies like it, investors, executives and lawyers say. But for foreign shareholders of those companies as well as Western Internet firms trying to operate in China, the rules could be a double-edged sword, they say.

“The objective, as with everything the Chinese government does, is to maintain control,” said attorney Antony Dapiran, a Hong Kong-based partner at Davis Polk & Wardwell LLP who has advised the kinds of Chinese companies that would be affected by the new rules.The Ministry of Commerce didn’t immediately respond to a request for more information on the purpose or implementation of the draft rules.

The draft rules, released by China’s Ministry of Commerce last week, target a complex corporate structure whose aim is to sidestep Chinese restrictions on foreign investment in politically sensitive industries like the Internet, telecommunications and education. The structure, known as a variable interest entity, or VIE, lets investors take stakes in offshore holding companies that rely on contracts to control—but not own—the Chinese entities that actually operate the businesses.

VIEs are used by everyone from Chinese Internet startups seeking U.S. venture capital to the biggest players in technology—companies like e-commerce giant Alibaba, search company Baidu Inc. and online gaming and social-networking firm Tencent HoldingsLtd.

Until now, the Chinese government largely turned a blind eye to VIEs. But for more than a decade, their extralegal status has made many foreign investors anxious that their interests might not be protected if Beijing cracked down on the structure, or the Chinese entities decided not to honor the contracts that bound them to the offshore holding companies.

Under the new draft rules, foreign investment through VIEs would be allowed—as long as the companies could show that Chinese people or entities wield “actual control” over the business. That certainty could be comforting to foreign investors.

“I think a lot of Chinese companies listed in New York trade at a discount whenever some kind of scare about VIE comes up,” said Hans Tung, managing partner at GGV Capital, a venture-capital firm that was an early backer of Alibaba. “If the VIE structure is recognized by Chinese law as a legitimate way for foreign investors to make foreign investments, it will make it much easier.”

Executives and investors say the big question is how Chinese officials will define control.

The Chinese founder of one Beijing-based startup that uses a VIE, who asked to remain unnamed because of the sensitivity of the issue, said he’s clearly in control now since he still owns a majority of the company. But he’s worried what would happen if the level of foreign investment in his firm rises.

“What will happen if we go through two more rounds of funding and if my stake drops below the foreign investors’ stake?” he asked. “Will the company be considered foreign-controlled?”

One solution might be the kind of management structure used by Alibaba, which maintains Chinese control by giving the power to nominate the majority of its directors to a small group of Chinese managers.

During a Ministry of Commerce briefing for foreign business representatives last week, Huang Feng, deputy director of the ministry’s foreign investment administration, cited Alibaba as an example of a company that would benefit from the new VIE rules, according to someone who attended the briefing. Mr. Huang didn’t elaborate.

Such an interpretation of control might encourage the Chinese founders and executives of Internet companies to amass greater power over their enterprises by using dual-share structures or other arrangements that give them more voting clout, lawyers say. It could also disappoint foreign shareholders hoping to exercise more influence on Chinese operations.

“With these new proposed rules I expect to see Chinese Internet and mobile companies to want to retain control with special supervoting arrangements,” said Rocky Lee, Asia managing partner at Cadwalader, Wickersham & Taft LLP, an expert on VIE structures who works with many Chinese technology firms.

Those who might find themselves in the trickiest position are foreign companies that use the VIE structure so they themselves can become players in China’s Internet industry, experts say.

For instance, in its 2013 annual report U.S. e-commerce giant Amazon Inc. described its business in China as being operated by Chinese companies directly owned by Chinese nationals, a structure that it said carried “unique risks” because of uncertainty over their legality. Amazon didn’t respond to a request for comment on how the draft rules might affect their China operations, and it is unclear what impact they might have.

The proposed VIE rules make it clearer that the Chinese domestic units of such companies would be seen as foreign. That means they’d likely need to seek government approval for permits and licenses—to provide Internet content such as videos, for example—that they could find tricky to obtain.

The proposed rules are in line with China’s unhappiness with foreign companies that try to use the VIE structure to operate in industries the government has tried to keep them out of, said Marcia Ellis, a Hong Kong-based attorney with experience advising VIE firms. She described Beijing’s attitude as: “We’re OK with true native-born, local-grown Chinese companies, but we’re not happy with you big multinational Internet companies trying to come in and use this structure.”


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