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A contrarian view on VIEs

The proposed Chinese foreign investment laws have received a great deal of attention because they propose to create rules to deal with the VIE structure. 

Most analysts, including foreign and Chinese law firms, are saying the new rules propose to treat VIEs that are controlled by foreign firms as foreign invested enterprises, subjecting them to full regulation and possible exclusion if they operate in restricted sectors. But they also point out that the intent is to look at the ultimate control of the VIE, and if the foreign company is controlled by Chinese companies or individuals (and many are), then the VIE would not be treated as foreign controlled. This proposal is said to have come from Robin Li of Baidu.

Steve Dickinson at the China Law Blog is taking a contrary view. In his post, China VIEs are Dead. Done. Over.  Stick a Fork in Them, Dickenson argues that the State Council has rejected the Robin Li proposal and the concept of Chinese controlled foreign companies is not going to be used. Instead the State Council is punting the decision to the various regulators. Dickenson points out the problems created if regulators selectively approve certain VIEs.

Chinese VIEs - winners and losers

China has proposed revising its approach to regulating foreign investment.  A good summary is here. Investments in most sectors will be treated the same for foreigners and locals. A negative list will restrict foreign investment in certain sectors. China has published proposed rules for this new approach, but it does not include the negative list. A good working assumption is that the negative list will include most of the industries that are in restricted or prohibited categories on the current foreign investment catalog. The proposed law is here (in Chinese). The Ministry of Commerce will accept comments until February 17.

One of the important changes is that variable interest entity (VIE) arrangements are specifically covered. A VIE will be treated as foreign invested if it is foreign controlled. In the common Chinese use, VIEs sign a series of contracts with a Cayman Islands incorporated, publicly listed company or its wholly foreign owned enterprise (WFOE) subsidiary. Those contracts give control of the VIE to the public company and under the new rules make the VIE a foreign invested enterprise. That means the VIE cannot operate in sectors on the negative list.   

Actual control and VIEs

Yesterday I wrote about the proposed new foreign investment law for China. The new law appears to change the way China will look at variable interest entities, focusing on who actually controls the entity vs. who is the owner of record. That could create problems for many VIE structures that would be found to have prohibited foreign investment. 

There is another way to look at this proposal, which is well explained in this article just released by Chinese law firm Haiwen(in Chinese). The proposal introduces a concept of actual control. That concept could be applied to the VIE, and the actual control of the VIE would be found to be with the foreign, typically Cayman Islands incorporated, public company. That would cause a problem if foreign investment continues to be banned in internet companies.  

The other way the concept could be applied is to look at the listed, typically Cayman Islands company. If this company is controlled by Chinese, perhaps that means that the VIE is actually controlled, indirectly, by Chinese, and can continue to operate legally. What it means is that China will look to ultimate control, rather than legal ownership to apply its foreign investment restrictions, and if Chinese are ultimately in control, then no restrictions will apply. 

The end of VIEs?

There is a potential development with variable interest entities (VIEs) that could threaten many US listed Chinese companies that use this structure. It has been reported in Chinese forums. The documents are all in Chinese and I may have misinterpreted them. I am sure lawyers are going to be pouring over this in the coming days – I will add links to their analysis when they publish. 

Today, January 19, 2015, the Ministry of Commerce (MOFCOM) released a draft of a new foreign investment law for public comments. What is notable about this new law is that it appears to introduce an actual control rule for determining when an enterprise has foreign investment and is thus subject to regulation as such. What that appears to mean is that a VIE that is controlled by an offshore company will be treated as a foreign invested enterprise (FIE).

The nature of VIE arrangements in China is that they give control to an offshore company (typically the listed Cayman Islands company or its Chinese subsidiary (WFOE)), yet argue to Chinese regulators that the VIE is a local company owned by locals, and therefore not subject to foreign investment restrictions. The proposed law appears to change that interpretation. Instead, a VIE controlled by a foreign company will be treated as a foreign invested enterprise. 

China needs an audit regulator

Xiao Gang, Chairman of the Chinese Securities Regulatory Commission (CSRC), said last week that during 2015 the CSRC would phase out the current approval based system for Chinese IPOs and implement a registration-based system. A registration-based system will be more like the process used by the U.S. Sec-urities and Exchange Commission. Regulators will let the market judge offerings, focusing instead on compliance. 

Most high profile IPOs from China are not listed on China’s stock exchanges but rather on US or Hong Kong exchanges, and the changes will not apply to those companies. 

This is a good step forward for China’s stock markets, in large part because it has the potential to create a more efficient market less subject to corruption and political favoritism.  

As regulators step back, it is critical that other institutional players, particularly auditors, lawyers, and investment bankers step up. They will become the prin-cipal gatekeepers to the market. Without increased professionalism by these players, the Chinese stock markets could become increasingly dangerous for investors. 

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