Today we have another guest post from Shoushuang Li and Fredrik ÷qvist. This post will discuss some of the legal uncertainties with respect to the capitalization of VIEs in China.
Capitalizing the VIE.†A VIE needs to be sufficiently capitalized in order to operate. While some VIEs that function primarily as license holding companies may need little capital, others require substantial funding. Because the public company does not have a direct ownership interest in the VIE, but rather controls it through contracts, it needs to find a way to get cash into the VIEs.
In the archetypal VIE form, the public company, or its wholly foreign owned enterprise (WFOE) subsidiary, loans the necessary capital to the individual shareholders of the VIE. The individual shareholders then contribute these funds to the VIE. The loan agreement between the public company or WFOE and the individual VIE owner is secured by an equity pledge in the shares of the VIE, and provides most of the control mechanisms that allow the VIE to be consolidated.†
The money that is to be used to capitalize the VIE is usually held by the public company or its wholly owned Chinese subsidiary. The equity capital in the VIE needs to be provided by the individual Chinese shareholders of the VIE. †So, the first problem to be addressed is how to get these funds from the public company to the individuals. This is typically done through a loan to the individuals from either the offshore parent company or from the WFOE. There are legal issues with both.
Loans from the offshore (typically Cayman Islands incorporated) parent are made in foreign currency, since the offshore company does not have renminbi. There is currently a US$ 50,000 cap on the amount of foreign currency a Chinese individual can convert to renminbi each year. Because $50,000 is usually insufficient to capitalize the VIE, a common practice has been to transfer funds into the private accounts of employees at the company who then transfer the money privately to the VIE owners. †Since each employee can convert $50,000 this approach avoids SAFE restrictions in practice, while creating significant legal risks.†
More commonly, the WFOE is used to make an interest free loan to the VIE owners for equity capital and directly to the VIE for debt capital. This approach raises another series of legal questions. SAFE circular No. 142 states that any money transferred into a WFOE can only be used within the scope of the WFOEs business license. In the case of an IT company, the WFOE would normally have a business scope that allows the company to engage only in technology consulting. A loan to individuals for the purpose of capitalizing an unrelated business is not likely to be within the business scope of the WFOE. Similarly, a loan to the VIE to provide debt capital would also likely be outside of the business scope of the VIE. This issue is rarely discussed in risk disclosures related to VIE arrangements.
Another way that is used to provide VIE’s with needed capital is through use of artificially designed arrangements. An example of such an arrangement would be a service agreement under which the VIE agrees to provide some sort of service to the WFOE. The VIE then bills the WFOE for these services and the WFOE pays the VIE. There are several risks to this approach. First, the service offered by the VIE must fit within its approved business scope. Secondly, if no actual services are provided, there is risk that the transaction could be seen as simply a means of circumventing the foreign exchange controls or as a prohibited foreign investment in the VIE. In addition, the service revenue will be taxed in the VIE and no deduction may be available to the WFOE.
Equity pledges.†The archetypal VIE arrangement includes an equity pledge agreement under which the individuals who own the VIE pledge their shares in the VIE as security for the loans made to them by the WFOE or the public company. †
Because an equity pledge is a form of security interest, it needs to be registered with the relevant Chinese authorities before it can be legally binding. †If there is no registration, the equity pledge agreement is unenforceable, yet many SEC filings fail to disclose this fact. †In the past, companies have had difficulty getting these equity pledges properly registered. Some companies have reported their difficulties with registering their equity pledge agreements, while many others report that they have been “in the process of registering” their pledges for prolonged periods of time. Chinese regulators currently seem to be more open to accepting equity pledges, so we expect to see more companies reporting that they have successfully registered the equity pledge agreements. Strong questions need to be asked of companies that do not report that their equity pledges are registered.
This is a quick glance at some of the more commonly discussed legal issues related to capitalizing VIE structures, and our hope is that this can be used by investors and professionals to better understand VIE structures, as well as the risks and potential costs involved in conducting business in this manner.
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