Legal challenges for VIEs | China Accounting Blog | Paul Gillis

Legal challenges for VIEs

This is another guest post, this time from Fredrik ÷qvist and Shoushuang Li. †Mr. Li is a senior partner with Dacheng, one of China's largest law firms.†

This post is a very basic outline of the legal challenges currently faced by VIE structures in China. This is not a complete list, and to make this post readable, we will stick to discussing the challenges to the practice of VIE’s as a whole. Legal issues relating to parts of the practise will be discussed in a later post.

Although it is often said that Chinese law is one based on written statutes, this is not really the whole truth; it is also based on regulations from law enforcing agencies. These regulations can be statements on how laws may be interpreted, which are important when there are no previous rulings to indicate how those laws are meant to be interpreted.

In order to illustrate the legal issues involved with the VIE phenomenon, we should therefore discuss both written statutes and edicts from agencies to get a more complete picture.

Written statutes: Perhaps the clearest example of where the concept of VIEs may be challenged is when they are used to circumvent Chinese regulations on foreign ownership. VIEs can allow a foreign entity to realise complete control-like effects over a company in a sector where it cannot legally operate according to Chinese law. As the intent of the contract is make something

Or, as clause 52 of Chinese contract law puts it:

A contract shall be null and void under any of the following circumstances:

(1) a contract is concluded through the use of fraud or coercion by one party to damage the interests of the State;

(2) malicious collusion is conducted to damage the interests of the State, a collective or a third party;

(3) an illegitimate purpose is concealed under the guise of legitimate acts;

(4) damaging the public interests;

(5) violating the compulsory provisions of laws and administrative regulations.

The question then, is how this should be interpreted: in a narrow sense, the contracts only transfer some of legal rights of ownership, which is not banned. In a slightly wider sense, the law intends to stop foreigners obtaining complete control or material control over companies, which is exactly what VIE contracts are making possible.

If the challenge to the VIE phenomenon stopped here we might well surmise that the government sees the interpretation in a more narrow sense; however, we also have edicts from agencies offering challenges, and this combination adds to an already unclear legal situation.

Regulations: The two main edicts challenging the use of VIE structures come from the Ministry of Industry and Information Technology (MIIT) and the General Administration of Publication and Press (GAPP).

The MIIT edict, which does not deal with VIEs specifically,prohibits domestic telecommunication services providers from leasing, transferring or selling telecommunications business operating licenses to any foreign investors in any form, or providing any resources, websites, or facilities to any foreign investors illegally operating telecommunications business in China.

Although the edict has yet to be followed by resolute action by the ministry, it clearly shows the negative view that MIIT has towards VIEs. In fact, the original plan was for MIIT to completely ban the use of VIE structures, but this was abandoned for a more moderate rule in the last minute.

The GAPP guidelines, on the other hand, expressly forbid VIE-type arrangements in the video-game business. Something that should definitely be taken into account in any risk evaluation, especially as local authorities have been giving this some attention.

It’s important to note here that the enforcement of Chinese law is another aspect that will come into this equation. This is unlikely to be uniform, and also highly unlikely to be straightforward. However, the paper trail being left by the government regarding VIE structures all points in one direction. So if, and when, we see some actual movement on the enforcement level, the framework will be there and companies will have been officially warned for years that these practices are in fact not legal.

A word on the Buddha Steel case: While it doesn’t appear as if the central government will act to shut down VIE IPO’s, this doesn’t mean the case is insignificant. It seems likely that the central government may continue to allow its local counterpart to police this issue as they see fit. This means we might start seeing regional differences in how VIEs are addressed, adding another layer of complexity to the VIE situation.

All in all the challenge to VIE structures is very real, exists on multiple levels, and appears to be intensifying. A basic understanding of how the legal landscape progresses on this matter should help professionals in many areas to better determined the risks involved with companies using these structures in China.

Fredrik ÷qvist ††

Shoushuang Li †

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