China VIEs Are Dead. Done. Over. Stick A Fork In Them.

January 19, 2015 marks the date of the death of the VIE investment structure in China. The death blow was dealt by the PRC State Council itself, the highest authority on such matters in China. Now that the issue is settled, we can all move on to figure out the effects. 

How was the VIE killed? On January 19, the State Council issued a discussion draft of legislation setting out the plan for overhauling the antiquated Chinese foreign investment legal regime. The new system is set out in the PRC Investment Law Discussion Draft (the “Draft”), a massive document in 178 Articles and 11 Chapters. The underlying philosophy of the Draft is explained in the Explanation of the PRC Investment Law (the “Explanation”).

Draft makes clear that the State Council understands how VIEs work and that their sole function is to evade the requirements of Chinese law. The Draft makes clear that such evasion is illegal and will be prohibited upon the effective date of the new investment law.

The new system will work as follows:

1. The nationality of any business entity will be determined by the place of formation of the entity. The nationality of the shareholders, the directors or the management is not relevant. The only issue is where the company is formed. Thus, a Cayman Island corporation owned and controlled by Chinese citizens is still foreign for purposes of the law. A Chinese company formed by such foreign investors is therefore treated as a foreign owned entity.
2. The Draft introduces the concept of “effective control”, a principle borrowed directly from the VIE structure. The Draft provides that any Chinese entity effectively controlled by a foreign owned entity will be treated as a foreign entity. This means that if foreign entity participation in a sector of the economy is prohibited, this prohibition extends to Chinese entities effectively controlled by foreign investors.
3. It is illegal for an entity effectively controlled by a foreign owned entity to operate in sectors of the Chinese economy that are restricted or prohibited to foreign investors. In other words, the restriction or prohibition applies to effectively controlled Chinese companies in exactly the same way that it applies to a foreign owned entity of any kind. Any effectively foreign controlled Chinese entity that enters into a restricted/prohibited sector is in violation of law. The operations will be shut down and penalties will be imposed as provided by law.

As we know, the core of the VIE is structure is that a foreign owned entity (a WFOE) effectively controls a Chinese owned entity through an elaborate series of contracts. Without such effective control, the foreign owner of the VIE is not permitted to consolidate the earnings of the Chinese entity into its books. I have argued in the past that the contracts are void under Chinese law. The State Council takes a different and even more devastating approach. The State Council has said that it will accept that the contracts are legal and enforceable.

All those opinion letters you have received say that. However, since the Chinese entity is effectively controlled by a foreign investor, it is obvious that the Chinese entity is in fact a foreign controlled entity. Therefore, that foreign controlled entity is prohibited from operating in a prohibited or restricted sector.

The effect of the Draft is to kill the VIE structure as an investment vehicle in China for the future. It is important to fully understand the impact. Even if the Draft is never adopted, for the future at least, the VIE structure is dead. The VIE structure is dead because it is now clear that the State Council understands how the VIE structure works as a contractual
device and it is clear that the State Council understands that the only reason VIEs exist is to evade the clear requirements of Chinese law. Most importantly, it is also clear that the State Council has firmly concluded this behavior is wrong and it will not be tolerated in the future. So it does not matter whether or not the Draft is adopted in its current
form. Whatever happens, the VIE structure is dead.

Now we come to the more interesting and difficult question. A large number of very large companies operate in China’s Internet and telecom sector as VIEs. Baidu, Sina and Alibaba are only a few of the hundreds of VIEs currently operating in China. These VIEs control the China’s Internet, e-commerce and cloud computing sectors. They are the only significantly large privately owned companies in China.

Yet, the remarkable fact is that these highly capitalized, powerful companies are all operating illegally (as we have pointed out many times on this blog). However, all of this illegal activity has been conducted openly and with the tacit acquiescence of the PRC regulatory authorities. As a result, the big issue for now is what is to be done about the existing VIE entities in China that will be rendered illegal if the Draft is adopted in its current form.

The Chinese VIEs have seen this coming, and beginning in 2013 Robin Lee of Baidu led the charge in seeking to have then existing VIEs be formally declared legal under Chinese law. Mr. Lee argued that the State Council should declare VIEs legal under Chinese law so long as Chinese citizens control the management of the foreign owned entity. Mr. Lee did not propose that the limitations on foreign participation in the Internet sector be removed. His plea was simply that his particular device be declared legal. After Mr. Lee made his plea, other owners of large Internet and telecom VIEs joined in to propose various “get out of jail free” techniques to leave them in control of an otherwise closed sector.

From a legal standpoint, the proposals of Robin Lee and others were impossible to implement legally and were impossible for the State Council to stomach as a matter of policy. For these reasons, the State Counsel rejected all of the “get out of jail free proposals.” The State Council “punted” and declined to address the issue
directly.

Instead it did the following:

1. Article 158 of the Draft states that the issue of what to do about existing VIEs will be resolved in accordance with the Explanation.

2. Article 3.2 of the Explanation repeats the various proposals advanced by Robin Lee of Baidu and by others. The Explanation states that after reviewing the issues and receiving input from society, the State Council rejects ALL of the “get out of jail free” proposals made by Baidu and other VIEs.

3. Article 3.2 provides the following “solution”:

a. The government will NOT provide issue a statement to the effect that existing VIEs are in compliance with Chinese law. In this sense, Robin Lee’s request has been
resoundingly denied.

b. The rule will be as follows. The decision on whether or not to allow effectively foreign controlled Chinese entities to continue to operate will be made on a case by case basis by the PRC government agency that controls the area of concern.

c. If a specific permit is needed to operate in a sector, that permit must be obtained.

d. With respect to VIEs, the effectively controlled Chinese entity must essentially go to the regulator for their specific industry sector and essentially ask for a license to operate in that sector even though foreign investment in this sector is prohibited and therefore granting the license requested would directly violate Chinese law. For example, foreign companies are not permitted to operate in the internet sector, and yet the VIE that seeks to operate in the internet sector would be asking to be permitted to do so even though it is supposed to be treated as a foreign company.

e. Article 3.2 provides that if the regulator issues a license in this situation, the the State Council will not intervene.

This all means that that the State Council has punted to the regulators of various different industry sectors the very difficult issue of what to do about existing VIE entities. We see this as the State Council essentially telling the regulators: You created the problem by turning a blind eye to this illegal activity. You did it because you determined that you would benefit. Now, we are telling you that you authorized an illegal activity. Now you need to figure out what to do.

The stock response we are already hearing to this situation is that the PRC regulators will ”knuckle under” and provide the required licenses to existing VIE operators. Virtually everyone says: There is no way that PRC regulators will shut down Baidu, Sina, Alibaba and the other major PRC VIE entities. This is probably true.

There are, however, a number of problems for the regulators if they knuckle under and grant a get out of jail free pass to existing VIE entities:

1. It is now been formally acknowledged that the VIE structure violates Chinese law. If existing VIE entities are permitted to continue to operate, then PRC regulators will essentially be rewarding open violators of the law. At minimum, this weakens the legitimacy of those regulators.

2. Competition within China is the much more important issue. If Baidu and others are allowed to maintain their licenses to operate with foreign funds in a restricted sector in violation of Chinese law, what will the regulators do when other Chinese ”entrepreneurs” seek to do the exact same thing?

Let’s say that the regulators limit the Internet sector just to Baidu and the other existing VIEs. This would give them an oligopoly position beyond that sought by their proposals. Mr. Lee and the others argued to protect China from foreign competition. He never argued to prevent other Chinese entrepreneurs from benefitting from the same closed system.
Thus, the proposal in the Draft gives Baidu and others MORE than they have asked for.

For the future, it is easy to say that VIE and other effective control mechanisms will be prohibited. This is not an issue. The problem is PRC regulators have openly allowed the VIE structure to be used. This then presents the PRC regulators with two unattractive alternatives:

1. If they grant existing VIE entities a “free pass,” they will be flaunting Chinese law. This will fly directly in the face of recent strong efforts by the PRC central government to initiate rule by law and not by “connection” with regulators. The public will likely believe that those with “free passes” secured them via illicit financial arrangements with regulators.

2. The alternative to a free pass is to order Baidu and the other major VIE Internet companies in China to shut down. But to do this would essentially close down China’s Internet sector, and with it, the most significant privately owned businesses in China.

Which direction will the Chinese regulators take? Most non-Chinese analysts assume that money will be their deciding factor and so they are predicting the “free pass” route. We are not so sure.

For right now, all we can say is the following

1. The VIE investment vehicle is dead for the future.

2. Existing VIEs in China are illegal.

3. We do not know what the Chinese authorities will do with the existing illegal VIE entities.

4. The issue will be resolved before the end of 2015.

What do you think?

And as proof that “we told you so” on VIEs, check out the following:

• China VIEs. Avoid, Avoid, Avoid.
• VIEs In China. The End Of A Flawed Strategy

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.