Variable Interest Entity Structure in China
February 9, 2012 by King & Wood
By Zeng Xianwu Bai Lihui King & Wood's Foreign Direct Investment (FDI) Group
To achieve the initial public offering ("IPO"), there are two options for Chinese companies, onshore
listing (also known as A-share listing) and offshore listing (also known as red-chip listing). Since the
conditions and qualifications for A-share listing are usually a little higher and the procedure is more timeconsuming than for the offshore listing, Chinese companies which cannot meet the A-share listing's
requirements or which need to complete IPO rapidly, usually would prefer the red-chip listing. For the
red-chip listing, there are two commonly-used structures for Chinese companies: the straight-forward
offshore listing structure and the VIE structure. In addition, for the purpose of attracting foreign investors
and for circumventing restrictions on foreign direct investment, during the Pre-IPO restructuring, the VIE
structure is also widely used by Chinese companies and foreign companies alike.
In 2011, after a series of public events, the variable interest entity ("VIE") structure re-attracted a lot of
attention and concerns from the PRC authorities, entrepreneurs, investors and other market
participants. This essay will describe the circumstances in which the VIE structure was created, how it
has been used and the changes in the regulatory environment which might affect the feasibility of utilizing
the VIE structure.
1 Overview
The VIE structure is also commonly referred to as the Sina-model structure, since it was first used by Sina
in 2000. In China, the foreign direct investment market is not totally open to foreign
investors. According to the Provisions on Guiding the Orientation of Foreign Investment, promulgated in
2002, and the Foreign Investment Industrial Guidance Catalogue revised in 2007, we understand that the
industries are classified into four categories, namely, the encouraged, permitted, restricted and
prohibited. With respect to the encouraged and permitted industries, there are few restrictions on foreign
investment, which means that foreign investors may usually make investments freely in those industries.
As to those restricted industries, higher conditions or qualifications or stricter requirements are provided
for foreign investors. Foreign investors are not permitted to invest in prohibited industries at all. Those
companies which adopted the VIE structure, in a sense, usually face restrictions on foreign investors, and
for the purpose of attracting foreign venture capital or private equity financing in the early stages and
completing offshore listings, the VIE structure was finally created by certain imaginative individuals in an
effort to circumvent certain legal restrictions which they encountered in China.
In recent years, more than one hundred Chinese companies have adopted the VIE structure for their
offshore listings, including internet companies such as Alibaba, Tencent, Baidu, Sina, Tudou, etc.; private
education companies such as New Oriental, Global Education & Technology Group and AMBOW
Education, etc.; media companies such as Focus Media, Vision China Meida and Bona, etc.; retail
companies and companies in other industries. The typical VIE structure is set up as illustrated in the
following diagram:
As indicated in the diagram above, foreign investors and PRC individuals establish SPV1 in Cayman;
then SPV1 sets up a wholly-owned SPV2 in Hong Kong; and then SPV2 establishes the wholly foreignowned enterprise ("WFOE") in the PRC. The domestic company usually is the one which owns licenses
or approvals for the business. However, due to restrictions on foreign investment, the WFOE cannot
obtain licenses or approvals from the PRC authorities to operate in the desired industry. Through a set of
contractual arrangements among the WFOE, PRC individuals (usually PRC individuals are the
companies' founders) and the domestic company, the WFOE may be able to actually control the domestic
company as if it directly owned the equity interests in such domestic company. Thus SPV1 may
consolidate the financials of the domestic company into the group's overall financial statements, which is
permitted and accepted by the US General Accepted Accounting Principles.
In practice, the contractual arrangements include:
(i) the Consulting and Service Agreement entered into by and between the WFOE and the
domestic company, which provides that the WFOE shall provide certain services (for
example, the consulting or strategic services and technical services) to the domestic
company for a fee, typically determined by the WFOE with the intended result of shifting
the domestic company’s profits to the WFOE;
(ii) the Asset License Agreement entered into by and between the WFOE and the domestic
company, under which the WFOE licenses certain assets including intellectual properties to
the WFOE for royalty fees;
(iii) the Voting Rights Agreement or Proxy entered into by and among the WFOE, PRC
individuals and the domestic company, in which the domestic company’s shareholder--PRC
individuals authorize the WFOE to exercise their shareholders rights in the domestic
company, including voting rights, inspection/information rights, signing rights and election
rights, etc.;
(iv) the Call Option Agreement entered into by and among the WFOE, PRC individuals and
the domestic company, in which PRC individuals grant the WFOE an option to purchase all
or a portion of their equity interests in the domestic company at a lowest possible price
permitted by PRC law;
(v) the Equity Pledge Agreement entered into by and among the WFOE, PRC individuals
and the domestic company, through which the PRC individuals pledge their equity interests
in the domestic company to the WFOE as a guarantee of the performance of their and the
domestic company’s obligations under other agreements among the three (3) parties in the
VIE structure; and
(vi) the Loan Agreement entered into by and between the WFOE and PRC individuals, in
which the WFOE extends a loan to PRC individuals to use for capitalization of the domestic
company.
The cash flow goes like this: SPV1 will fund the SPV2. SPV2 will make a capital
contribution to the WFOE. The WFOE will extend a loan to the PRC individuals, who will
in turn establish and finance the PRC domestic company. When the PRC domestic company
makes a profit, it will distribute a dividend to the PRC individuals. The PRC individuals
will make a repayment of the loan to the WFOE. The WFOE will use the proceeds of the
loan together with other funds to be discussed below to make a dividend distribution
offshore to SPV2, which will in turn make a dividend distribution to SPV1. In addition,
through the contractual arrangements between the WFOE and the PRC domestic company,
the domestic company will also make certain payments to the WFOE for provision of
services. This payment will be part of the dividend to be distributed by the WFOE offshore,
thus completing the chain of cash flow.
At the beginning, the VIE structure was used primarily for asset-light companies, such as internet
companies, advertising companies, software companies, education companies and media companies,
etc. However, after several years’ development, the asset-heavy companies also began to choose VIE
structures for their financing or offshore listing and the typical example was China Qinfa Group
Limited. Recently, the VIE structure has been increasingly used by asset-heavy companies.
2 Risks
During the last decade, with various investors' efforts, the VIE structure has become more and more
familiar to foreign investors, Chinese companies and the PRC authorities, and has been widely used in
foreign investments in China, especially in the restricted or prohibited industries to foreign
investors. However, for foreign investors, the potential risks existing in the VIE structure and
uncertainties in respect of government policies are just like the Sword of Damocles over their heads. We
will analyze the risks associated with the VIE structure in the following section.
2.1 Risks associated with the VIE structure
From series of contractual arrangements elaborately designed by investors, companies and other market
participants, it is not hard to find that the VIE structure is crafted to remove any risk of the WFOE losing
control of the domestic company or its assets. Due to the reluctance of the parties from disclosing the
entire structure of the transaction, the enforcement of such contractual arrangements is likely to be
difficult in China. Moreover, even if the contractual arrangements are finally enforced under PRC law,
the damages to the company will be significant for the investors. After all, to some extent, the contractual
arrangements cannot be compared with the direct ownership of the domestic company through equity
investment.
For instance, if all parties to the contractual arrangements perform their obligations, everything is
fine. However, if, for example, the PRC individuals or the domestic company decide not to perform their
obligations under the contracts, the WFOE may have a difficult time to maintain control over the PRC
domestic company. Consequently, we have known some limited but significant cases in which the
offshore holding companies lost control over the domestic companies. The result is typically difficult,
expensive and time-consuming dispute resolution process, which may lead to some kind of settlement or,
alternatively, the foreign investor giving up on the PRC domestic company and their presence in China.
Most of time, we only notice there have been more than one hundred Chinese companies which
successfully achieved listing overseas. On the other hand, we tend to pay little attention to such failed
cases in which the domestic foreign investors even lost control over the domestic companies. However,
in any case, the potential risk still exists for each market participant and is worthy of consideration by
foreign investors at the stage of designing the transaction structure.
In the listing process of Sina, when one Sina's founder was removed from Sina, the VIE structure was
affected by such change of senior officers or shareholders of domestic companies. Although the adverse
effect was successfully eliminated and the VIE structure was retained at last, the instability from the
structure is still a high profile case in the VIE's history. Another case is Agria Corporation, a Chinese
seed producer which completed its IPO on NASDAQ in 2007, and which also faced the risk of losing
control of the domestic company and such risk was eventually settled through compensation in equity and
cash to the founder of domestic company (he was also the former director and the legal representative of
the domestic company) who claimed the ownership of the offshore parent company.
Sina and Agria Corporation both faced the risk of losing VIE structure, but fortunately, after hard
negotiation, such risk was successfully removed and the VIE structure was retained eventually. Certainly,
there are also not so exciting examples for foreign investors. One is GigaMedia and the other is Alipay.
GigaMedia is a listed company on NASDAQ, which owns online games business in China through the
VIE structure. In 2010, GigaMedia announced it was involved in the dispute with its former founder of
the domestic company, who was removed from the domestic company but refused to return the company
seal, financial chops and other documentation to GigaMedia. As a result, such former founder in fact still
controls the domestic company. Even though there are a set of contractual arrangements, GigaMedia has
no choice except to bring a series of legal actions against such former founder inside and outside of
China. Furthermore, even though GigaMedia may regain the ownership and control of the domestic
company, it is undeniable that such event will bring adverse effect on its business in China and its actual
control of such domestic company. Additionally, GigaMedia has already had to announce that it would
deconsolidate the financials of domestic company subject to the resolution of such dispute.
Alipay is another classic case which may be repeated by foreign investors and other market participants
over and over again. The VIE structure was set up between Alibaba Group and Alipay. Alibaba Group's
shareholders were Yahoo, Softbank, Jack Ma and other PRC individuals. In 2011, Jack Ma, the founder
of Alipay successfully severed such VIE structure between Alibaba Group and Alipay, and committed to
make certain compensation to Yahoo and Softbank in the future. From the announcement by Jack Ma,
the reason of unwinding the VIE structure was to obtain the Payment Business License from the PRC
authorities, because only those domestic companies which had the qualifications could apply for the
Payment Business License and the VIE structure would not be accepted by the PRC authorities. Alipay
eventually set off a big bomb in the Chinese private equity market. As a result, many investors began to
re-examine the VIE structure.
From the above cases, it is not difficult to find that the VIE structure is not as stable as some have
imagined, to say the least. The founder, senior management or shareholder of the domestic company play
a very important role in the VIE structure. Once there are changes to such positions involving interests,
potential risks of the VIE structure will appear. The VIE structure helped over one hundred Chinese
companies complete the offshore listings, but we should never forget such potential risks when we
discuss the successful cases.
2.2 Risks from governmental policies
Why did Chinese companies, foreign investors and other market participants create the VIE
structure? They were not unaware of the potential risks of the VIE structure, but they still adopted it,
because they had no other choices when faced with the restrictions on foreign investment in China. In
fact, most companies using the VIE structure have attracted foreign financings, but at the same time most
of them face restrictions on foreign investment. After obtaining supports from foreign funds or other
foreign investors, Chinese internet companies got rapid and great development and some internet giants
such as Baidu, Alibaba and Tencent, etc., have grown up in the last decade. Of course, in those cases,
Chinese companies avoided the restrictions on foreign investment and all relevant the PRC authorities'
approvals by using the VIE structures.
Sina might have chosen to use the VIE structure in 2000, to some extent, because it obtained the tacit
consent from the PRC authorities. Over past years, the PRC authorities never formally confirmed the
validity of the VIE structure under PRC law. As a general rule, the PRC authorities typically do not like
the idea of foreign investors using indirect ways to get around legal restrictions on foreign investment in
the first place; however, in order to attract foreign investment in technology focused industries such as
telecommunications and internet, the PRC authorities have tended to acquiesce the usage of the VIE
structure in China. That is beginning to change, because while the PRC authorities still welcome foreign
investment, they have begun to be more concerned about "hot" money flowing into China through less
than above-board means. As a result, the scale has tipped from welcoming foreign investment to higher
scrutiny of the legality of the transaction structure. With prevalence of the VIE structures, some
subsequent regulations or cases imply or reveal the PRC authorities' attitude which is not so positive at
least at present.
(a) Circular
The Circular on Strengthening the Administration of Foreign Investment in Value-added
Telecommunications Services ("Circular") promulgated by the Ministry of Industry and
Information Technology ("MIIT") on 13 July 2006 was the first attempt to explicitly
circumscribe the use of the VIE structure. In the Circular, it is provided that a
telecommunications enterprise within the territory of China may not lease, shift or sell any
license for telecommunications business in any form, or provide resources, places and
facilities or any other conditions for any foreign investor to engage in any illegal
telecommunications operation by any means within the territory of China. Meanwhile,
certain key assets including trademarks, domain names and servers shall be held by the
value-added telecommunications service provider or its shareholder which holds the valueadded telecommunication service license. This Circular states that the PRC authorities do
not welcome the VIE structure in the value-added telecommunications service area. This
Circular also requires that the telecommunications enterprise which plans to list oversea
shall first get the approval from MIIT.
(b) Online Games Notice
The Notice on Further Strengthening of the Administration of Pre-examination and
Approval of Online Games and the Examination and Approval of Imported Online
Games ("Online Games Notice") promulgated on 28 September 2009, provides that foreign
investors are not permitted to invest in online games operating businesses in China via the
WFOE, equity joint venture, or contractual joint venture, and it also expressly prohibits
foreign investors from gaining control over or participating in domestic online games
operators by indirect means, such as setting up other joint ventures, signing relevant
agreements or providing technical supports. We are not aware of whether any listed
companies utilizing the VIE structure were penalized or required to take apart the VIE
structure.
From the regulatory perspective, the Circular and Online Games Notice are both only
regulations other than laws; however, such regulations at least send a signal on use of the
VIE structure. Meanwhile, most experts on VIE still believe that the PRC authorities are
unlikely to prohibit all VIE structures.
(c) National Security Review
On 3 February 2011, the State Council released the Notice on Establishing National Security
Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign
Investors ("Notice"). To specify the implementation procedures of the national security
review, later, on 4 March 2011, the Ministry of Commerce ("MOFCOM") promulgated the
Interim Rules on Issues Related to the Implementation of the Security Review System for
Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( "Interim Rules"),
which is replaced by the Rules on the Implementation of the Security Review System for
Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( "Rules") on 1
September 2011.
Article 9 of the Rules re-attracts concerns from the public, which provides that with respect to merger and
acquisition ("M&A") of the domestic enterprise by foreign investors, whether the M&A transaction falls
within the scope of national security review shall be judged from the substantive contents and actual
influences of the transaction; and foreign investors shall not avoid national security review through any
means, including without limitation commissioned shareholdings, trusts, multi-level investments, leases,
loans, contractual control, overseas transactions, etc.
The "contractual control" mentioned in the Rules obviously refers to the VIE structure. However, after
reviewing the Notice and Rules, we may find that not all M&A deals will be subject to a national security
review. The national security review process will apply only if the target domestic enterprise is involved
in a business that concerns either national defense security issues ("National Defense Security
Businesses") or national economic security issues ("National Economic Security Businesses").
National Defense Security Businesses include military industry enterprises and supporting enterprises,
enterprises adjacent to major and sensitive military facilities, and other entities relevant to the national
security of China. National Economic Security Businesses include enterprises involving major
agricultural products, major natural resources and energy industries, important infrastructure projects,
transportation services, key technologies, as well as major equipments that are related to national
security. It is worth noting that in relation to M&A deals involving National Economic Security
Businesses, a national security review process may only be triggered if the foreign investor intends to
acquire actual control of the target domestic company.
In addition, the M&A in the Notice refers to the following circumstances:
(i) Foreign investors purchase equity interests of domestic non-foreign invested
enterprises or subscribe for capital increase of domestic non-foreign invested
enterprises, which convert such domestic enterprises into foreign invested enterprises.
(ii) Foreign investors purchase equity interests of domestic foreign invested enterprises
owned by Chinese shareholders, or subscribe for capital increase of domestic foreign
invested enterprises.
(iii) Foreign investors establish foreign invested enterprises and purchase assets of
domestic enterprises via agreements by such foreign invested enterprises and then
operate these assets, or purchase equity interests of domestic enterprises by such
foreign invested enterprises; and
(iv) Foreign investors directly purchase assets of domestic enterprises and establish
foreign invested enterprises through such assets to operate such assets.
Combining the Notice and Rules, we may conclude that the VIE structure has attracted
increased attention from the PRC authorities, and such regulations only indicate that
the PRC authorities have the intention to restrict the use of the VIE structure in certain
industries. From existing PRC laws and regulations, it is hard to get a conclusion that
the VIE structure will be prohibited in all areas.
It is also worth considering whether the existing VIE structures before promulgation of the Rules will be
unwound or will face penalty. Since there are no more supporting materials from practical cases, at least
until now, we are not aware of any companies with existing VIE structure facing risks of penalty or risk
of unwinding the VIE structure. However, based on our experience, it is likely that previously established
VIE structures may be left untouched. In addition, investment into such pre-existing VIE structures on an
offshore level might not attract the attention or objection from the PRC authorities. However, foreign
investors should examine all facts and review all relevant laws and regulations before making a decision
to create a new VIE structure in certain industries on a case by case basis.
(d) Practice
The promulgation of the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors
("M&A Rules") on 8 August 2006 by six (6) PRC departments, provides that the domestic companies,
enterprises or natural persons shall, when they merger and acquire related domestic companies through
companies legally established or controlled by them in foreign countries, report to MOFCOM for
approval and the persons concerned may not evade the above requirements by re-investment of the
foreign-invested enterprises or by other means. The M&A Rules leaves a road for related M&A, i.e. to
obtain the approval from MOFCOM. However, during the five (5) years after the promulgation of the
M&A Rules, there is no case where the approval was successfully obtained.
It is clear that since the issuance of the M&A Rules, more and more Chinese companies have adopted the
VIE structure. In the early stage, the VIE structure was almost only used on the asset-light
companies. However, after 2006, those asset-heavy companies also chose to utilize the VIE structure. It
is believed that one of the reasons for the increasing use of the VIE structure is that the VIE structure may
avoid obtaining the approval from MOFCOM. In fact, it is unimaginable and unreasonable that such
asset-heavy companies may move enormous assets out of China only by several agreements without any
governmental approval or other legal procedures. The PRC authorities may also be on the alert for the
abuse of VIE structure in asset-heavy industries. There are some cases which adopted the VIE structure
in the asset-heavy industries and successfully listed overseas, but unfortunately we also understand there
are cases which have been rejected at IPO just for using the VIE structure in the asset-heavy industries.
In early 2011, Buddha Steel withdrew its IPO in USA, citing that the company was advised by local
governmental authorities in Hebei Province that its VIE structure contravened the current Chinese
management policies related to foreign-invested enterprises. On the one hand, this case might simply
reflect the local government's attitude towards specific companies or industries, not towards the VIE
structure itself. On the other hand, it reveals that different local governments may hold different views
regarding the VIE structure.
Above all, no matter from the legislation perspective or on a practical level, it is clear that the VIE
structure faces the risks of uncertainty on policies from the PRC authorities.
3 Conclusion
In summary, the VIE structure has brought the prosperity to the Chinese internet market, and the VIE
structure also had potential risks due to governmental polices in the past ten years or so since its
appearance.
With respect to the risks from the structure, from the above analysis we may find that the certain persons
in the domestic companies usually play a critical role in the VIE structure, and we all understand it is very
important for the WFOE or offshore companies to avoid the risks from such persons. To better maintain
the stability of the VIE structure, the following options may be adopted:
(i) Diversify the shareholding of the domestic company. If no shareholder alone or in
conjunction with other shareholders, over whom he/she may bring influences, may control
the domestic company, at least, it may help to reduce the risk of losing control of the
domestic company. The perfect arrangement would be that each shareholder alone or in
conjunction with other related shareholders holds less than 33% equity interests of the
domestic company.
(ii) Carefully appoint the directors and the legal representative of the domestic company. In
the GigaMedia case, the former legal representative refused to return the chops and
documentations of the domestic company. In order to avoid such similar events from
occurring again, when appointing directors and the legal representative, the WFOE or
offshore companies should carefully consider the proper persons who will represent the
interests of the WFOE or offshore companies.
(iii) Balance the interests between the persons controlling the domestic companies and those
representing the offshore companies. Once the persons who control the domestic companies
may get reasonable or greater returns from the offshore companies, the risk on severing the
VIE structure by them will be reduced accordingly.
In respect of the risks from governmental polices, before establishing the VIE structure, the
companies should ensure that the VIE structures are in compliance with PRC law and may
be enforceable in the future. Considering the limited cases on national security review or
other polices in practice, we would suggest that the companies should communicate with the
PRC authorities first, obtain professional advice on a case by case basis, and then make a
decision whether to utilize the VIE structure or how to use it properly.