On April 20, 2020, almost twenty years to the day after the listing of Sina Corp., China’s State Administration for Market Regulation (“SAMR”) published on its website a notice in relation to the merger review of a simple case of concentration of operators, the Shanghai Mingcha Zhegang Management Consulting Co., Ltd. and Huansheng Information Technology (Shanghai) Co., Ltd. Newly Established Joint Venture Case (the “SMZ Case”). (www.samr.gov.cn/fldj/ajgs/jzjyajgs/202004/t20200420_314431.html) This seemingly innocuous notice arguably constituted another important milestone for the VIE Structure: It marked the first time that SAMR officially accepted a merger control filing for concentration of operators (an “AML Filing”) where one of the parties had adopted the VIE Structure. Does the acceptance of this AML Filing mean that, after two decades, a Chinese regulator has finally officially recognized the legitimacy of the VIE Structure?
In Part I of this article,[i] (http://www.hk-lawyer.org/content/vie-structure-past-present-and-future-–-part-i.)
we explored the history of the VIE Structure. In the second and concluding part of this article, we will explore the current legal status of the VIE Structure and consider what is likely to happen to this structure in the future.
II. THE CURRENT LEGAL STATUS OF THE VIE STRUCTURE
Despite the facts that the VIE Structure has been in use for more than two decades, and that it has been adopted by some of the largest and most respected companies in China, its legality has always been in doubt. If an issuer has adopted the VIE Structure, the risk factor section of its prospectus will typically include stipulations such as the following paragraph, extracted from JD-Daojia’s registration statement filed with the SEC on May 12, 2020:
“In the opinion of our PRC counsel… (i) the ownership structures of Dada Glory and our VIE, currently do not and immediately after giving effect to this offering will not result in violation of PRC laws and regulations currently in effect; and (ii) the agreements under the contractual arrangements between Dada Glory, our VIE and its shareholders governed by PRC law are valid, binding and enforceable against each party thereto in accordance with their terms and applicable PRC laws and regulations currently in effect, and do not result in violation of PRC laws or regulations currently in effect. However, we have been further advised by our PRC counsel that there are substantial uncertainties regarding the interpretation and application of current and future PRC laws, regulations and rules.… It is uncertain whether any new PRC laws or regulations relating to variable interest entity structure will be adopted or if adopted, what they would provide.”
PRC counsel are usually willing to opine that the VIE Structure is legal (at least in the case of e‑commerce and many other value-added telecommunication (“VAT”) businesses) with the rather significant caveat that there are “substantial uncertainties” regarding the interpretation and application of the law – that is, the VIE Structure is legal until the relevant regulator responsible for interpreting the regulations says that it is not legal. The basis for PRC lawyers stating that the VIE Structure is legal (even in this highly caveated fashion) is somewhat technical. Recall that, if we step back and look at the sum of the parts of the VIE Structure, there is no doubt that it represents an attempt to avoid restrictions on foreign investment in the relevant sectors. However, PRC lawyers consistently opine that, under PRC law, we need not look at the sum of the parts. Instead the legality of each element that makes up the VIE Structure should be reviewed separately. If each element is legal, then the entire structure is legal.
III. PRC REGULATORS’ LONG-RUNNING LOVE-HATE RELATIONSHIP WITH THE VIE STRUCTURE
Given the seemingly shaky foundation of these “substantial uncertainties” upon which the VIE Structure is built, market players have carefully watched for each signal of approval or disapproval of the structure from PRC regulators. Although, up until the issuance of the SAMR notice on the SMZ Case, no Chinese authorities had affirmatively blessed the VIE Structure in writing, stakeholders believed that they had tacit approval to continue using it – at least in the case of most companies in the value-added telecommunications sector. Despite numerous incidents over the years in which one regulatory authority or another attempted to take a swipe at the VIE Structure, it has survived and persisted.
Below we analyze a few (but by no means all) of the attacks on the VIE Structure that have taken place over the past decade or so.
- 2009 – Online Game Companies
The most direct attack on the legality of the VIE Structure used with respect to an online business was launched in 2009 by the General Administration of Press and Publication (the “GAPP”, today renamed as the National Radio and Television Administration), the National Copyright Administration, and the National Office of Combating Pornography and Illegal Publications when they issued Xin Chu Lian  No. 13 (“Circular 13”), which expressly prohibits foreign investors from using contractual or other control arrangements to gain control over domestic Internet game operators. If applied strictly, Circular 13 would render the VIE Structure used by online game companies invalid and illegal. However, we are not aware of any enforcement actions taken against online game companies on the basis of the VIE Structure pursuant to Circular 13. As stated by Bilibili Inc. (a PRC online game operator) in its prospectus filed in March 2018: “While Circular 13 is applicable to us and our online game business on an overall basis, the [relevant regulator] has not issued any interpretation of Circular 13, and we are not aware of any online game companies which use the same or similar variable interest entity contractual arrangements as those we use having been challenged by the [relevant regulator].” In fact, some companies, such as Linekong Interactive (HKSE primary listing in 2014), Bilibili Inc. (NASDAQ primary listing in 2018), JOYY Inc. (NASDAQ primary listing in 2012) and Netease (HKSE secondary listing in 2020), that operate online game businesses using the VIE Structure, have completed overseas listings following the issuance of Circular 13. Unsurprisingly, the risk factor section of the prospectuses of these issuers included broad Circular 13 disclaimers. For example, JOYY Inc.’s prospectus stated that: “we are advised by our PRC counsel… that the enforcement of Circular 13 is still subject to substantial uncertainty.… In the event that we, our PRC subsidiaries or PRC consolidated affiliated entities are found to be in violation of the prohibition under Circular 13, the GAPP, in conjunction with the relevant regulatory authorities in charge, may impose applicable penalties, which in the most serious cases may include suspension or revocation of relevant licenses and registrations.”
Many market participants take the view that, given that the GAPP and its successor body (the National Radio and Television Administration) and the other regulators that promulgated Circular 13 did not have jurisdiction over regulating the VIE Structure, the statement in Circular 13 has no real impact. Conversely, the argument runs, had the Ministry of Commerce (“MOFCOM”), endorsed the position taken in Circular 13, then it would be of more importance and it might be harder for online game companies that use the VIE Structure to complete an IPO. (Note that there have been other attempts by regulators of specific sectors (such as compulsory education) to impose a ban on the use of the VIE Structure in that specific sector. An analysis of these sector specific regulations is beyond the scope of this article.)
- 2011 – Buddha Steel
In September 2010, Buddha Steel submitted its U.S. IPO application and disclosed its VIE Structure in its registration statement. In March 2011, however, Buddha Steel asked to withdraw its filing because “Baosheng Steel was advised by local governmental authorities in Hebei Province of the People’s Republic of China that the Control Agreements contravene current Chinese management policies related to foreign-invested enterprises and, as a result, are against public policy.” Some practitioners view this as a one-off event, while others believe that the local government intended to draw a line between the use of the VIE Structure in asset-heavy and asset-light industries. The use of the VIE Structure in an asset-heavy industry, such as the steel manufacturing industry, raises the same issues that the State Council raised with respect to the Unicom or CCF Model, which preceded the VIE Structure, (See Part I of this article for an analysis of the Unicom or CCF Model.) i.e., how can the capital required to fund the purchase and construction of real estate, manufacturing equipment and factories be legally funneled from the foreign investor to the VIE? Which entity should account for the depreciation of these physical assets in its financial statements? These issues simply do not arise in the case of a VIE Structure used in connection with asset-light businesses such as online services.
It would be somewhat strange for a local governmental authority to issue a restriction that was intended to impact companies throughout China. Instead, it is much more likely that the requirement that Baosheng Steel and Buddha Steel unwind their VIE Structures was related to local politics rather than to any overarching principle. In any case, many market participants took the Buddha Steel incident as an indication that each expansion of the use of the VIE Structure beyond the VAT sector should be considered separately and very carefully.
- 2011 – Security Review Measures
In August 2011, MOFCOM released the Measures on Security Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “Security Review Measures”), which specifically stipulate in Article 9 that “foreign investors may not evade mergers and acquisitions security review by any means, including but not limited to.… contractual control.” In practice, many transactions using the VIE Structure do not implicate national security and thus are not subject to the Security Review Measures. However, it was still of great interest to market participants that MOFCOM (the regulator responsible for, among other things, the regulation of foreign investment in China and thus able to enforce a ban on use of the VIE Structure if it chose to) seemed to be taking a swipe at the VIE Structure in the Security Review Measures. At the time, commentators speculated that MOFCOM might expand this “anti-VIE” position into a full scale ban on the use of the VIE Structure by foreign investors in all industries and not just sectors subject to security review.
- 2015 – Draft Foreign Investment Law
In January 2015, MOFCOM seemed to be on the brink of enacting just such a full scale ban on the use of VIE Structure. In that month, MOFCOM released for public comment a draft of the proposed Foreign Investment Law (“FIL”), under which a VIE Structure controlled by a foreign party would be deemed to be a foreign investment and thus would be subject to the restrictions and limitations on foreign investment in certain industries. In effect this meant that the VIE Structure would no longer be able to be used by foreign companies to avoid the restrictions and limitations on foreign investment in specific industries. The one exception to this under Article 45 of the draft FIL was that if an investor could provide evidence satisfactory to MOFCOM showing that the VIE Structure would ultimately be controlled by Chinese investors, MOFCOM would treat such investments as domestic investments.
Over the next four years (until the final version of the FIL was enacted in March 2019), many commentators speculated as to whether the final version of the FIL would include these provisions effectively eviscerating the usefulness of VIEs. Speculation was also rife as to whether the specific exception permitting Chinese controlled VIE Structures to be treated as domestic investments would be drafted in such a way so as to allow major listed companies such as Alibaba, Tencent and Baidu that use the VIE Structure to continue operating their businesses in China or whether there would be an explicit exception to grandfather all already-listed companies.
The exception in the draft FIL for companies that are ultimately controlled by Chinese investors prompted increasing interest in weighted voting rights among Chinese founders of companies that used a VIE Structure. Although MOFCOM did not provide any specific details in the draft FIL about what would constitute “control” by Chinese investors, many assumed that a weighted voting rights structure through which a Chinese founder maintained the majority of the voting rights of a company would satisfy the requirement even if he or she no longer held the majority of shares of that company. Some founders used the draft FIL as a rationale for pushing PE investors in the founder’s company to accept a weighted voting rights structure.
Many companies that had already completed listings using a VIE Structure by January 2015 when the draft FIL was released were quick to point out that their PRC national founders controlled the company through a weighted voting rights structure or other mechanism. For example Baidu stated in its 2015 annual report that: “The draft Foreign Investment Law, if enacted as proposed, may materially impact the viability of our current corporate structure, corporate governance and business operations in many aspect[s]… for any companies with a VIE structure in an industry category that is included in the “negative list” as restricted industry, the VIE structure may be deemed legitimate only if the ultimate controlling person(s) is/are of PRC nationality.… Through our dual-class share structure, Mr. Robin Yanhong Li, our chairman, chief executive officer and principal shareholder, a PRC citizen, possessed and controlled 53.6% of the voting power of our company as of February 28, 2015.”
Some commentators speculated that the delay in enacting the final FIL was at least in part due to an internal government struggle over how to treat VIEs. Not every VIE was controlled by PRC founders. In fact, given that the Hong Kong Stock Exchange (“HKSE”) didn’t permit weighted voting rights until 2018, HKSE-listed companies using VIE Structures were not able to use weighted voting rights to maintain PRC founder control and thus were often not controlled by PRC founders. Such HKSE-listed companies might have been significantly disadvantaged by the FIL relative to their U.S.-listed peers had the FIL been promulgated in its 2015 draft form.
IV. Recent Positive Governmental Signals with respect to the VIE Structure
In 2015, the outlook for the VIE Structure was very bleak. There was every indication that, after a string of attacks on the VIE Structure by various governmental agencies, MOFCOM was on the brink of issuing regulations that would make it impossible to use a VIE Structure to avoid foreign investment restrictions unless the relevant foreign company was in some yet undefined manner “controlled” by Chinese investors. At the very least, this would have restricted “true” foreign companies (that is, 100% foreign-owned companies (like Google or SnapChat) rather than companies established by Chinese founders that utilize an offshore structure in order to facilitate investment by non-Chinese PE funds and eventual listing on non-Chinese exchanges) from using VIE Structures and for those companies that had a Chinese founder would (a) have given such founders significantly more leverage when negotiating with PE investors as it would be necessary for the founder to continue to control the company regardless of circumstances, and (b) limit their potential listing venues to those that permitted weighted voting rights arrangements.
However, in fact, the release of the draft FIL in 2015 likely ignited an internal struggle within the government over how companies that used the VIE Structure, especially in the VAT sector, should be treated. In the last couple of years, we have seen the culmination of that struggle. Instead of being banned, which seemed likely in 2015, the VIE Structure has, in the last two years, come close to being officially blessed.
- 2019 – The Final Version of the Foreign Investment Law
When the final version of the FIL was enacted it included no provisions concerning VIEs. Again, VIE Structures were in a “grey area” under PRC law, not expressly permitted or prohibited.
Although the FIL gave no affirmative blessing of the VIE Structure, the failure to include provisions that would have banned the use of the VIE Structure as a means of avoiding foreign investment restrictions was seen by many as a significant step forward. Effectively, MOFCOM was admitting that the very powerful national champions that used the VIE Structure and had already been listed had won: it appeared that MOFCOM had decided not to force the matter.
- 2018–2019 – Companies that Use VIE Structure Selling CDRs in China
With the aim of attracting overseas-listed Chinese companies to come home and list in China, over the past three years, the China Securities Regulatory Commission (“CSRC”) has been incrementally loosening listing restrictions and has unveiled multiple reform initiatives.
The reform started with CSRC drafting the Several Opinions on the Launch of a Pilot Project on the Domestic Issuance of Shares or Depositary Receipts by Innovative Enterprises (the “Opinion Paper”), which was promulgated by the General Office of the State Council on March 30, 2018. Under the Opinion Paper, red-chip companies (including those with pre-existing VIE Structures) in certain high-tech industries, such as big data, cloud computing, biotech and artificial intelligence, are allowed to issue Chinese Depositary Receipts (“CDRs”) and apply for listing on designated boards of Chinese stock exchanges. Following the Opinion Paper, CSRC has issued several implementation rules that reiterate its positive attitude towards high-tech companies with VIE Structures.
On March 1, 2019, the Science and Technology Innovation Board (“STAR Board”) was established. CSRC and Shanghai Stock Exchange (“SSE”) unveiled a set of detailed rules for the STAR Board, which, among other things, allow red-chip companies with VIE Structures to issue shares or CDRs on the STAR Board, provided that they fully disclose the detailed arrangements and provide updates in their annual reports. On June 12, 2020, Ninebot, a leading supplier of electric scooters, became the first company to obtain approval from the listing review committee of SSE to sell CDRs on the STAR Board. (http://static.sse.com.cn/stock/information/c/202006/264f0c7bc0be4b888b11a5686937da40.pdf.) The fact that Ninebot is a Cayman Islands company with a VIE Structure makes this case particularly interesting. Ninebot still needs the final greenlight from CSRC.
CSRC’s approval of companies that utilize a VIE Structure listing CDRs on the STAR Board represents a strong indication that the use of the VIE Structure, at least in high-tech industries, is officially approved of. CSRC would not have issued rules permitting companies utilizing VIE Structures to list CDRs in China unless all relevant regulators had come to a consensus on this point. How could VIE Structures in general be banned after CSRC had approved the listing of CDRs on a Chinese exchange by companies using VIE Structures?
- 2020 – The SMZ Case
As briefly mentioned at the beginning of Part II of this article, the formal acceptance by SAMR of the SMZ Case may also signal that the VIE Structure has finally come out of the “grey area” and obtained formal recognition from the regulatory authorities (or at least from SAMR).
Up until now, it has been market practice not to make an AML Filing with respect to transactions involving a VIE Structure because, up until the SMZ Case, SAMR had not officially accepted or cleared any filing in relation to transactions involving a VIE Structure, and it was the consensus among stakeholders that this was unlikely to change. There was no clear basis in law for SAMR to refuse such filings. PRC counsel theorized that SAMR refused to accept these filings as it did not want to be viewed as giving a stamp of approval to the VIE Structure by accepting and clearing such an AML Filing. Given this, it might seem reasonable to interpret the acceptance by SAMR of the SMZ Case as SAMR giving a stamp of approval to the VIE Structure. When drawing this conclusion, it is, however, important to understand the context of the SMZ Case.
In the SMZ Case, Shanghai Mingcha Zhegang Management Consulting Co., Ltd. (“Mingcha Zhegang”) and Huansheng Information Technology (Shanghai) Co., Ltd. (“Huansheng Information”) proposed to set up a joint venture to engage in information technology and network technology development in the catering industry, data processing, artificial intelligence application software development, artificial intelligence hardware development and other businesses, and to explore new models of industry-research cooperation to provide more technical solutions for the catering industry. Upon establishment of the joint venture, Mingcha Zhegang and Huansheng Information will respectively hold 60% and 40% of its equity and will jointly control the company.
The principal business activities of the Mingcha Zhegang group include providing enterprises in the catering industry and government departments with artificial intelligence solutions. According to information disclosed in the public notice, Mingcha Zhegang’s ultimate controller is Leading Smart Holdings Limited, a Cayman Islands company, which maintains control over Mingcha Zhegang, a purely domestic company, through related entities based on a series of contractual arrangements, as illustrated below.
Two points are worth noting in the SMZ Case: (i) the joint venture itself did not utilize the VIE Structure, rather it is Mingcha Zhegang, a party to the joint venture transaction, that has an underlying VIE Structure; and (ii) due to limited information disclosed in the public notice, it is unclear whether Mingcha Zhegang adopted the VIE Structure for the purpose of circumventing foreign investment restrictions – the business activities listed in Mingcha Zhegang’s business license do not appear to fall within the scope of restricted or prohibited industries. It remains to be seen whether SAMR will accept an AML Filing when the transaction itself involves the VIE Structure (e.g., the purchaser acquires control of the target through a VIE Structure) or when the VIE Structure in question is utilized to sidestep foreign investment restrictions. However, it is important not to lose sight of the fact that in the past any VIE Structure within the entire group of companies related to the actual parties to the relevant transaction, whatever the purpose of that VIE Structure, would result in SAMR refusing to accept the AML Filing. The SMZ Case does not then constitute “business as usual” – something has definitely changed. (Note that SAMR has not yet published its decision on the SMZ Case. It will be closely watched by market participants.)
When viewed in the context of (i) the failure of the final version of the FIL enacted in 2018 to address VIEs and (ii) the CSRC’s recent actions to permit companies using VIE Structures to list CDRs in China, the acceptance by SAMR of the SMZ Case AML Filing is significant. There is clear evidence of a consensus among regulators in China that the VIE Structure, at least when used in connection with VAT businesses, is acceptable.
V. THE FUTURE OF THE VIE STRUCTURE
Over the past two decades we have seen the pendulum swing back and forth a number of times as the PRC government vacillated between tacitly approving the VIE Structure and actively attacking it. Based on what has occurred in the last couple of years, we think that it is likely that the swinging pendulum has stopped. The VIE Structure is now and will continue to be tacitly approved if not officially blessed. It is likely that China will continue to permit the use of the VIE Structure in general, while potentially restricting its use in certain limited sectors of the economy. The VIE Structure is not the issue: there are simply some sectors in which any form of foreign control is not acceptable.
However, as discussed in Part I of this article, there are a number of issues with the VIE Structure. If non-Chinese investors were permitted to establish or directly invest in Chinese VAT businesses on exactly the same terms as domestic Chinese investors – that is, without any limitation on the percentage of equity that can be held by non-Chinese investors, without any additional limits on the business scope of the VAT services, and without any longer or more complicated application or approval processes – the VIE Structure would eventually disappear. Although liberalizations of investment restrictions and reforms of investment approval processes have occurred and will likely continue to take place in the future, we are still some years from achieving parity between the terms and conditions of investment by Chinese and non-Chinese investors..