Chapman, Maximilian J --- "China's Variable Interest Entities in Context: Past, Present and Future" [2016] UNSWLawJlStuS 5; (2016) UNSWLJ Student Series No 16-05

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CHINA’S VARIABLE INTEREST ENTITIES IN CONTEXT:

PAST, PRESENT AND FUTURE

MAXIMILIAN J CHAPMAN^[*]

I INTRODUCTION

In 2000, Sina Corporation made headlines by being the first Chinese business to list on the NASDAQ in New York using the ‘Variable Interest Entity’ (‘VIE’) structure, which uses contracts instead of shareholding to effect corporate control. In the years since, VIEs have become at once a buzzword amongst corporate lawyers and a headache for regulators in the People’s Republic of China (‘PRC’), the United States (‘US’) and Hong Kong. The VIE structure has important implications for a range of issues, from access to capital by Chinese private enterprises, to access to the Chinese market by foreign private equity and venture capital firms, to the PRC’s current transformation from an economy dominated by investment, heavy industry and exports to one led by consumption, innovation and services.

This paper critically examines both the VIE structure in the PRC context and how the new PRC foreign investment law is likely to affect companies using the structure. Part II discusses the origins of VIEs in US accounting principles, the rationale for using them in China, and the mechanism by which they operate. Part III discusses the risks under PRC Contract Law arising from the uncertain legal status of the contractual arrangements that comprise the VIE structure. Part IV explores how the new foreign investment law, currently in its draft reform and expected to be passed in the coming years, is likely to affect companies using VIEs. Part V elaborates upon the policy implications of the new law, both in a general sense and in respect of Chinese private enterprises and foreign investors in particular. It argues that the new law does not address the circumstances that brought about the use of VIEs as a transactional device. Part VI concludes.

II ORIGINS, PURPOSES AND MECHANISM

A Accounting Origins

The term ‘variable interest entity’ is an accounting concept and the nature of its application in the PRC context is best understood in light of these origins. The term was born out of the need for reconsideration of what constituted a ‘controlling financial interest’ for the purposes of determining when to require a parent to consolidate its subsidiary’s financial statements, in order to prevent parent companies ‘manipulating their financial statements to hide losses and fabricate earnings’.^[1] In 2003, the US Financial Accounting Standards Board issued Interpretation No. 46 (‘FIN 46’) to expand upon its earlier Accounting Research Bulletin 51 (‘ARB 51’). ARB 51 dictated that ‘usual condition for a controlling financial interest’ was met upon ‘ownership by the company...of over fifty percent of the outstanding voting shares of another company’.^[2] However, under FIN 46, a parent will also have a controlling financial interest in another company, if it is the ‘primary beneficiary’ of a VIE. A VIE is an entity in which:

(a) ‘the equity investment at risk is not greater than the expected losses of the entity’; or

(b) ‘as a group, the holders of the equity investment at risk lack any of...

(1) the direct or indirect ability to make decisions about an entity’s activities through voting rights or other rights’;

(2) ‘the obligation to absorb the expected losses of the entity if they occur’; or

(3) the right to receive the expected residual returns of the entity if they occur’.^[3]

A ‘primary beneficiary’ is an enterprise possessing ‘a variable interest that will absorb a majority of the entity’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both’.^[4] Thus, if a company is exposed to the majority of the VIE’s losses and rewards, it is deemed to have a controlling financial interest and will therefore be required to consolidate its financial statements, despite the lack of equity ownership.^[5]

B Why use VIEs in China?

The simple, core principle that variable – not only equity – interests must be consolidated has been transplanted into the PRC to serve a radically different purpose.^[6] In the PRC, far from being a tool to prevent the manipulation of financial statements, the VIE is deployed to facilitate the circumvention of laws and regulations. While in the US the VIE was created to curtail a mischief the regulator then considered to exist, in the PRC, by contrast, the VIE started to be used to facilitate a mischief the regulator had not hitherto considered. Indeed, the irony of seeing what began as a loophole-closing device being co-opted by Chinese executives, assisted by their investment bankers and corporate lawyers, has not been lost on many.^[7]

The VIE has been used in the PRC to serve two purposes. The first and most well known purpose is to circumvent restrictions on foreign investment in specific industries. Under the Catalogue for the Guidance of Foreign Investment Industries (the ‘Catalogue’), industries are classified as ones in which foreign investment is encouraged, restricted or prohibited.^[8] The VIE structure can be used as a workaround to these restrictions or prohibitions, allowing Chinese private enterprises to acquire foreign capital in spite of a ban on foreign investment in the relevant sector and/or in the form desired.^[9] This is important because these enterprises constantly have to operate in a less than level playing field when compared to state-owned enterprises (‘SOE’) in terms of access to bank lending and the domestic stock markets.^[10] For foreign investors, the VIE allows them access to lucrative sectors in the Chinese economy that would otherwise be off-limits.^[11] These rationales raise important policy issues, which will be discussed in Section V.

The second use of the VIE has nothing to do with the Catalogue. In 2006, the Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (‘M&A Rules’) became effective.^[12] One effect of the M&A Rules was to subject domestic enterprises, using a controlled offshore company to acquire the affiliated domestic enterprise, to examination and approval requirements.^[13] This process of offshore restructuring, known as a ‘round-trip investment’, became common because it lends substantial tax and regulatory benefits to Chinese shareholders and foreign investors.^[14] In terms of tax, the offshore company is subject only to withholding tax on the distribution of dividends from its domestic affiliate, which, depending upon the jurisdiction of incorporation of the offshore company and the application of any relevant tax treaty, could be as low at 5%.^[15] Moreover, equity participation of a foreign investor in a domestic enterprise triggers the requirement of unanimous shareholder consent, as well as governmental consent, upon: (i) amendment to the company’s articles; (ii) transfer of its equity capital; (iii) increase or reduction of its equity capital; or (iv) its liquidation and dissolution.^[16] Channelling investments through an offshore vehicle facilitates evasion of these requirements. Upon the promulgation of the M&A Rules, however, it became clear that a round-trip investment via equity control would no longer be tolerated by the authority in charge, namely, China’s Ministry of Commerce (‘MOFCOM’).^[17] Since then, contractual control via VIEs has been substituted for equity ownership to sustain the offshore financing of Chinese businesses operating even in sectors not restricted under the Catalogue.^[18]

C The Mechanism of VIEs in China

Having explained both how the VIE operates in its original context and the reasons for its adoption in the PRC, this section draws these strands together by examining how the original VIE mechanism is transformed to serve the ends it operates for in the PRC.

At the core of the VIE structure is an offshore holding company (‘Special Purpose Vehicle’, ‘SPV’ or ‘ListCo’) and an onshore operating company (the ‘VIE’ or ‘OpCo’).^[19] The SPV is capitalised by the Chinese shareholders of the OpCo and foreign investors that usually include venture capital and private equity investors.^[20] These investors may later exit their investments by way of an Initial Public Offering on an overseas exchange, such as in New York or Hong Kong.^[21] The SPV is usually incorporated in a common law jurisdiction with favourable tax treatment, such as Hong Kong, the Cayman Islands, the British Virgin Islands or Bermuda.^[22] Typically, it does not have any operations.^[23] Next, a wholly owned, Chinese-incorporated subsidiary (‘WFOE’) is interposed between the SPV and the OpCo.^[24] The WFOE obtains a license allowing it to run a consulting business with the OpCo as the sole customer.^[25] For its part, the OpCo is owned solely by the Chinese partners, who are typically founders, chairmen or trusted employees of the business.^[26] The OpCo holds the operating license necessary for operating in the restricted or prohibited sector.^[27] The WFOE then enters into a series of contracts with the OpCo to secure the extraction of its cash flows, and with the OpCo’s Chinese shareholders in order to secure effective control over the OpCo itself.^[28] This contractual control seeks to mimic equity ownership.^[29]

The so-called ‘control mechanism’ is comprised of a bundle of contracts, which, together, ‘make the nominee shareholders contractually act on behalf of the WFOE as shareholders of the operating company’.^[30] The bundle may include (i) a Loan Agreement (an interest-free loan by the WFOE to the Chinese shareholders, who will use the proceeds to capitalise the OpCo and repay the principal by way of dividends received from the OpCo); (ii) an Equity Pledge Agreement (as security for full compliance by the Chinese shareholders with their obligations under the other contracts); (iii) a Call Option Agreement (granting the WFOE the option to purchase the Chinese shareholders’ interest in the OpCo at a pre-determined price if restrictions are relaxed); (iv) a Power of Attorney (granting voting rights and the right to attend meetings to the WFOE); and (v) a Voting Agreement (allowing the WFOE to instruct the Chinese shareholders on how to act cast their votes).^[31]

The so-called ‘cash extraction mechanism’ comprises a bundle of contracts, which guarantee receipt by the WFOE of the OpCo’s profits.^[32] The VIE’s financials are ‘a form of assets to their balance sheets to attract public investors in the international capital markets’.^[33] The cash extraction mechanism commonly comprises: (i) a Consulting/Technical Services Agreement (by which the WFOE provides industry-specific services to the OpCo in return for payment by way of the residual profits of the OpCo); and (ii) an Intellectual Property (‘IP’) Licensing Agreement (by which the WFOE is granted royalty fees in return for licensing IP rights to the OpCo).^[34]

III RISKS ARISING FROM UNCERTAIN LEGALITY

Thus, the VIE structure involves a matrix of contracts securing control by an offshore investment vehicle over a domestic operating entity. It complies in form, but not substance, with PRC laws restricting foreign investment in certain industries, as well as those imposing onerous consent requirements for changes to the articles and capital structure of foreign-invested domestic enterprises. It is this non-compliance in substance that raises the unsettled question of whether the contracts are enforceable under PRC law.^[35]

The question is not an academic one, and is likely to become relevant in the event of a dispute between Chinese and foreign shareholders over matters such as differences over management, a low share price, or when the Chinese shareholder no longer feels the need for overseas financing or know-how.^[36] Admittedly, it is true that if the Chinese shareholders of the OpCo also hold shares in the SPV, then any incentive that may arise for them to breach the contractual arrangements is mitigated by the prospect of loss to the value of their shareholding in the SPV.^[37] Interestingly, however, in the Alipay case, the Chinese shareholder (Alibaba) held 30% of the SPV and this was not enough to prevent it breaching the contractual arrangements. It did so after the People’s Bank of China released tougher regulations on online payments licenses in relation to foreign investors. The move left the non-Chinese majority shareholders of the ListCo (Yahoo and Softbank) without a stake in the success of the online payments license-holding OpCo.^[38] Ultimately, Yahoo and Softbank resorted to settlement discussions with Alibaba.^[39]

Absent an alignment of ownership, the danger epitomised by the situation of foreign shareholders like Yahoo and Softbank is that conflicts of interest cause the Chinese shareholder to come to the view that it no longer has sufficient incentive to comply with the contractual arrangements.^[40] In such circumstances, the Chinese shareholder may take possession of the OpCo’s financial chops, company seals and business registration certificates.^[41] This is what happened in the case of Gigamedia, where the ListCo fired the Chinese shareholder from his executive position in the WFOE. It then attempted (though failing for lack of compliance with formalities) to enforce the Equity Pledge Agreement against the Chinese shareholder.^[42] As a result, the OpCo was no longer able to ‘enter into contracts, conduct banking activities or take any official corporate action’.^[43] Since a ListCo often (though admittedly not in the case of Gigamedia) lacks assets apart from the OpCo’s cash flows, its investors stand to suffer substantial loss.^[44]

Even if Gigamedia’s Equity Pledge Agreement had complied with formalities, the company would arguably have faced other hurdles in enforcing it. Article 52 of the PRC Contract Law provides that a contract is invalid if it is attempted to ‘conceal illegal goals under the disguise of legitimate forms’ or if ‘mandatory provisions of laws and administrative regulations are violated’.^[45]A literal reading of this would suggest that either of subsections (3) or (5) may be used by a court to invalidate the contracts if the issue came before it.^[46] This interpretation is supported by a recent decision of the Supreme People’s Court on a similar issue. In the Chinachem case, an onshore company (China SME) agreed to subscribe to capital in a company operating in a foreign investment-restricted industry (China Minsheng Banking Corp.) on behalf of an offshore company (Chinachem).^[47] The subscription was carried out using the proceeds of a loan by Chinachem to China SME, the interest on which was to equal the amount of the dividends received by China SME from China Minsheng. China SME brought an action alleging the agreements were invalid. The Court agreed and declared that the agreements concealed illegal goals under the guise of a lawful form, and were therefore invalid under Art 52(3) of the Contract Law.^[48]

It is true that the Chinese shareholder in a VIE structure would own the shares in the OpCo in his or her own right, not on behalf of the WFOE. It is also true that the OpCo would channel profits to the ListCo by way of payment for actual services rendered, not as an interest payment on a questionable ‘loan’.^[49] Nonetheless, it is argued that these factual differences are not to the point. The Supreme People’s Court judgment in the Chinachem is notable for the ‘substance over form’ approach that it takes. Even if it were possible to mount the argument that the VIE structure is a less egregious breach of the law than that involved in the Chinachem structure, this would not diminish the objection that – on some level – it still conceals illegal goals under a lawful form. Apart from this, it is inherently improbable that a PRC court would side with foreign investors in a case involving a breach of government policy.^[50] Indeed, in two (non-binding) arbitration cases decided by the Shanghai Sub-commission of the China International Economic and Trade Arbitration Commission, both of which featured actual VIE structures, the award invalidated the VIE agreement on the basis that it used a lawful form to cover up illegal objectives.^[51] Thus, it seems accurate to observe that foreign investors are protected by little more than the sense of goodwill, as well as reputational concerns, of their Chinese partners.^[52] Even if conflicts of interest lead a desire to litigate the contractual arrangements, foreign investors may justifiably shy away from doing so for fear of possible sanctions under Article 52 of the Contract Law.

IV NEW FOREIGN INVESTMENT LAW: CERTAINTY, FINALLY

The uncertainty over enforceability of the VIE contracts and the attendant risks for foreign investors may finally be put to rest if the New Foreign Investment Law (‘New Law’) is passed by the National People’s Congress.^[53] The New Law conforms with the trend towards national treatment of foreign enterprises, which is dictated by the PRC’s accession to the World Trade Organisation.^[54] The laws requiring the establishment of different corporate vehicles (i.e. the Equity Joint Venture, Contractual Joint Venture and Wholly Foreign Owned Enterprise) for foreign investment are to be replaced by a unified regime that eliminates the universal requirement for approval of a foreign-invested enterprise.^[55] Instead, foreign investors will be subject to onerous reporting obligations, including implementation reports, reports upon the occurrence of specified events and periodic reports.^[56]

Although the New Law does not mention VIEs explicitly, it is clear that they are subject to its application. ‘Foreign Investment’ is widely defined and includes, inter alia, the control of a Domestic Enterprise through contract, as well as overseas transactions that result in the transfer of actual control over a Domestic Enterprise to a Foreign Investor.^[57] Moreover, the definition of ‘Foreign Investor’ includes a domestic enterprise controlled by an enterprise established under the laws of another country or region.^[58] Control is deemed to exist in three instances. Firstly, it exists if the controlling party holds 50% or more of the controlled enterprise’s ‘shares, equity, property shares, voting rights or other similar rights.’^[59] Control also exists if a party possesses less than 50% of the enterprise’s voting rights but nonetheless: (i) is ‘entitled to directly or indirectly appoint at least half of the members of the board of directors’; (ii) ‘has the ability to ensure that its nominated persons can obtain at least half of the seats on the board of directors’; or (ii) is entitled to voting rights that are ‘sufficient to exert a material impact on the resolutions of the shareholders’ meeting, the general meeting, the board of directors, or other decision-making body’.^[60] Finally, control exists if the controlling party is ‘able to exert a decisive influence on the operations, finance, personnel, technology, etc., of the enterprise through contract, trust or other means.’^[61]

In summary, control exists where there is: i) controlling equity ownership; (ii) control over corporate decision-making; or iii) control over corporate operations. It is not clear what amounts to a ‘material impact’ or ‘decisive influence’. However, it seems safe to suggest that either of (ii) or (iii) may exist in a VIE structure. As mentioned earlier, the Power of Attorney grants the WFOE the right to exercise the Chinese shareholders’ right to vote and attend shareholder meetings, which allows the WFOE effective control over corporate decision-making. Moreover, the Consulting and Technical Services Agreement provides the WFOE with the means to control the VIE’s operations by attaching conditions to the use of technology, knowhow and intellectual property rights licensed to it. Thus, assuming that control exists, the critical question is whether the OpCo is controlled by a Chinese Investor or a Foreign Investor. If it is foreign-controlled, then the OpCo is a Foreign Investor and the contractual arrangements linking it to the SPV amount to a Foreign Investment. All of the provisions of the New Law referring to ‘Foreign Investment’ and ‘Foreign Investor’ will apply. If the OpCo is controlled by a Chinese national or a company controlled by a Chinese national, the New Law will not (subject to a caveat, explained below) apply.^[62]

Under the New Law, a Market Entry Permit need be obtained only if a Foreign Investor intends to invest in a field specified in the list of restricted investment or in an investment that exceeds the monetary threshold.^[63] Foreign Investors cannot invest in a field specified in the list of prohibited sectors, nor can a Domestic Enterprise do so if ‘a Foreign Investor directly or indirectly holds [its] shares equity, property shares or other rights and interests or voting rights’.^[64] This is effectively an exception to the general rule that a Chinese-controlled but foreign-invested domestic enterprise is not a ‘Foreign Investor’. Prohibited and restricted investments will be listed in the Catalogue of Special Management Measures.^[65] Conditions may be attached to the Permit.^[66] The effectiveness of these provisions is reinforced by a sanctions provision, which states that foreign investors who use contractual controls to circumvent the Draft Law will be subject to the sanctions for investing in prohibited sectors or in restricted sectors without a Market Entry Permit.^[67] These include an order to cease investment, dispose of assets, or confiscate illegal gains; or fines up to RMB 1 million or 10% of the investment.^[68]

The interaction of the nationality of the controller (i.e. Chinese Investor or Foreign Investor) with the nature of the investment sought (i.e. restricted industry or prohibited industry investment) generates four possible outcomes. For a foreign-controlled OpCo investing in a restricted industry (i.e. a deemed Foreign Investor), a Market Entry permit is required and a VIE structure cannot be used to circumvent this requirement. This represents a tightening of the current position, whereby a VIE structure could be used to do so. In relation to a Chinese-controlled OpCo investing in a restricted industry (i.e. a deemed Chinese Investor), a Market Entry Permit is not required. Therefore, the New Law allows foreign investors content to take a minority stake in an enterprise operating in a restricted industry to do so without the contractual risk associated with using a VIE structure.^[69] This liberalises the current position, whereby VIEs are used to bypass approval procedures. In relation to a foreign-controlled OpCo seeking to invest in a prohibited industry (i.e. a deemed Foreign Investor), the New Law outlaws the use of VIEs to circumvent this prohibition, tightening the status quo. Finally, for a Chinese-controlled OpCo seeking to invest in a prohibited industry (i.e. a deemed Chinese investor), the New Law also outlaws the use of VIEs to circumvent the prohibition, as a result of Article 25’s reference to a domestic enterprise in which a Foreign Investor directly or indirectly holds any shares or voting rights. Thus, not only will foreign entrepreneurs be unable to use a VIE structure to secure a controlling interest in a business operating in a prohibited industry, but also foreign financial investors, including private equity and venture capital investors, will be unable to obtain even a minority interest in a Chinese enterprise operating in a prohibited sector.

One remaining question is the issue of ‘grandfathering’, which concerns the extent to which the tough approach of the New Law should apply to VIEs currently operating in restricted or prohibited sectors. Important technology companies such as Sina, Sohu, Tencent, Baidu and Alibaba are famous examples of companies listed on overseas exchanges that employ VIE structures.^[70] In an Explanatory Note accompanying the New Law, MOFCOM has canvassed three potential approaches for dealing with existing VIEs. The first approach would allow the VIE structure to remain unchanged if the company simply reports to MOFCOM that it is Chinese-controlled. The second approach is similar, but would require MOFCOM verification that the company is in fact Chinese-controlled. The final approach would involve the company applying to MOFCOM for a Market Entry Permit, upon which MOFCOM would consider all relevant factors (including actual control) before deciding whether to issue the Permit.^[71] It seems clear that, despite the likely crackdown on the future use of VIEs, regulators are likely to be far too pragmatic to adopt anything less than a sensitive approach to existing VIEs.^[72]

V POLICY IMPLICATIONS OF THE NEW LAW

The preceding section canvassed the elements of the New Law relevant to Chinese private enterprises and foreign investors considering using a VIE structure. Essentially, in all but the limited field of foreign minority investments in restricted sectors, the New Law represents a significant crackdown on parties’ ability to circumvent foreign investment restrictions. There are some undeniable advantages to this. Firstly, it is no longer necessary to consult the pronouncements of a variety of regulators in order to ascertain the legality of a proposed VIE structure. The introduction of unified, general standards mean that the discretion previously accorded to various regulators is constrained.^[73] Regulatory certainty allows the confidence of foreign investors to be maintained.^[74] Secondly, the New Law eliminates the legal fiction that domestic enterprises controlled by foreign investors are not themselves foreign investors.^[75] Finally, through the Market Entry Permit system, it embraces the suggestion that there need to be workable and commercially flexible approval procedures.^[76]

In the three-year grace period the New Law allows to facilitate compliance with its provisions, companies, investors and their transactional advisors will no doubt be busy negotiating transitional arrangements. They would welcome the improved certainty and flexibility the New Law brings, while devising alternative ways of addressing the difficulties the VIE structure was first employed to address. For Chinese private enterprises, that difficulty was primarily obtaining bank financing and accessing the domestic capital markets. For foreign investors, the difficulty was a restrictive foreign investment policy. Given these divergent reasons for using the VIE structure, the policy implications of the New Law for Chinese private enterprises and foreign investors will be discussed separately below.

A For Foreign Investors

As outlined above, the New Law, if passed, will make it impossible to use contractual arrangements to gain any stake in a business operating in a prohibited industry, or a controlling stake in a business operating in a restricted sector without a Market Access Permit. If there is any silver lining under this cloudy horizon, it is that the New Law would render it unnecessary to use a VIE structure to make a minority investment in a restricted industry. Foreign investors have long lobbied the Chinese government to liberalise market access in the underlying industry sectors, which would remove the difficulty precipitating the existence of many VIEs.^[77] However, now that approval requirements for minority investments in restricted industries are on the verge of being eliminated, foreign investors will hope that the Chinese government comes to the view that sufficient control can be provided by imposing Joint Venture and minimum Chinese shareholding requirements, rather than insisting on continued blanket prohibitions.

In the future, restricted and prohibited industry sectors will be set out in the so-called ‘Negative List’, which will replace the existing Catalogue of Industries Guiding Foreign Investment (the ‘Catalogue’).^[78] The State Council is expected to publish the List once the New Law is passed.^[79] The backdrop to the introduction of the Negative List is negotiations with the US and European Union for bilateral investment treaties, which would demand greater market access for foreign investors. For now, the guiding document is the 2015 revision to the Catalogue. On its face, the 2015 Catalogue is an impressive revision. It greatly reduces the number of industrial sectors restricted to foreign investors (from 79 to 38). Within the class of sectors that remain restricted, the number of sectors subject to a condition that investments are made by joint venture has been reduced (from 43 to 15). Moreover, the number of sectors subject to a condition that investments must involve a Chinese majority shareholder has also been reduced (from 44 to 35). However, these numbers belie the fact that many of the changes are simply codifications of existing provisions found in industry-specific regulations. The Catalogue states that, from now on, such regulations do not have force of law and only formal laws and regulations have the power to affect prohibited and restricted industry sectors.^[80] It appears, therefore, that the 2015 revision makes the Catalogue more closely resemble the Negative List, which is to be an exhaustive statement of foreign investment restrictions.

Disregarding the changes to the Catalogue that merely represent codifications to existing law and practice, how far does the 2015 Catalogue go in liberalising market access? In healthcare, the minimum Chinese shareholding require for foreign investment in medical institutions has been removed to leave only the requirement for a Joint Venture. Pilot schemes in the Shanghai Free Trade Zone and subsequently in other cities for wholly foreign-owned medical institutions suggest a genuine trend of liberalisation in this sector. Interestingly, technologies for the connection of personal and household appliances to the Internet are now encouraged, while more sensitive areas of technology remain prohibited. Similarly, while value-added telecoms services remain restricted, the operation of e-commerce platforms is now permitted.^[81]

This resonates with the developmental priorities outlined in China’s 13^th Five Year Plan, approved by the Chinese Communist Party last year and to be released in March 2016.^[82] The 13^th Five Year Plan stresses the so-called ‘Internet Plus Program,’ which is aimed at encouraging the use of the Internet to promote innovation across primary, secondary and tertiary sectors. Thus, it is possible to see the Five Year Plan as a ‘guide’ to the sectors that might be liberalised for foreign investment over the coming years. More broadly, the 13^th Five Year Plan reflects the transformation of the Chinese economy from one that is led by investment, heavy industry and exports to one led by consumption, innovation and services.^[83] As mentioned earlier, the New Law will mean that foreign investors will be hoping for greater scope to make minority investments in restricted sectors. Those that are realistic will confine their hopes for liberalisation to sectors stressed by the 13^th Five Year Plan. One enduring certainty is that prohibitions in politically sensitive sectors, such as media and communications, will not be changed.^[84]

B For Chinese Private Enterprises

It is important to remember that, for all the exuberance of foreign investors, the use of VIEs would not have become as widespread as it is today had Chinese private entrepreneurs been able to access loan facilities from domestic banks and raise capital on the domestic markets. This is borne out by the reality that, most commonly, the SPV in a VIE structure is controlled by Chinese citizens, or at least recently naturalised ‘foreigners.’ Its true foreign investors are usually financial or public investors who invariably have no will or capacity to control the company’s business operations in China.^[85] This being the case, it becomes important to consider whether the difficulties faced by private enterprises in accessing credit and capital still exist today. If so, then clearly the new foreign investment law represents a significant regulatory risk to their business. However, it should be remembered that the reason for this regulatory risk is not that the New Law targets VIEs, but that it targets the end to which the VIE structure is employed. As discussed, one use of the VIE structure is in the context of round-trip investments to reduce tax and regulatory costs. Clearly, this subject matter is foreign to a foreign investment law and the New Law has nothing to say on it. Therefore, there it nothing to suggest that VIEs may not still be used for round-trip investments.

Some have suggested that the difficulty of obtaining domestic financing has eased for private companies, and that the incentive for them to seek foreign capital through the use of VIEs has consequently reduced.^[86] It is true that towards the end of 2015, the State Council announced that the current requirement for the China Securities and Regulatory Commission (the ‘CSRC’) to approve Initial Public Offerings (‘IPOs’) is to be eliminated within two years. The National People’s Congress, China’s legislature, must approve changes to the Securities Law before the change takes effect. Once enacted, authority in relation to the IPO process will be devolved to the stock exchanges, including the key bourse of the Shanghai Stock Exchange and the growth-oriented Shenzhen Stock Exchange. The exchanges will focus on enforcing disclosure requirements as their Western counterparts do and will not interfere, as the CSRC has, with pricing and timing. The changes to the law are expected to alleviate the wait list for IPOs, which often stretches back for years. This will allow growing private enterprises to access more capital more easily. Equally importantly, the amended law should mark the end of an era in which a company’s ability to successfully navigate the listing process is dictated by the strength of their political connections, thereby improving the efficiency of capital allocation.^[87] By allowing every company in need of capital to access the market, investors will be able to allocate their capital to those enterprises that look to be able to make the most productive use of that capital. The class of investment choices will no longer be constrained by political decisions that generate inefficient outcomes.

However, if it seems that China’s regulators are content to concede their privileging of SOEs in the capital markets, the outlook is altogether bleaker in relation to bank loans. Anecdotal evidence suggests that loans from the large, state-owned banks to small, risk-prone businesses are either unavailable or unaffordable, with interest rates often set at unacceptably high levels.^[88] The slowing rate of growth of the Chinese economy frequently makes international news headlines and is the subject of concern of policymakers around the world. Among the problems are high levels of corporate debt, an excess of industrial capacity and overinflated real estate prices. In this environment, it is a matter of economic reality that banks apply sizeable valuation discounts to land advanced as security for loans. Equally, it is understandable that the People’s Bank of China does not wish to excessively loosen monetary policy since this would exacerbate unsustainable debt and capacity issues. Both these circumstances conspire to make loans unaffordable for private enterprises.

As this analysis demonstrates, the problem is not a lack of economic basis for unaffordable loans. Rather, the problem lies in the circumstances that gave rise to the circumstances of excess debt and capacity in the first place. Again, this is a problem of capital allocation. When the central bank lowers the base rates, banks are reluctant to pass on rate cuts to borrowers because this would erode their ability to continue to offer high rates to deposit-holders. Deposits are commercial banks’ largest liability and the banks use high rates as a lever to prevent excessive withdrawals. Even when rate cuts are passed on, due to political pressure, the beneficiaries are SOEs and local municipalities, which use loan proceeds to refinance old debt.^[89] Not only does this delay structural reform by SOEs, but also it diverts capital away from the private enterprises that would make more productive use of it. If private enterprises are to have better access to bank financing, the privileged position of SOEs within the banking system must first be addressed.

VI CONCLUSION

VIEs involve the use of contractual arrangements by an offshore-controlled, Chinese-domiciled and wholly foreign-owned company to exert control over – and extract returns out of – a domestic operating company operating in an industrial sector in which foreign investment is either restricted or prohibited. VIEs comply with the letter of the law, but not with its spirit. There are considerable risks involved for foreign investors. If a Chinese shareholder has an incentive to breach the contractual arrangements, the likely unenforceability of the contractual arrangements under PRC law renders a foreign investor practically helpless. The likelihood of this result has been confirmed by decisions of PRC courts and arbitration commissions.

The draft new foreign investment law closes the loophole that VIEs have hitherto exploited. Under the New Law, all foreign investors, including investors using the VIE structure, will be subject to the same laws and regulations. Consequently, as with foreign investors who exert control by equity, foreign investors using the VIE structure may not acquire an interest in a company operating in a prohibited sector, nor may they circumvent the requirement for a Market Access Permit if acquiring a majority stake in a company operating in a restricted sector. If, on the other hand, a foreign investor intends to acquire a minority interest in a company operating in a restricted sector, little reason remains to use the VIE structure since there will no longer be a requirement for a Market Access Permit in this scenario.

The effect of the New Law can only be judged in light of the difficulties that gave rise to the use of VIEs in China. For foreign investors, the difficulty was the restrictive foreign investment environment. For Chinese private enterprises, the difficulty was accessing credit from banks and capital on the markets. While industrial policy will continue to guide the foreign investment landscape, the overall trend is one of liberalisation. Moreover, the signs are promising that access to the domestic capital markets for private enterprise is improving, although access to credit from state-owned banks will continue to be a problem so long as state-owned enterprises retain their privileged position in the domestic banking system. The curtain may be closing on the saga of the VIE, but, with China’s peculiar model of state capitalism, we know that other battles between the State and the market are never far away.

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^[*] Graduate-at-Law. Juris Doctor (with Distinction), University of New South Wales Law School, 2015; Bachelor of Arts (Asian Studies & Chinese Studies), University of Sydney, 2011.

^[1] Li Guo, ‘Chinese Style VIEs: Continuing to Sneak under Smog?’ [2014] CornellIntLawJl 9; (2014) 47 Cornell International Law Journal 569, 572; see also David Schindelheim, ‘Variable Interest Entities in the People’s Republic of China: Is Uncertainty for Foreign Investors Part of China’s Economic Development Plan?’ (2012-2013) 21 Cardozo Journal of International and Comparative Law 195, 207; Maria Mengwei Ma, ‘The Perils of Prospects of China’s Variable Interest Entities: Unravelling the Murky Rules and Institutional Challenges Posed’ (2013) 43(3) Hong Kong Law Journal 1061, 1064.

^[2] Financial Accounting Standards Board, ARB No. 51: Consolidated Financial Statements (August 1959).

^[3] Financial Accounting Standards Board, FASB Interpretation No. 46: Consolidation of Variable Interest Entities; an Interpretation of ARB No. 51 (December 2003), [5], available at <http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1218220134120 & acceptedDisclaimer=true> .

^[4] Ibid [14].

^[5] Ibid; Guo, above n 1, 573; Schindelheim, above n 1, 208; Ma, above n 1, 1064.

^[6] Guo, above n 1, 576.

^[7] Ibid.

^[8] Catalogue of Industries for Guiding Foreign Investment, promulgated by the State Planning Commission (SPC), State Economic and Trade Commission (SETC) and the MOFTEC, effective on June 20, 1995; amended in 1997 (by Order No. 9 of the SPC, the SETC and the MOFTEC), in 2002 (by Order No. 21 of the SPC, the SETC and the MOFTEC), in 2004 (by Order No. 24 of the NDRC and the MOFCOM), in 2007 (by Order No. 57 of the NDRC and the MOFCOM), in 2011 (by Order No. 12 of the NDRC and the MOFCOM), and in 2015 (by Order No. 12 of the NDRC and the MOFCOM, effective on 10 April 2015).

^[9] Guo, above n 1, 574-5; Ma, above n 1, 1065.

^[10] Ma, above n 1, 1064-5.

^[11] Ma, above n 1, 1065; Wei Shen, ‘Deconstructing the Myth of the Alipay Drama – Repoliticizing Foreign Investment in the Telecommunications Sector in China’ (2012) 36 Telecommunications Policy 929, 931; Guo, above n 1, 575.

^[12] Provisions on Foreign Investors' Merger with and Acquisition of Domestic Enterprises, promulgated by the Ministry of Commerce, State-Owned Assets Supervision and the Administration Commission of the State Council, the State Administration of Taxation, the State Administration for Industry and Commerce, the China Securities Regulatory Commission, effective on August 9, 2006; amended in 2009 (by Decree No. 6 of the Ministry of Commerce, effective on June 22 2009).

^[13] Ibid, Art 11.

^[14] Shen, above n 11, 932.

^[15] Ibid.

^[16] Ibid.

^[17] Guo, above n 1, 575-6; Ma, above n 1, 1065, 1066-7.

^[18] Ma, above n 1, 1067; Guo, above n 1, at 576, citing the IPOs of China Qinfa and New Oriental Education as prominent examples.

^[19] Wei Shen, ‘Will the Door Open Wider in the Aftermath of Alibaba? – Placing (or Misplacing) Foreign Investment in a Chinese Public Law Frame’ (2012) 42(2) Hong Kong Law Journal 561, 567-8.

^[20] Ibid; Ma, above n 1, 1063.

^[21] Ma, above n 1, 1064.

^[22] Shen, above n 19, 567; Guo, above n 1, 577.

^[23] Guo, above n 1, 577.

^[24] Shen, above n 19, 567; Guo, above n 1, 577.

^[25] Guo, above n 1, 577.

^[26] Ibid 578.

^[27] Shen above n 19, 565; Guo, above n 1, 578.

^[28] Shen above n 19, 567.

^[29] Ma, above n 1, 1063; Guo, above n 1, 579-80.

^[30] Shen, above n 19, 566; Ma, above n 1, 1068.

^[31] Shen, above n 19, 565-6; Ma, above n 1, 1067-8; Guo, above n 1, 578.

^[32] Shen, above n 19, 566.

^[33] Ma, above n 1, 1064; Guo, above n 1, 579.

^[34] Shen, above n 19, 566; Ma, above n 1, 1067.

^[35] Ma, above n 1, 1068; Schindelheim, above n 1, 216, 219; Guo, above n 1, 591.

^[36] Serena Y Shi, ‘Comment: Dragon’s House of Cards: Perils of Investing in Variable Interest Entities Domiciled in the People’s Republic of China and Listed in the United States’ (2014) 37 Fordham International Law Journal 1264, 1294.

^[37] Guo, above n 1, 584.

^[38] Ma, above n 1, 1069; Guo, above n 1, 588.

^[39] Guo, above n 1, 589.

^[40] Guo, above n 1, 584; Schindelheim, above n 1, 220.

^[41] This was the case in Gigamedia (discussed below). See Ma, above n 1, 1069; Schindelheim, above n 1, 220.

^[42] Ma, above n 1, 1069. See further Guo, above n 1, 585; Schindelheim, above n 1, 221-2.

^[43] Schindelheim, above n 1, 221.

^[44] Ma, above n 1, 1068; Schindelheim, above n 1, 217; Guo, above n 1, 585.

^[45] Uniform Contract Law of the People’s Republic of China, adopted at the 2^nd Session of the 9^th NPC on 15 March 1999, effective on 1 October 1999, Art 52.

^[46] Guo, above n 1, 591-2.

^[47] Ibid 1070; Guo, above n 1, 594.

^[48] Ibid.

^[49] Ma, above n 1, 1070; Guo, above n 1, 594-5.

^[50] Ma, above n 1, 1068-9; Schindelheim, above n 1, 217; Guo, above n 1, 595.

^[51] Guo, above n 1, 592-3.

^[52] Shi, above n 41, 1295.

^[53] Notice of the Ministry of Commerce on Soliciting Public Opinions on the Foreign Investment Law of the People's Republic of China (Draft for Comments), promulgated by MOFCOM, effective on January 19 2015 (the ‘New Law’).

^[54] Chou, Thomas et al, ‘China’s Draft Foreign Investment Law: A Paradigm Shift in Regulation of Foreign Investment’ Morrison & Foerster Client Alert (12 February 2015), 2, available at <www.mofo.com/~/.../150212ChinasDraftForeignInvestment.pdf>.

^[55] Ibid 1; Chin, Michael et al, ‘China to Unify Inbound Foreign Investment Laws – But Will it Create a True Level Playing Field with Domestic Investors?’ Hogan Lovells Client Alert (28 January 2015), 1, available at <http://www.hoganlovells.com/newsmedia/pubDetail.aspx?publication=11346> .

^[56] Chou et al, above n 61, 4; Chin et al, above n 62, 5; Doorman, Alexander et al, ‘Draft New Foreign Investment Law: Big Bang in China?’ Freshfields Bruckhaus Deringer Client Alert (26 January 2015), 3, available at <http://www.freshfields.com/en/knowledge/Draft_new_Foreign_Investment_Law/> .

^[57] New Law Art 15.

^[58] New Law Art 11(2).

^[59] New Law Art 18(1).

^[60] New Law Art 18(2).

^[61] New Law Art 18(3).

^[62] New Law Art 12.

^[63] New Law Art 27.

^[64] New Law Art 25; Doorman et al, above n 63, 4.

^[65] New Law Art 24.

^[66] Chin et al, above n 62, 3, 5-6; Doorman et al, above n 63, 3.

^[67] New Law Art 149.

^[68] New Law Arts 144-5.

^[69] Chou et al, above n 61, 3-4.

^[70] Chin et al, above n 62, 9.

^[71] Doorman et al, above n 63, 4-5; Chin et al, above n 62, 10.

^[72] Ma, above n 1, 1079-80.

^[73] Shen, above n 19, 591-3; Shen, above n 11, 939-40.

^[74] Ma, above n 1, 1062; Shen, above n 19, 582.

^[75] Guo, above n 1, 603.

^[76] Guo, above n 1, 603.

^[77] Chin et al, above n 62, 9.

^[78] New Law Arts 23, 24.

^[79] Doorman et al, above n 63, 2; Chin et al, above n 62, 4.

^[80] Practical Legal Company, China releases new foreign investment catalogue (Practical Law China, 16 March 2015), <http://uk.practicallaw.com/1-604-7265#> .

^[81] Ibid.

^[82] Sara Hsu, ‘China’s Next Five-Year Plan: Realistic Objectives?’ The Diplomt (November 7 2015).

^[83] Keith Johnson, ‘China’s Leaner and Greener 5-Year Plan, Foreign Policy (October 30 2015).

^[84] Shen, above n 11, 940.

^[85] Guo, above n 1, 603.

^[86] Ma, above n 1, 1081; see also Shen, above n 19, 582.

^[87] Gabriel Wildau, ‘China to deregulate IPO approvals within two years’, Financial Times (10 December 2015).

^[88] Hong Shen, ‘China’s Small Businesses Lose Out on Cheaper Loans; Credit goes to state-run enterprises and local municipalities’, Wall Street Journal (1 April 2015).

^[89] Kellee S. Tsai, Financing Small and Medium Enterprises in China: Recent Trends and Prospects Beyond Shadow Banking, HKUST Working Paper No. 2015-24 (May 2015), 7.