The variable interest equity (VIE) structure has
long been used by foreign investors wishing to invest in China’s prohibited or
restricted industries. But an investigation into New Oriental Group has highlighted
issues with the structure and led to calls to fully-open foreign investment
Chinese online media
company Sina pioneered the trend back in 2000, when it used the VIE structure
to list on the New York Stock Exchange. Education company New Oriental Group is
one of many Chinese companies since then to have also used the structure to
list on international capital markets.
New Oriental
announced it was under investigation by the US Securities and Exchange
Commission (SEC) in a press release on July 17. While the company believes that the
investigation concerns the consolidation of one its subsidiaries into the
company’s financial statements, it has not stopped bloggers such as Stan Abrams
at China Hearsay and Paul Gillis of China Accounting Blog from speculating that this could be the end of VIEs.
The structure
Foreign investors can use VIEs as a
workaround structure to access restricted or prohibited industries under the country’s
Foreign Investment Industrial
Guidance Catalogue (外 商投资产业指导目录). The basic
structure includes at least one domestic company, owned and controlled by PRC
owners, an offshore holding company and a wholly foreign-owned enterprise
(WFOE).
The holding company
owns the WFOE through a series of intermediary holdings. The domestic company
and the WFOE enter into a series of structured agreements, including an
exclusive equity option, equity pledge, voting proxy and technical licence and
service agreements. These agreements allow the domestic company to be
indirectly controlled by the holding company and its financial results are
consolidated into the WFOE’s financial statements, as if it were one of the
company’s subsidiaries.
Investigation
Beijing-based Brad Shu, a partner at
Jade & Fountain PRC Lawyers said the SEC might not be questioning the VIE
structure, but they were concerned about whether franchises may be consolidated
into the company’s financial statements.
Eric Liu, a partner
with Han Kun Law Offices in Beijing added: “It is the change in shareholder
structure rather than the VIE per se
that draws the attention of the SEC.”
This is not the first
time the SEC has looked into companies using the VIE structure. In 2011, it
launched a series of investigations into Chinese companies, albeit again over
financial issues.
Legal issues with VIE
While the VIE structure does not
violate Chinese law, it does go against the spirit of it. The purpose of the
Industrial Guidance Catalogue is to regulate foreign investment into industries
that are allowed, restricted or prohibited. Industry advisers previously warned
IFLR companies using variable
interest entity (VIE) structures in private equity investments into China are playing a dangerous game.
“There has been no
official decision or legislation denying the legality and validity of VIE,”
said Liu. “If investors can bypass the Catalogue using the VIE structure while
the authority is aware of it, then it is not prohibited,” he added.
There are also
questions over whether the structure can effectively protect investors,
especially from management’s abuse of power at domestic firms. In addition,
there are issues with enforceability and validly of the structure’s contracts.
But while Chinese law
may not protect investors, Liu and Shu contend that foreign law can protect
investors during contractual disputes or abuse of power.
Opening foreign investment
In his opinion piece
from Caixin,
Zhang Jiwei said that perhaps it was time to remove the VIE structure and
completely open up China’s foreign investment. “The fact that a large amount of
foreign investment has poured into these areas has contributed to their
development, and probably suggests that we should lift the prohibitions,” he
wrote.
Lifting prohibitions
will not be easy, argued Shu, as foreign investment restrictions will be a
long-run policy in China. Liu said even regulating the VIE structure seems
impractical because any official comments will have a profound and lasting impact
on the market.
This article first appeared in IFLR's sister publication China Law & Practice.