In 2013, Alibaba Group went public on the Nasdaq stock market. With its sky rocketing sales revenue and profit, Alibaba is a clear winner. A key reason in Alibaba’s success is its effective use of foreign capital and know-how. But the Chinese government restricts foreign investment and control of the TMT industry. So how did Alibaba take advantage of foreign investment in such regulatory environment? The answer lies in its variable interest entity (VIE) structure.
This structure has become commonplace and is issued by many of China’s most well-known technology giants. Companies that use VIE structure include Baidu, Focus Media, New Oriental and Sina. On Jan 19, 2015, China’s Ministry of Commerce (MOFCOM) released for public comment a draft Foreign Investment Law (FIL) along with an accompanying explanatory note. FIL would shake up the legal landscape of technology start ups in China. But so far, MOFCOM has not come out with a final version of the regulation. Many investors are asking what will happen to foreign investment in China.
The draft FIL contemplates a paradigm shift in China’s approach to the regulation of incoming foreign investment, which will have a significant impact on technology companies. Most notably, it may eliminate the VIE structure, the legal structure under which most Chinese high-tech companies are organized. The VIE structure is also adopted by foreign-invested PRC companies in industries with foreign investment restrictions, such as the TMT industry.
A typical VIE structure involves an off-shore holding company (a special purpose entity, “SPE”) commonly registered either in the Cayman Islands or the British Virgin Islands. The offshore SPE is owned by foreign investors and PRC founders. The offshore SPE then holds 100% ownership of a Hong Kong registered SPE, which then owns 100% of a wholly owned subsidiary (WFOE) in China. Domestically, the PRC founders would then set up a VIE that they directly own. This VIE would hold licenses and assets that cannot be legally owned by foreign investors, such as telecommunication licenses. The WFOE would have full control and receive the complete economic benefit of the VIE through a series of contractual arrangements.
The draft FIL focuses broadly on the control of a domestic enterprise and its inclusion of “arrangements that effect control of a domestic enterprise through contracts, trusts and other means” associated with foreign investments. Thus, the draft FIL will directly regulate VIEs. A comment in a Note discusses existing contractual control structures, clearly directed at VIE structures. This comment suggested both registration and approval as potential options for regulating VIE structures, depending on whether they are Chinese or foreign-controlled. Such control related provisions will prevent the use of VIE structures that allow foreign control.
Currently, VIE is essentially used to by pass de facto prohibitions on foreign investment in TMT and other industries under PRC regulations. Even though the draft FIL did not include specifics on how it applies to VIE structures, the control related provisions suggests that the PRC government may exert tighter regulation and possibly eliminate the VIE structure. Thus if FIL is implemented, foreign investors may face challenges in trying to gain control of Chinese companies in the high-tech industry. Since the Chinese stock market crisis last year, FIL has been postponed until indefinitely. However as the Chinese stock market stabilize and many Chinese companies leaving the US stock exchange, the Chinese government may roll out the FIL regulation. Thus moving forward, what will FIL brings to the Chinese TMT industry. We await to see whether it will foster more domestic tech winners or limit the technology industry as a whole?