How Foreign Companies Use a VIE Structure to Operate in China

Welcome everyone to the second edition of the China Tech Law Newsletter! With your support this newsletter is quickly approaching 2,000 subscribers!

So let's get right into today's topic - how foreign tech companies use VIE structures to operate in China. These structures have been around forever in China, but now they are making the front page of major global media publications on a routine basis. So what's going on here?

I touched on this a bit in the first newsletter edition two weeks back. These structures are workarounds for foreign owners to access some of the key licenses (such as the ICP license discussed last time) which are otherwise off limits to direct foreign ownership. If a foreign technology company primarily conducting its product offering over the internet requires an ICP license, a VIE structure is one of the few ways for it to get that license. Without that license, its business will be at best operating in a gray zone for compliance with local regulations and at risk of being shut down. This is why the VIE is so important and so commonly used.

VIE structures are indirect ownership structures which are put together in relatively plain view of regulators here and, while never officially endorsed, are tolerated and even tacitly acknowledged on occasion in regulations which have come out over the years. More on that below. In fact, each time a major piece of relevant law comes out on foreign investment, we are looking to see what if anything they say about VIEs to get a clue into the regulators' thinking.

What exactly is a VIE?

VIE stands for "Variable Interest Entity". The VIE was originally conceived long ago as an accounting term for when one company was de facto controlled by another group of companies such that its financial results were consolidated into the larger group for financial reporting purposes. As if it were actually a subsidiary of that group, even though not actually owned by that group.

Why would anyone want a complicated structure like this? Well as it turns out, a few enterprising attorneys, accountants, and investment bankers creatively capitalized on the VIE model to start finding a way for Chinese internet businesses to raise funding in foreign currency (USD) from venture capital investors, and eventually list for an IPO outside of mainland China in Hong Kong or on NASDAQ in the US - Sina, Netease, and Alibaba are notable examples. Where they could hold the key domestic licenses but still take foreign investment and be foreign-owned. The model is now extremely widespread and an open secret with regulators, including the Ministry of Industry and Information Technology which issues the ICP license for such businesses.

Let's look at the example below on Meituan-Dianping, a popular "super app" in China offering all kinds of services, most notably food delivery. We can see that an offshore company (often a Cayman company), directly or often with a Hong Kong holding company in between, establishes a wholly-owned subsidiary in China (or what we commonly refer to here as a "wholly foreign-owned enterprise" (WFOE)).

The WFOE funds, typically, two Chinese nationals as nominee shareholders to establish a domestic company to apply for and hold the key licenses in China. The WFOE and the domestic company with the licenses then enter into a series of contractual arrangements through which the after-tax profits of the license-holding company are transferred to the WFOE.?These agreements may include a consulting agreement, an intellectual property rights licensing agreement and other arrangements. This takes care of the financial results for purposes of group consolidation by the auditors.

To ostensibly lock-up these nominee shareholders, the WFOE and the shareholders enter into additional agreements which include an equity pledge agreement in which they pledge all of their equity interests in the license-holding company to the WFOE. Oh the irony here. Because not only is enforcing such pledge relatively difficult in practice, it would perhaps even be suicidal in making the company then "foreign-owned" and no longer eligible to hold the licenses for which it was originally established. That is unless other more reliable nominee shareholders were ready to step in.?

The nominee shareholders also execute undated letters of resignation from the board of directors, and proxies and letters of authority authorizing the WFOE to take certain actions on behalf of the nominee shareholders.?The WFOE will have an option agreement with the right to purchase, or designate someone else to purchase, all of the equity in the license-holding company.?This takes care of the control aspect for purposes of group consolidation by the auditors.

The business contracts with the company and equity pledge and other contracts with the shareholders together gives the WFOE (and its offshore parent structure) ultimate control over the license-holding company to the point that the auditors sign off on consolidation of its results when the group is ready to IPO.

Meituan Example

You might be asking by now, what does this have to do with foreign companies which are not the next Alibaba planning an IPO for a China business? Bear with me, we're getting there - we first need to understand how its used by Chinese internet founders to lay the groundwork for how foreign companies piggy-back off this experience.

First let's look at the below case of Meituan-Dianping (current market cap US$170 billion!) with a relatively simple VIE structure. What has always been an interesting, and now ever more publicly discussed point, is the ultimate reliability of these structures. Disclosures like the one below by Meituan to the investing public are required and nothing new, yet few investors take notice or care about how risky they might appear. A fact that the SEC has started to make more and more noise about as well.

In this particular case, Dianping (a listings platform in China similar in part to Yelp) was acquired by Meituan in 2015. But it had not yet updated its local VIE nominee shareholder structure to swap out the old Dianping founders as nominee shareholders to the Meituan founders as new nominee shareholders. The swapping of those two sets of founders is what's going and being publicly disclosed to Hong Kong listing authorities and the general public in the before and after charts below.

OK, now we can start to get into the some of the practical differences for "Chinese" versus "foreign" VIE structures. A VIE structure works for many Chinese internet companies because the founders own equity at both the onshore and offshore levels. Wang Xing (pictured here) is the principal founder of Meituan (and owner of 11.44% at the time of IPO).

A huge portion of the value lies in the company with the key domestic license or licenses, suggesting there might be some incentive for nominee shareholders not to play ball, disregard the control contracts discussed above (whose ultimate enforceability has always been questioned), and run the business on their own (or at least threaten to). However, because they own equity at the offshore level as well, there is more than enough incentive for the Chinese owners to be well-behaved nominee shareholders at the local level.

Don't get me wrong, there are cases of things going bad. We do not have enough room to cover it here, but the (in)famous case of Jack Ma and the "carveout" of Alipay from the Alibaba group structure (much to the chagrin of Alibaba's two major foreign shareholders - Yahoo and Softbank) is a rare and public case of a VIE structure gone wrong. Let's save that story for another newsletter edition.

KEY PRACTICE NOTES - The Challenges Foreign Companies Face on VIEs

By now you're probably able to guess what comes next - the challenge that foreign companies face in piggybacking off the VIE experience of the Meituan's of the world is with finding the right nominee shareholders. These companies are not using VIEs to do a "red chip" offshore IPO on the back of a local China internet business. The founders of the company are most certainly foreigners themselves (so ineligible to be nominee shareholders) or out of the picture completely, and the venture in China is of course also new and perhaps one of many markets the foreign company competes in.

A foreign company coming to China will certainly look to hire local talent to manage the local China business, but these managers will not have sufficient skin in the game through equity at the offshore level to have the same alignment as Wang Xing does with Meituan's VIE structure. You as a foreign company also have to ask yourself, do you want to give a new local GM hire such control and leverage over the local structure when you may need to ask that person to leave later for poor performance reasons?

For most clients we work with in restricted industries where difficult licenses are required, however, a VIE structure is rarely the first step taken (although it is often part of the long-term plan). What we typically recommend is working with a partner who does have an ICP license (discussed briefly in my last newsletter) or setting up a WFOE first and testing for product-market fit before then setting up a full VIE structure and applying for the proper licensing on your own.

As I have counseled many clients, the rules surrounding the strict need for some of these licenses (such as ICP) are never black and white, and in the beginning you do often have leeway and some argument if ever challenged as to why you have not yet obtained the license. Regulators are not 24/7 scanning the business landscape for cases of companies (foreign or otherwise) which are not compliant when "compliant" itself is never clearly defined in the first place.

At this early stage in your company's lifecycle in China, you need a logical and coherent story to tell if questioned by the regulators or someone else. It does not need to be a bullet proof story. It needs to be a plausible story. The worst thing to do is to say you didn't know there was a legal license out there in your industry. The better thing to say is you did the analysis with the help of legal counsel and came to the conclusion that a license may not be needed because of reasons A, B, C. If they feel you do need such license, OK, you'll get the application started immediately (or better yet, you already have started!). That process could then ultimately include setting up the domestic license entity and linking it through VIE control contracts to your current WFOE.

The Future of VIEs

Expanding on what I talked about in the last newsletter edition, the future viability of VIE structures is always under some question. But they have survived for over 20 years now and still have far too much inertia to be declared illegal and unwound anytime soon.

What we do is take cues from how VIEs are discussed directly (rare) or indirectly (sometimes) in major regulations that come out from time-to-time.

Example 1: The 2020 Foreign Investment Law

An early draft of the Foreign Investment Law mentioned VIE structures with references to foreign investors controlling or holding the rights of a domestic company by means of contracts, trusts or other methods being considered foreign investment. But the wording was removed in favor of more vague language on the need for government supervision in the final version which became effective on January 1, 2020. This was seen as a "win" by VIE fans who feared restrictions under the new law.

Example 2: The 2022 Foreign Investment Negative Lists

The "red-chip" structures used for offshore IPOs described above in the Meituan example are discussed in the most recent Foreign Investment Negative List. Traditionally red-chip VIE structures were used to avoid the negative list restrictions on foreign investment. But the revised negative list calls out requirements for domestic companies needing government approval before listing abroad and that overseas investors must not participate in the management of the local company.

Arguably a VIE structure with the foreign parent's control over the WFOE, which in turn has control over the local company, could constitute participation in the management of the local company. However, this would not mean that such structures are prohibited, just that they cannot automatically list overseas for an IPO. Again, VIE proponents will view this continued tacit acknowledgement as a glass-half-full win.

Example 3: 2022 CSRC Rules on Overseas Listings

Recent rules laid out by the China Securities Regulatory Commission allow for filings to be made to CSRC even for companies which indirectly list overseas, a clear reference (based on the requirements in the rules) to VIE structures. This is a continuation of CSRC's acknowledgement and attempt to get more control and visibility over red chip structure IPOs.

Example 4: 2021 Education Sector Implementation Rules

The education sector has long been on the fringe of what was openly tolerated by regulators for foreign investors using a VIE structure. Recent rules in 2021 sought to further prohibit foreign ownership (including control) of certain education businesses and raises questions whether VIE structures (especially for private schools) would be fully covered and forced to unwind/restructure. Pundits have long been viewing the private education sector as the most aggressive application of the VIE model and the most likely to be outright banned, given how sensitive the sector is from the government's perspective.

As I mentioned in the first newsletter, folks have consistently predicted the death of the VIE, yet it is still on balance a workable solution for foreign companies especially in non-controversial industries. Education was always on the front line as the next target, and the new restrictions last year should come as no surprise.

Here its important to look at broader macro policy. Data security and data privacy are high on the government's priority list, especially starting from last year. But B2B SaaS applications are on solid ground because a VIE structure does nothing to reduce the need to comply with a whole host of new data regulations. Companies which have specific requirements under the laws, such as local data storage in China, will have to comply with these regulations and if necessary change their business model and IT infrastructure accordingly. That is the cost of doing business in a market with so much potential, and a cost and requirement our clients are willing to accept and comply with when necessary.

OK, thanks for making it to the end here. I have to say its been real fun to write the first two editions, and I really have to credit my friend and colleague Robin Tabbers for inspiring and pushing me to write this.

Stay tuned for another edition of the China Tech Law Newsletter in 14 days, and if you haven't already PLEASE SUBSCRIBE and SHARE!