Moving towards liberalisation and deregulation?

Transcription

1 Moving towards liberalisation and deregulation? Date: April 11, 2013 Speaker: Ji Zou, Corporate Partner, Shanghai, Allen & Overy LLP Allen & Overy

2 Contents I. VIE Structures II. III. VAM and Put Option Equity Contribution IV. Other Key Updates V. Conclusion and Outlook Allen & Overy

3 Overview What is VIE? To gain control of the PRC operating entities through contractual arrangements (loan agreement, equity pledge agreement, option agreement, voting trust proxy agreement, POA, IP license agreement, services agreement) instead of equity ownership Why VIE? p to circumvent foreign ownership restrictions imposed by Chinese authorities (applicable to restricted and prohibited industries) p to enable round-trip investment without triggering central MOFCOM approvals (also applicable to encouraged and permitted industries) p to consolidate financial statements Examples: Allen & Overy

4 Structure VC/PE MNC Founders Offshore Offshore Holding Co Onshore 100% Loan Share pledge Option, Voting trust Founders/Nominees 100% License (IP) WFOE Services Service fees Op Co Equity Interest Contractual arrangements 4 Allen & Overy

5 Structure Diagram for Neworiental (NYSE: EDU) Shareholders of New Oriental China 81.1% Tiger Global 18.9% New Oriental Education Corporation (Canada) New Oriental Education & Technology Group Inc. (Cayman Islands) Offshore 100% 100% 100% 100% Onshore Beijing Judgment Education & Consulting Co., Ltd. (PRC) Beijing Hewstone Technology Co., Ltd. (PRC) Beijing Decision Education and Consulting Co., Ltd. (PRC) Trusted Nominees 100% Equity Interest Contractual arrangements consisting of trademark license agreements, teaching support agreements, new enrollment system development and service agreements and website development and use agreements, an equity pledge agreement or an exclusive option agreement Beijing New Oriental Education & Technology (Group) Co., Ltd. (PRC) 100% 25 schools in China (PRC) 100% Other subsidiaries (PRC) 5 Allen & Overy

6 Challenge 1: Uncertain Regulatory Environment Historically, VIE is tacitly accepted or at least acquiesced by Chinese authorities Recent Regulatory Development: p Notice on Further Strengthening the Administration of Pre-examination and Approval of Online Gaming and Examination and Approval of Imported Online Gaming (2009): prohibit foreign control over domestic online gaming operators through contractual arrangements [enforcement remains unclear; listing of Taomee in 2011] p Regulation on Implementing the Security Review System for M&As of Domestic Enterprises by Foreign Investors (2011): prohibit foreign investors from avoiding M&A security review through contractual arrangements [we are not aware of any real case as of today] p CSRC internal report to the State Council: require all overseas listings via VIE structure to be approved by MOFCOM and CSRC; existing listed companies are grandfathered p Have not seen official rules Allen & Overy

7 Challenge 1: Uncertain Regulatory Environment (Cont d) Recent Cases: p Buddha Steel case (2011): Buddha Steel failed to be listed on NASDAQ - because Hebei local authorities determined the VIE structure to be against public policy (steel industry is a sensitive sector) p Foreign investors need to consider regional and industrial differences in how VIEs are addressed. p Wal-Mart case (2012): MOFCOM approves the acquisition of Yihaodian by Wal-Mart on the condition, among others, that Wal-Mart will not use VIE structure to engage in value-added telecommunication service currently operated by Yihaodian. p The approval itself does not expressly invalidate VIE structure. However, it is possible that PRC authority could ban the use of the VIE structure in certain key sectors. Allen & Overy

8 Challenge 2: Contract Enforceability Contractual arrangements are more tenuous than outright ownership. The validity and enforceability of the underlying contracts is unclear. We are not aware of any court judgment in this aspect. The risk is that the contracts may be deemed unenforceable on the basis that they subvert public policy. The equity pledge contract is unenforceable if the pledge is not duly registered. p Gigamedia v. Wang Ji (2011): The equity pledge is unenforceable because the management who controlled the chop and business licence refused to register the pledge [Wang Ji has no stake in the foreign parent]. The enforcement of the contracts may be subject to the rights of third parties. p Tudou case (2011): The founder s wife claimed interest in the equity of the VIE in a divorce dispute. The dispute was settled by money compensation from the founder to his wife. Allen & Overy

9 Challenge 3: Loss of Control If conflict of interest arises between the Chinese founder and the foreign investors, the Chinese founder could breach the contracts and take the VIE and licences, which would force the foreign investors to sue to enforce the controversial contracts. p Gigamedia v. Wang Ji (2011): Wang Ji (also the shareholder of the VIE) refused to step down from the management position and took unauthorised control of the VIE and the WFOE through possession of the company / financial chop and business licence. Without these items, the VIE and the WFOE were unable to enter into contracts, conduct banking activities or take any corporate actions. The dispute was subsequently settled and Gigamedia sold its investment. p Alipay (2011): Jack Ma unilaterally terminated the VIE arrangements relating to the domestic company that operates Alipay. The purpose was alleged to meet PBOC s qualification for applying for a payment business permit. Jack Ma and Yahoo and Softbank subsequently reached a settlement. Allen & Overy

10 Challenge 4: Exit Options HK listing p HKSE generally allows the listing using VIE structures, but adopts a heightened review standard p HKSE revised its rules to impose additional requirements on the listing using VIE structures in In case where VIE structures are adopted for unrestricted businesses, the application will be referred to the Listing Committee for decision. US listing p New Oriental (2011): SEC investigated on New Oriental on whether it should consolidate its VIEs. Eventually SEC accepted the consolidation on an expanded PoA. p Three companies (all using VIE structures) got listed in US since September 2011: p VIPshop (B2C website selling discounted brand products) p YY Incorporation (online social platform) p China Mobile Games and Entertainment Group (mobile game and entertainment) Allen & Overy

11 Practical Pointers: Properly structure the VIE arrangements Align the interests of the foreign investors and the PRC founders [Gigamedia v. Wang Ji] Explore possible direct equity ownership Improve the corporate governance of the VIEs; effectively control the onshore assets (including company chops, business licences, bank accounts, key assets, etc.) Seek advice from industrial authorities before setting up the VIE structure Keep a close eye on regulatory development Allen & Overy

12 Contents I. VIE Structures II. III. VAM and Put Option Equity Contribution IV. Other Key Updates V. Conclusion and Outlook Allen & Overy

13 Overview VAM (Value Adjustment Mechanism): An arrangement to secure investor s expected investment return. VAM is commonly adopted in PE/VC investment. Two Common VAM Structures (1) cash payment (a) (compensatory) payment made by the target corp (or the original investors) to the new investors; or (b) (clock-back) payment made by the new investors to the target corp. or the original investors (2) Put option If the target corp fails to meet certain financial objectives, the new investor may put the equity the original investors at pre-agreed price. Allen & Overy

14 Effectiveness Effectiveness of option arrangement Generally effective, subject to approval by local ministry of commerce (MOFCOM) involving foreign invested enterprises (FIEs). Note: put option can only be agreed between the original investors and the new investors, as PRC law has restrictions on the company s redemption of its equity interest from its shareholders (unless in limited statutory circumstances). Effectiveness of cash payment arrangement Effective if the payment is made by the shareholders; ineffective for the target company to be the payment obligor. Allen & Overy

15 Cases Case #1 - Haifu vs. Shiheng/Wisdom - Cash Payment Background New investor (Haihu), target corp (Shiheng) and existing investor (Wisdom) agreed on the VAM arrangement that if target corp fails to reach the agreed profitability post new investor s investment, new investor would be entitled to a cash compensation calculated in accordance with the agreed formula against target corp and further against existing investor if target corp fails to pay the cash compensation. In December 2009, Haifu brought an action before the Intermediate Court of Lanzhou, demanding a compensation in the amount of RMB 19,982,095 from both the target corp and existing investor. Judgment The Intermediate Court of Lanzhou and the Superior Court of Gansu Province held that the VAM arrangement was invalid. The key reason is that the arrangement was intended to provide a guaranteed return to an investor, which is against the fundamental principle under the PRC law. In November 2012, The Supreme Court review finally ruled that : (i) the agreed compensation from target corp to new investor was invalid as this was a guaranteed return which impaired the interest of the target company and its investors; and (ii) the agreed compensation from existing investor to new investor was valid and enforceable as there was no damage to the interest of the of the target company and its investors and did not violate any PRC laws. Allen & Overy

16 Case #2 Put Option A Beijing case Put Option (2009) In an earlier case heard by Beijing Haidian District People s Court in 2009, the validity of a put option in an equity transfer agreement was upheld by the court. Under the agreement, if the target corp incurs losses for two years in the following three years, the original investor (i.e. the transferor) shall unconditionally buy back all the equity interest held by the new investor (i.e. the transferee) at a price equals to the purchase price plus interest. The Court held that the ratchet clause did not violate any mandatory provisions of the PRC laws and the parties' freedom of contract should be respected. This is a domestic company with no foreign investment. But it confirms a put option arrangement Allen & Overy

17 A few key points: An VAM (including put option) against the shareholders of the target corp would be recognised; An VAM against the target corp itself will not be recognized Enforcement of a put option is subject to government approval and cooperation of copartners (e.g. to obtain the requisite unanimous board consent for the contemplated equity transfer and to execute the equity transfer agreement). PE/VC investors need to rely on due diligence vis a vis VAM arrangements. Allen & Overy

18 Contents I. VIE Structures II. III. VAM and Put Option Equity Contribution IV. Other Key Updates V. Conclusion and Outlook Allen & Overy 2013

19 Overview Tentative Provisions on Equity Contribution involving Foreign-Invested Enterprises ("MOFCOM Rules"), effective on 22 October The MOFCOM Rules apply to the situations where the Company invested is: newly established as an FIE (Scenario A); converted into an FIE from a purely domestic company through capital increase (Scenario B); an existing FIE but its shareholdings changes through capital increase (Scenario C). Requirements on Equity Contribution clear and complete title to the equity or shares for capital contribution. Equity Company shall not be a a real estate enterprise, a foreign invested holding company or a foreign invested venture capital equity investment enterprise The equity interests or shares of the Equity Company must be legally transferable. Not allowed under certain circumstances, including: equity interests/shares not paid in full; subject to pledge; frozen by the competent authority; Equity Company fails to pass the annual inspection. Allen & Overy 2013

20 Applicable Structures Scenario A Pre-investment Post-investment Foreign Investor Foreign Investor Offshore Offshore PRC Establishment via Equity Contribution PRC Invested Co (FIE) Equity Co (FIE) Invested Co Invested Co acquires equity in Equity Co through onshore Equity Contribution Equity Co Allen & Overy 2013

21 Applicable Structures Scenario B Pre-investment Post-investment Foreign Investor Foreign Investor Offshore Offshore PRC Chinese Investor Capital Increase via Equity Contribution PRC Chinese Investor Invested Co (FIE) Invested Co Equity Co (FIE) Invested Co acquires equity in Equity Co through onshore Equity Contribution Equity Co Allen & Overy 2013

22 Applicable Structures Scenario C Pre-investment Post-investment Foreign Investor Foreign Investor Offshore PRC Capital Increase via Equity Contribution Offshore PRC Invested Co (FIE) Invested Co (FIE) Equity Co (FIE) Invested Co acquires equity in Equity Co through onshore Equity Contribution Equity Co Allen & Overy 2013

23 Relevant Issues Share swap Applicable to the investment through onshore share swap where a foreign investor (buyer) uses the equity held in an Equity Company (usually an FIE) as the consideration to acquire the equity held by the seller in an Invested Company. Valuation Requirements Equity contribution to be appraised by a Chinese valuation firm. Contributed registered capital shall not exceed the valuation price. Foreign Investment Restrictions No circumvention of foreign investment restrictions by using equity contributions. If there is any conflict with the foreign investment restrictions, the parties should divest relevant assets or transfer relevant equity before they apply for the equity contribution. Opportunity Provides additional investment channels and allows investment/reinvestment through equity contribution to facilitate asset restructurings and mergers. Reduce restructuring related costs Tax treatment not yet clear. Allen & Overy 2013

24 Contents I. VIE Structures II. III. VAM and Put Option Equity Contribution IV. Other Key Updates V. Conclusion and Outlook Allen & Overy

25 Overview Further Adjustments to Measures for the Administration of Foreign Exchange for Direct Investment ( SAFE Circular 59 ), effective on 17 December administrative approvals are removed 14 administrative approvals are simplified most pre-approvals for routine operations are downscaled Generally, SAFE Circular 59 is for the purpose of simplifying administrative procedures, increasing efficiency, cutting costs and improving the domestic investment environment. Lending offshore becomes feasible An FIE is allowed to provide a loan to its overseas parent company, by way of undistributed profit to its overseas parent company. Approved offshore lending is limited to the overseas parent company s share of profit in the Chinese subsidiary, which is the sum of the subsidiary s dividends payable and undistributed profits. FIEs making losses or breaking even, including those with excess cash, still lack the practical means to finance foreign related parties with excess domestic cash. Allen & Overy

26 Employment & Data Protection Judicial interpretation rules relating to labour disputes in the PRC (effective on 31 December 2012) Non-compete and compensation: if an employee has performed non-compete obligation but no compensation is provided or agreed, the compensation shall be no less than 30% of the average monthly salary of the last 12 months prior to the termination of the labour contract. Modification / alteration of a labour contract by oral agreement will be held valid, if the contract has been actually performed by both parties for one month. Foreign employee s employment relationship will not be protected, if he fails to obtain a working permit before entering into a labour contract. Guidelines on the protection of personal data protection processed by public or commercial information systems issued by the State Standard Administration Committee, effective on 1 February 2013 Only applicable to data processed by automated means (e.g. various computer information systems). Service Providers are limited to public or commercial entities Not compulsory national standards but merely "recommendations" for Service Providers. Good attempt for future private data protection legislation Allen & Overy 2013

27 Dispute Resolution Amendments to the Civil Procedure Law (effective on 1 January 2013) strengthens the Chinese arbitration regime in two important respects: Narrowing the statutory grounds upon which PRC courts can refuse enforcement of domestic arbitration awards; and Allowing parties to arbitration proceedings to apply to the PRC courts for interim measures before the commencement of those arbitration proceedings. CIETAC Dispute CIETAC headquarters in Beijing has recently issued a notice forbidding the CIETAC Shanghai and Shenzhen sub-commissions from accepting arbitration claims or conducting arbitrations. Until that issue is finally resolved, it is recommended to leave the venue blank (under the latest version of the CIETAC Arbitration Rules, the arbitration will be submitted to Beijing) or, to avoid any confusion, clearly specify CIETAC Beijing. Allen & Overy 2013

28 Contents I. VIE Structures II. III. VAM and Put Option Equity Contribution IV. Other Key Updates V. Conclusion and Outlook Allen & Overy

29 Conclusion and Outlook Small steps toward liberalization for foreign investment, but no substantial changes No substantive change in terms of foreign exchange control on direct investment. Allen & Overy

30 Questions? These are presentation slides only. The information within these slides does not constitute definitive advice and should not be used as the basis for giving definitive advice without checking the primary sources. Allen & Overy means Allen & Overy LLP and/or its affiliated undertakings. The term partner is used to refer to a member of Allen & Overy LLP or an employee or consultant with equivalent standing and qualifications or an individual with equivalent status in one of Allen & Overy LLP's affiliated undertakings. Allen & Overy