In Focus: Variable Interest Entities (VIEs)-Part I

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1 1 In Focus: Variable Interest Entities (VIEs)-Part I Introduction Over the past several months, a number of developments have generated growing concern about variable interest entities ( VIE ) within PRC legal and investment circles. First, in August 2011 PRC authorities released the Provisions of the Ministry of Commerce on Implementing a Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors for the new national safety review of mergers between foreign invested companies and domestic companies in certain sectors. Language in these guidelines suggested that investment made through VIEs by foreign investors may also be subject to the national safety review. Second, a dispute between Alibaba Group Holding ( Alibaba ) and its major shareholder, Yahoo Inc. ( Yahoo ), concerning Alibaba s unauthorized spin-off of Alipay, its valuable online payment subsidiary. Yahoo invested in Alibaba through a VIE. According to the Interpretation of Non-financial Institution Payment Service Management Measures issued in 2010 by the People s Bank of China, a foreign invested payment service company must be approved by the State Council before it can obtain an operating license; if such a company fails to obtain an operating license before September 1, 2011, it may no longer engage in the payment service business. According to the chairman of the board of Alibaba, the spin-off sought to isolate Alipay from Alibaba, with its ties to Yahoo, a foreign investor, to ensure it will be treated as a domestic company during the review by the People s Bank of China. Third, in March of 2011, Buddha Steel, a PRC steel firm, withdrew its planned US$38 million public offering and listing on Nasdaq at the last minute. As the reason for its decision, the company stated that local authorities had determined that the VIE arrangements it used to structure the offering were against public policy. Fourth, a white paper titled Report Concerning Overseas Listings of Internet Companies such as Tudou was reportedly prepared by the China Securities Regulatory Commission for close circulation in high level government circles. The report, which uses the NASDAQ listing of Tudou, a PRC video sharing website, as a case study, is said to analyze the factors driving domestic firms to adopt VIEs, underscore the growing heavy reliance of China s high technology firms on foreign capital markets, and raise alarm about the deceptive and silent transfer of tens of billions of dollars worth of tangible assets into offshore shell companies and the spreading use of VIEs by domestic companies in traditional industries. The report reportedly calls for the authorities to prohibit the use of VIE contractual control by new companies but grandfather the use of domestic companies with a VIE structure that have already obtained an offshore listing. It also reportedly recommends that more support be offered to well-known domestic internet companies

2 2 to go public in the domestic A-Share market and that internet firms that are temporarily unable to launch a domestic public offering be permitted to directly list on overseas markets. Finally, the chairman of the China Securities Regulatory Commission ( CSRC ), Mr. Guo Shuqing, recently stated that the CSRC is researching regulations aimed at supervising VIEs. He offered no further details, but his comment was significant as this marked the first time that the CSRC has expressly stated any interest in regulating VIEs. VIE Origins To understand the origin of VIEs, it is first necessary to discuss consolidation of financial statements. Under GAAP, an entity that has a controlling financial interest in another entity must consolidate and report the assets and liabilities of the latter in its own financial statements. For many years, financial interest was defined as equity ownership, and a controlling financial interest was simply one in which one entity held more than 50% of the voting interests of another entity. This is referred to as the voting interest model. The sudden and spectacular decline of U.S. energy trader Enron in 2001 demonstrated that relying solely on the voting interest model to assess the need for consolidation of financial statements was not entirely reliable. In particular, Enron was found to have used numerous offshore special purpose vehicles ( SPV ) to hide its enormous debts and liabilities. Enron exercised de facto control of the SPVs through means other than voting interests, including but not limited to contractual rights and securitization. Accordingly, under the voting interest model, Enron was not required to consolidate these losses in its financial statements. After the Enron scandal, the US Financial Accounting Standards Board reviewed the existing accounting principles and promulgated important changes. First, it recognized that a controlling financial interest can exist based on factors other than voting interests. Second, it provided guidance as to when the voting interest model should not be used to determine controlling financial interest. And third, it put forth a new model for assessing controlling financial interest in such cases. This new model, known as the risks and rewards model, provides that a party who participates in the majority of the entity s economics must consolidate the entity s operation in its financial statements. Significantly, the party can be an equity holder, but it can also be a lender, guarantor, or a contractual counter-party, and the other entity the one providing the equity, borrowing the money, making the guarantee or subject to the contractual obligation is a VIE. The Use of VIEs in China The Chinese internet-media giant Sina Corporation (Sina) was the first domestic enterprise to utilize a VIE to complete an offshore public listing. According to Sina s offering prospectus, by using a VIE structure, it managed to avoid

3 3 triggering an official review for violating China s regulatory restrictions on foreign investment in internet-related businesses. The Sina VIE structure In simplified terms, Sina s VIE structure had three basic components: an offshore structure, an onshore structure, and a series of contracts executed between the onshore structure and one or more unaffiliated domestic companies and their shareholders. The offshore structure consisted of a Cayman holding company and a Hong Kong company. The former served as the listing vehicle and the point of investment for foreign investors. The latter, a wholly owned subsidiary of the Cayman company, held the equity interests in the onshore structure. The onshore structure initially consisted of a single company, Beijing Stone Rich Sight Information Technology Co., Ltd. ( BSRS ), a Sino foreign equity joint venture, which is one form of foreign invested enterprise ( FIE ). BSRS was established by the Hong Kong Company and a PRC domestic enterprise established by one or more of Sina s PRC founding shareholders. BSRS provided internet content and sold internet advertising, both regulated activities requiring a license. Prior to its listing, Sina modified the onshore structure by restructuring equity and business. First, two new PRC domestic companies were created: Beijing Sina Information Services Co., Ltd. ( Sina Information ) and Sina Interactive Advertising Co., Ltd ( Sina Advertising ). The former was established as a stand-alone domestic company by Sina s founding shareholders, while the latter was established as an equity joint venture by BSRS, as a minority shareholder, and a Sina founding shareholder. Next, Sina had BSRS transfer its internet content provider business, including assets and business license, to Sina Information. It also had BSRS transfer its internet advertising business and license to Sina Advertising. Following the transfer of these business operations, the third component of Sina s VIE structure came into being as BSRS executed a number of contracts, including software technical services agreements, consulting services agreements, and share pledge agreements, with each of the new companies. Under these agreements, Sina Information would operate the Sina website ( and sell advertising space to Sina Advertising, and Sina Advertising would sell online advertising space to third parties. BSRS, in turn, would provide contract technical services, consulting and other services to both companies. The fees paid to BSRS by Sina Information and Sina Advertising consumed substantially all the companies annual revenue. Furthermore, because of the contracts, BSRS could control Sina Information without holding equity. It could also exercise a greater degree of control over Sina Advertising than was possible based solely on its minority equity position. The following is Sina s equity holding and VIE structure at the time of its listing.

4 4 SINA.COM (Cayman) 100% 100% 100% 100% Offshore RSIL (HK) SINA HK (HK) SINA Online (USA) SINA Ltd. (BVI) Onshore Beijing Stone 97.3% Zhidong Yan 2.7% 70% 30% BSRS 25% Contractual Control Business Agreements Contractual Control Sina Information Sina Advertisement 75% Zhidong The development of the VIE Structure Inspired by the success of Sina s listing, other Chinese companies, notably many internet related firms, including Sohu, Baidu, Dangdang, also adopted a VIE structure to pursue overseas public listings. According to one assessment, from 2000 until now, some 250 domestic enterprises have used VIE structures to complete offshore public listings. More recently, 34 of the PRC domestic enterprises pending approval for a U.S. public offering in 2010 used a VIE structure. Again, the key attraction of a VIE structure, especially for firms operating in restricted or prohibited sectors, is the ability to attain an overseas listing and foreign investment without the need tp obtain for PRC government approval or review. The foreign financing, which includes PE investment and listing proceeds, reaches the domestic enterprise through the FIE. Typically, a foreign enterprise extends financing to the FIE in the form of capital increase or shareholder loans, and the FIE then makes a loan to one or more individual shareholders of the domestic enterprise. The shareholders then cause the domestic enterprise to increase its registered capital and apply the loan proceeds to the increase. As collateral for the loan, the shareholders execute share pledge agreements, offering some or all of their equity in the domestic enterprise to the FIE. They also execute share sale agreements with the FIE that give it the exclusive right to acquire the equity when the law permits. In the interim, the technical services agreements require the domestic enterprise to pay fees to the FIE, which it pays out as dividends to its foreign investors.

5 5 Despite lingering doubts about the long term viability of the VIE structure, VIEs remain a popular choice for domestic enterprises to work around PRC restrictions on foreign investment to facilitate an offshore listing. In the U.S., where the principles of full disclosure by issuers and informed independent judgment by investors govern the securities market, the use of VIE structures by Chinese companies is not a barrier to listing on U.S. markets provided that the accompanying PRC legal opinion expressly opines on whether the contractual control is in compliance with PRC law. And in Hong Kong, use of a VIE structure does not render a PRC issuer unsuitable for listing if the issuer fully discloses the contractual arrangements in its prospectus and if the issuer can demonstrate the legality of and its ability to effect enforcement of the contractual arrangements. The Dispute over VIEs VIEs have proved to be a double edged sword. On the one hand, by using VIEs, hundreds, of domestic enterprises, including many promising next generation firms, have been able to access major global capital markets, giving them additional sources of funding and enabling them to build a global presence. On the other hand, VIEs enable foreign investors to circumvent Chinese government foreign investment approvals and regulations and to participate in domestic industries restricted or prohibited to foreign investment, which presents a substantial direct challenge to the national administration of foreign investment and, arguably, economic security. Summary Since current laws and regulations prohibited or restricted foreign investment in some domestic industries, many domestic enterprises adopted the contractual control of VIEs to access foreign investors and capital markets. Adoption was particularly strong among domestic firms in sensitive sectors with high growth potential, such as internet, education, and advertising. In Part 2 of this In Focus series, we will take a closer look at some of the key laws and regulations driving interest in VIEs among domestic firms and some of the latest government initiatives aimed at putting additional pressure to discourage this practice.