China’s regulations on variable interest entity structure and recent developments

Background to the VIE Structure

VIE Structures came to prominence after Enron used special purpose entities to conceal losses on its balance sheet from its investors in the early 2000s. This prompted the US accounting standards to introduce the concept of the VIE as a consolidation requirement for reporting purposes, in cases where control over a legal entity may be demonstrated through a contractual structure instead of a conventional shareholding ownership. SINA was one of the first Chinese internet companies to rely on such a method of consolidation by establishing a VIE Structure for its listing in the United States.

The primary driver for Chinese companies, aiming to access foreign capital markets, using a VIE Structure rather than a direct shareholding structure is that, Chinese laws have imposed regulatory prohibitions and restrictions on foreign ownership in certain business sectors (such as some areas of the value-added telecommunication services).

In a typical Chinese VIE Structure, the Chinese founder incorporates an offshore holding company in the Cayman Islands, acting as the vehicle / platform for future financing and a public listing (Cayman SPV). The Cayman SPV would then, usually through a wholly-owned subsidiary incorporated in Hong Kong, establish a wholly foreign-owned enterprise (WFOE) in China. The WFOE would enter into a set of control documents with a Chinese domestic company (and its nominee shareholders, such company, the OpCo) with the ultimate effect of allowing the OpCo, operating the business falling within the foreign investment restrictions / limitations, to be controlled by the Cayman SPV / WFOE. The economic benefits generated by the OpCo would also be received by and transferred to the Cayman SPV / WFOE under such a VIE Structure. The VIE Structure is based on a contractual arrangement and the Cayman SPV does not own any equity interest in the Chinese OpCo.

Notable regulatory developments and judicial decisions relating to VIE Structure

It is clear that the Chinese authorities have noticed the extensive use of the VIE Structure by Chinese companies in offshore capital markets. However, to date, the Chinese regulator has neither confirmed nor denied the legitimacy of the VIE Structure as a generally applicable structure, but chooses to examine such structures on a case by case basis in different scenarios – without, to date, a definitive conclusion as to the legitimacy or illegitimacy of the VIE Structure.

Notable regulatory events include:

• In September 2009, the National Press and Publication Administration, the National Copyright Administration and other relevant authorities issued a notice on the administration of online gaming operations, which clearly prohibited foreign investors from conducting online gaming operation business through contractual control arrangements.
• In 2012, the Ministry of Commerce (MOFCOM) issued an anti-monopoly review opinion regarding Walmart’s acquisition of a 51.3 per cent equity stake of a Chinese e-commerce company. Such Chinese e-commerce company was structured as a VIE with operations in value-added telecommunication business. MOFCOM did not raise concerns in terms of a potential monopoly of the market, but specifically prohibited Walmart from acquiring the target company’s value-added telecommunication service business operated through a VIE Structure in China.
• In January 2015, MOFCOM issued a draft Foreign Investment Law for public opinion which introduced the ‘actual control test’ - essentially defining control of a Chinese company through contractual arrangements as a form of foreign investment and therefore subject to the foreign investment regime. This has, however, not been adopted in the official Foreign Investment Law released in March 2019. Accordingly, whether or not a VIE Structure would be caught under the Chinese foreign investment regime remains ambiguous.
• In June 2018 and April 2020, the China Securities Regulatory Commission (CSRC) issued trial measures to allow so-called “red-chip” Chinese companies (i.e. financing platform / vehicle normally incorporated in the Cayman Islands by Chinese individuals but with their main business operations in China, including those using a VIE Structure, the VIE-structured Companies), to apply for listing in China’s capital markets. CSRC has further noted that it will consult with MOFCOM and the relevant competent authority in reviewing the listing application made by a VIE-structured Company. In October 2020, a VIE-structured Company (i.e. Ninebot Limited) engaging in the business of electronic scooters and robotics manufacturing involving provision of value-added telecommunication services successfully obtained the approval from CSRC for the issuance and listing of the China Depositary Receipt (CDR) on China’s Sci-Tech Innovation Board of Shanghai Stock Exchange.
• Between 2021 and 2023, the Chinese authorities released several rules prohibiting investment, through VIE or contractual arrangement, in private schools providing compulsory education, non-profit private schools providing pre-school education, or school-subject tutoring institutions.

We have found very few judicial cases with views on the legitimacy of the VIE Structure. We note one arbitral award rendered by the then Shanghai Sub-commission of China International Economic and Trade Arbitration Commission in 2012 which held a VIE Structure in an online gaming business to be illegal, on the grounds that the Chinese regulator had issued rules prohibiting foreign investment in the Chinese online gaming industry via contractual control (as mentioned above). In 2015, China’s Supreme People’s Court (SPC) considered the legitimacy of an investment agreement, where the buyer had acquired the seller’s private school business through a VIE Structure. The SPC ruled that the investment agreement was valid and enforceable, but stopped short of giving its direct opinion as to the legitimacy of the VIE Structure employed under such investment agreement. The market has since viewed this judgment as a positive sign in terms of China’s judicial body’s attitude towards the VIE Structure.

Recent legislative development on overseas listings by VIE-structured Companies

On 17 February 2023, CSRC released the Trial Administrative Measures of Overseas Securities Offering and Listing by Domestic Companies along with relevant notes and five regulatory guidelines (collectively, the New Overseas Listing Rules), which came into effect on 31 March 2023. Under the New Overseas Listing Rules, VIE-structured Companies seeking an IPO on offshore capital markets must conduct a filing with CSRC, and the possibility of VIE-structured Companies going through such filing with CSRC under the new regime is not ruled out. At a press conference held by CSRC, an CSRC official stated that “CSRC will seek opinions from competent regulator(s) and complete filings for overseas listings by enterprises with VIE Structures in place that satisfy compliance requirements, and will support enterprises in taking advantage of both (onshore and offshore) markets and resources to develop and grow.”

According to the New Overseas Listing Rules and looking at recent applications and cases published by CSRC, in considering the application by a VIE-structured Company seeking a overseas listing, CSRC will examine (through information provided and disclosed by the applicant / issuer), amongst others: (i) the reasons for, and detailed arrangements of, the VIE Structure; (ii) the risks that may arise from the VIE Structure relating to the control over the OpCo, default by relevant parties involved in the VIE Structure and taxes, etc.; and (iii) the measures / mitigants to address such risks. The New Overseas Listing Rules also require the issuer’s PRC counsel to verify and provide opinions on the legitimacy of the VIE Structure.

The market generally believes that CSRC’s stance towards VIE-structured Companies for an IPO filing under the New Listing Rules conveys a positive signal from the Chinese regulator. However, as of the date of this article, we have not seen a VIE-structured Company which has succeeded in the filing with CSRC pursuant to the New Overseas Listing Rules although there are a number of them currently in the waiting / review list of CSRC as published on CSRC’s official website.

We note that a VIE-structured Company named Adicon Holdings (engaging in a generic testing business which is prohibited from foreign investment) was successfully listed on the Hong Kong Stock Exchange (HKEX) on 30 June 2023. We understand from the information in the public domain that Adicon Holdings obtained HKEX’s approval for listing before the effective date of the New Overseas Listing Rules, and was therefore not required to make a filing with CSRC. It remains unclear whether it would be able to go through the CSRC filing should the New Overseas Listing Rules apply to it.

There are different perceptions about how CSRC may handle filing applications made by VIE-structured Companies which operate in business sections prohibited or restricted from foreign investment. Some hold the view that if a VIE-structured Company is ultimately controlled by Chinese individual(s) (either through shareholding structure or board of directors), and there is no material concern from a national security or a cyber security perspective regarding the business conducted by the OpCo, the chance for the VIE-structured Company to go through the CSRC filing is reasonably high.

Given the short period of time after the New Overseas Listing Rules came into effect, it is still too early to tell how CSRC will handle the filing applications made by VIE-structured Companies. We monitor further developments in this area.