Investors of US-listed Chinese internet companies should prepare for a regulatory risk surge brought by a redefinition of “foreign investment” in the proposed Foreign Investment Law. 95 Chinese companies currently listed in the US with Variable Interest Entity (VIE) structures might face legal challenges when the new law becomes effective. However, the draft Foreign Investment Law is not likely to become effective until the end of 2016.
On January 19, 2015, the Chinese Ministry of Commerce (DoC) released a draft of the proposed Foreign Investment Law (FIL) for public comment. The draft FIL was designed to grant “national treatment” to all foreign investors, except for those who invest in sectors on the “Special Administrative Measure List”, or “Negative List.” While the proposed law will generally shorten the FDI procedure in China, the DoC also alters the legal environment of FDI by redefining “foreign investment”. Therefore, existing foreign investments in the “Negative List” sectors that have circumvented the restrictions with structures called Variable Interest Entities (VIEs) are likely to face a surging regulatory risk once the new law becomes effective.
The VIE structure for current foreign investment
Under the current legal framework, companies owned only by Chinese legal persons are regarded as domestic entities and are accessible to the restricted sectors with licence. In other words, any arrangement that ends up with Chinese shareholders owning the company will be eligible to apply for licence in the “Negative List” sectors, such as Internet, Telecommunication, Media, and Education. The VIE structure enables foreign investors to maintain actual control over the target company with a set of contracts, instead of direct ownership. This arrangement enables Chinese companies to bypass the government restrictions and to receive foreign investment.
The VIE structure was first introduced in 2000 when the Chinese Internet company Sina.com was listed in the United States. As an approach to sidestep government restrictions, it has gained increasing popularity among Chinese companies that wish to list abroad. Until 2014, 95 out of the 200+ Chinese companies listed on the New York Stock Exchange and the NASDAQ (including Internet giants like Alibaba, Baidu, Tencent, JD.com, etc.) use the VIE structure.
Changing Risks for VIE structure under the draft law
Despite its wide range of adoption, the VIE structure has never been legally recognized by Chinese law and regulations. For the past 14 years, foreign investors have been worried about risks from this legal vacuum: potential Chinese government crackdown, Chinese company not honoring the contracts, and investigations from the US Securities and Exchange Commission (SEC).
The draft FIL, once it becomes law, will change the regulatory risks of these companies. The draft FIL redefines “foreign investment” as any form of arrangement that exerts foreign “actual control” over the business. The contractual control enabled by VIE structures will therefore be recategorized as “foreign investment” if the government decides that the “actual control” of the company is in foreign hands. Consequently, regulatory risks arise from the uncertainty of Beijing’s standards to distinguish who has “actual control.”
However, for companies that can prove the VIE is controlled by Chinese, this adjustment will bring peace of mind to overseas investors, because it suggests legal recognition of the contractual control in VIE. In other words, if Beijing decides that a VIE is in “actual control” under Chinese legal persons, the regulatory risks VIEs are facing will be significantly reduced.
Action plans to mitigate risks
In order to mitigate regulatory risks from the proposed FIL, companies and overseas investors should monitor the FIL legislation process closely, adjust the management structure, and prepare concrete documentation to prove the “actual control” from Chinese.
Investors should also note that much uncertainty still exists as to where the Chinese regulatory reform on FDI is ultimately heading. As a division of the State Council, the DoC will have to revise the draft with other important regulatory bodies like the National Development and Reform Commission (NDRC) and the State Administration for Industry & Commerce (SAIC) before handing the draft to the National People’s Congress (NPC) for final approval. According to the NPC’s current agenda, the FIL will not be reviewed in 2015. Hence, it is highly unlikely that the Foreign Investment Law will become effective in 2016. Companies still have plenty of time to follow the revisions of the draft.
Moreover, foreign investors who wish to exert stronger control of listed Chinese companies with VIE structures may need to adjust their strategies. Beijing’s incentives behind the draft FIL are to strengthen the control of foreign invested companies by Chinese. Investors should watch for higher risks of regulatory discrimination under the new FIL.
