China continues to bar foreigners from ownership in many sectors of the economy that are considered particularly sensitive from the standpoint of national security. The internet is one such sector where direct foreign ownership is prohibited.
Yet it is well known that virtually the entire internet sector has been funded by initial public offerings (IPOs) in overseas markets, making foreign investors the owners of many companies in this sensitive sector – in direct violation of the clear provisions of the law. New regulations recently promulgated by the Ministry of Commerce (MofCom) suggest that this unusual situation has reached its end.
This trick was managed by use of what is known in the US as a Variable Interest Entity (VIE). Under a VIE structure, a Chinese internet provider is effectively owned by a foreign entity through the use of a complex set of contractual arrangements rather than through ownership of stock. The control is so total and complete that the arrangement is considered the equivalent of ownership under US accounting rules.
New internet order
On September 1, the Regulation of the Ministry of Commerce on the National Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the Regulations) became effective. The regulations provide the long-awaited procedures for national security review for foreign-related merger and acquisition activity that is required under the recently promulgated PRC Anti-Monopoly Law. To the surprise of many, the Regulations also took direct aim at the VIE procedure.
The provisions are deceptively simple. Article 9 of the Regulations provides that it is not permitted to make use of “contractual controls” to evade the requirements of Chinese law that would otherwise restrict or prohibit foreign investment in a sensitive sector. This is a clear prohibition against the use of VIE structures. Since the whole goal of VIEs here is to hide foreign investment from Chinese regulators, it is likely that such structures will not be caught by national security review at the outset of the investment.
To deal with this issue, Article 10 of the Regulations provides that where such contractual controls are used but not reported to the Chinese regulators, the parties involved have the independent duty to immediately terminate the offending conduct. If the parties do not take action on their own, the regulators have the authority to order the immediate termination of the offending investment by whatever means necessary.
What does this mean for foreign investors in China? Many investors persist in the belief that existing VIE structures are sound and that such arrangements can still safely be used in the future. This has always been a mistaken analysis of Chinese law, and the new regulations make that clear.
The immediate impacts are numerous and serious. First, IPOs in the internet sector that explicitly rely on a VIE structure are clearly under a cloud and are quite properly being delayed or cancelled.
Many investors have proposed expanding the VIE structure for foreign IPOs in other restricted sectors of the Chinese economy, such as telecom and medical services. It is now clear that this expanded use of the VIE structure in China will not succeed.
The Regulations show that existing foreign investment in the internet sector is built on a shaky foundation. It is clear that Chinese regulators have the legal authority to step in and order that all of these investments be terminated. Even if this drastic step is not taken, it is equally clear that existing contractual arrangements are in violation of Chinese law. This renders the contracts unenforceable and VIE structures essentially meaningless.
None of this is actually new; these risks have long been known. However, the clarity of the Regulations means that there is no longer any place to hide by claiming that Chinese law on these issues is ambiguous or unclear. Where Chinese law says that ownership by foreigners is restricted or prohibited, the law means what it says.
Foreigners who invest in violation of the law are making a bet that the violation will be ignored. In today’s China, this is extremely unlikely.
Steve Dickinson is a partner with Harris & Moure PLLC in Seattle, Washington and Qingdao, China