China’s VIE on path to reform

China’s Variable Interest Entity (VIE) structure, which is used for foreign investment in restricted sectors, looks like it’s on the path to reform, according to Paul Gillis, professor of practice, Guanghua School of Management at Peking University, speaking at PEI’s Asia Forum 2014 in Hong Kong.

Foreign investors must use a VIE structure to invest in China’s lucrative but restricted sectors such the internet, including ecommerce and education, and many Chinese companies listed in the US use a VIE. However, there have been justifiable concerns that the VIE structure is not enforceable.
The VIE aims to control a company through contracts instead of ownership, Gillis said.

“Contracts are put in place with the Chinese company, which is typically owned by a Chinese individual. The contracts try to transfer all rights and benefits of ownership to the [VIE-structured company]. The problem is that sometimes owner doesn’t respect those contracts.”

“We’ve had situations where the VIE and the entire business just disappeared when the founder decided to keep the company and go home, and the investor was left with nothing. Then someone tried to take [a VIE dispute] to court. It got to China’s supreme court which held that these contracts are not enforceable.”

However, at a recent Ministry of Commerce meeting, officials raised the point that a VIE contract does not fall under antitrust rules, he said.

“Internet companies are buying other internet companies and that probably should be subject to antitrust review and the bureaucrats are being cut out of the process, which is something they don’t like.”

In addition, during the Third Plenum meeting last November there was a commitment to revise rules on foreign investment in education and ecommerce, Gillis said.
“We have some hope that rules will be liberalized to get rid of the need for the VIE.”

Gillis, however, added that the VIE historically used to hold the most minimum parts of a business. “With internet companies, for example, you’d see the internet content provider license in the VIE and the rest of business in a Chinese subsidiary of an offshore company that’s listed [a wholly foreign-owned enterprise or WFOE].”

“What we’ve seen over the last decade or so is the disturbing trend of more of the business being conducted in the VIE even though much could be extracted and operated in the WFOE. It’s often easier to run a business by putting all in the VIE, but that’s the riskiest way of doing it.”