CHINA'S LEAKED CSRC REPORT FIVE YEARS LATER: BASELINE FOR VIE TRAJECTORY?

• Author: Brown, Ian Emerson
• Position: Chinese Securities and Regulatory Commission, variable interest entity

1. INTRODUCTION II. OVERVIEW OF THE VIE STRUCTURE A. VIE Practice in Context of China B. Breakdown of the VIE Structure III. TRAJECTORY OF THE VIE STRUCTURE IN CHINA A. VIEs Have Provided a Necessary Safety Valve B. Tide is Turning Against VIEs C. Draft Foreign Investment Law D. Potential Regulatory Trajectories IV. CSRC REPORT OF 2011 A. Policy Recommendations B. Implications V. Analysis of Government Actions A. China's Carrot-and-Stick Strategy: Stick B. China's Carrot-and-Stick Strategy: Carrot C. Summary VI. CONCLUSION I. INTRODUCTION

   Over the course of the past decade, the investment vehicle known as the Variable Interest Entity (VIE) has increasingly become a focus of controversy regarding U.S.-listed Chinese firms. While the VIE structure--commonly known in China as the "Sina-structure"--was historically used as a vehicle for tax evasion by U.S. companies, it has become popularized in its current form as a means to penetrate China's more restricted industries. (1) The structure essentially capitalizes on an accounting workaround, which allows one party to acquire controlling interest over another, without the assumption of equity ownership. (2) A foreign parent company can thereby secure de facto control over a Chinese domestic company, the VIE, based solely on the presence of a contractual relationship. In doing so, the parent company may indirectly absorb the dividends of the VIE, and thus consolidate the VIE into its accounting reports. (3) The significance, however, is that once consolidated, the parent company gains the ability to list on U.S. markets, which effectively lists the Chinese company by extension. (4)

   Given that the VIE structure allows both foreign and domestic companies to effectively flaunt China's legal regime regarding cross-border transactions and foreign investment, one might have presumed the invalidation of such a mechanism long ago. (5) However, VIEs created quite the catch-22 for Chinese authorities. Although this structure promotes the evasion of compliant trade practices, VIEs encourage a considerable influx of Foreign Direct Investment (FDI) and foster the success of numerous Chinese startups abroad. (6) In fact, over 42 percent of Chinese companies listed on U.S. markets as of 2011 were thought to operate using the VIE structure. (7) Given the VIE's prevalence, the Chinese government has shown a great deal of reluctance in quashing the VIE outright, as the fallout would likely consist of considerable economic repercussions. (8)

   A landmark Draft Foreign Investment Law ("Draft") promulgated in January 2015, however, foreshadowed a dramatic shift, if not the complete cessation, of VIE practice. (9) The Draft intimated a number of potential regulatory changes that could mean the closing of loopholes upon which the VIE structure depends. (10) Even more worrisome, neither the Draft nor the pertinent regulatory bodies chose to comment on the repercussions of such changes for current VIE-structured companies, particularly foreign-controlled VIEs operating in restricted and prohibited Chinese industries. (11) Given the considerable amount of investment tied up in this ambiguous structure, it is essential to define the legal standing and likely trajectory of VIEs.

   In light of the Draft, this comment evaluates the potential courses of regulatory action to help determine what will be the most likely outcome for the VIE structure. Specifically, this comment seeks to show that the regulatory actions taken to date are consistent with the notorious "CSRC Leaked Report" ("CSRC Report"), a blueprint on VIE removal leaked by the Chinese Securities and Regulatory Commission (CSRC) in 2011. Once established, this baseline will help distill possible government policy regarding the VIE vehicle, which, in turn, will allow for a more accurate assessment of the VIE's ultimate prospects.

   Given the evidence, this comment finds that the Chinese government has been actualizing the strategy set forth in the CSRC Report with regard to VIE dissolution. In this vein, government policy, by employing a carrot-and-stick strategy, (12) has been gradually and progressively phasing the VIE out of practice. If true, it can be extrapolated that any eventuality with regard to the Draft and VIE practice will likely comport with this regulatory design and, therefore, that foreign investors should anticipate People's Republic of China (PRC) government actions tailored to this end.

   The remainder of this paper is organized as follows. Part II is an overview of the structural ins-and-outs of the VIE vehicle. Part III reviews the regulatory trajectory of the VIE to date. Part IV introduces the notorious leaked CSRC Report of 2011 and provide the blueprint with which to compare subsequent regulatory actions of the PRC government. Part V analyzes both the legal environment and regulatory climate of VIE practice to demonstrate its adherence to the CSRC Report. Finally, Part VI concludes this comment.

2. OVERVIEW OF THE VIE STRUCTURE

   1. VIE Practice in Context of China

      In short, the VIE structure is a chain of contractual agreements whereby nonvoting de facto control is assumed over an operating company--the VIE--by a parent company, typically for the exploitation of specific strategic, financial, or political benefits. (13) Once contractual control has been assumed over the operating company, future benefits received by the entity are then enjoyed by the parent company as "variable interests." (14) In the case of U.S.-listed companies, these variable interests are required to be consolidated into the company's financial statements to discourage accounting fraud and duly promote transparency. (15)

      This de facto control is particularly pertinent to China because of the considerable red tape observed in the PRC's more restricted industries--most notably telecommunications and e-commerce. (16) The web of agreements constructed by the VIE acts to effectively mimic ownership, thus allowing for the assumption of foreign control, while, at the same time, still abiding by China's ban on foreign ownership. (17) And thus, instead of outright defiance of the law, the brilliance behind the VIE structure lies within the pseudo-ownership captured in its creative compliance. (18)

   2. Breakdown of the VIE Structure

      The VIE structure--which for the remainder of this paper will be specific to VIE practice in China (19)--was created almost exclusively to circumvent the foreign limitations in China's more restricted industries. (20) The sensitivity of these more restricted industries required a creative yet sophisticated model both to comply with the law and to avoid regulatory friction. The following section provides an overview of the elements necessary to form a VIE structure.

      As indicated in the diagram, the VIE structure can be viewed as a series of steps: (22)

      Step 1: The Offshore Holding Company. Chinese, or Chinese and foreign, investors form an offshore holding company, usually in the Cayman Islands or British Virgin Islands for tax preferences, often with the intention of listing on a U.S. stock exchange. (23)

      * Step 2: Hong Kong Subsidiary. (Optional and not featured on the above diagram) The Offshore Company creates a 100 percent owned subsidiary in Hong Kong to act as a legal buffer as well as an entry point into China. (24)

      * Step 3: Onshore Foreign Invested Enterprise.

      The subsidiary in Hong Kong, or the parent company directly, establishes a wholly foreign-owned enterprise (WFOE)--a type of foreign-invested enterprise (FIE) in which the foreign party owns 100 percent of the Chinese company--in Mainland China. The WFOE acts as the VIE's last link of the chain with actual equity ownership. (25)

      * Step 4: Onshore Domestic Operating Company. The Chinese shareholders that created the initial offshore company also create a domestic operating company (OpCo). (26) Through a series of contractual agreements, the profits and voting rights are thereby transferred unto the WFOE; in practice, this essentially makes the OpCo an extension of the WFOE. (27)

      Financing: (i) Chinese, and possibly foreign, investors form an offshore company; (ii) next, the offshore company creates a subsidiary in Hong Kong; (iii) the Hong Kong subsidiary makes a capital contribution to the WFOE; and (iv) finally, the WFOE provides the necessary capital, typically as a loan from its converted registered capital, for the creation and/or expansion of the Domestic Operating Company. (28)

      Profits: (i) The OpCo makes a profit from its respective business; (ii) the OpCo transfers the profits to the WFOE via a series of contractual arrangements meant to absorb all earnings made, effectively shifting the profit in the form of a business transaction; (iii) next, the WFOE makes a dividend distribution to the Hong Kong subsidiary; and (iv) finally, the Hong Kong subsidiary makes a dividend distribution to the Offshore Holding Company, thereby completing the circuit. (29)

      If tailored properly, this contractual construct will ensure the offshore parent's ability to maintain de facto control as well as safely and efficiently transfer the VIEs profits to the WFOE. (30) However, in the end, contractual control still pales in comparison to equity ownership in terms of providing investor security. Despite a meticulously planned contractual leash, an unhappy shareholder or member of the OpCo's management can bring the VIE structure to its knees if pressure is applied at the right point. (31) Even in light of several high-profile scandals, however, the VIE continues to be a prevailing market practice for foreign investment. (32)

3. TRAJECTORY OF THE VIE STRUCTURE IN CHINA

   1. VIEs Have Provided a Necessary Safety Valve

      Given the long-standing legacy of VIE employment in China, the conspicuous absence of a regulatory regime has been widely interpreted as evidence of tacit government approval. (33) However, both the VIE structure and the lucrative loophole that it creates...