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EXPERT GUIDE
March 2014
Bankruptcy & Restructuring 2014
Baker
& Mckenzie
Skadden
& Watkins
Latham
Vedder
priceLLP
Deloitte
Moore
Stephens
& Watkins LLP
Lathaminternational
Trinity
EXPeRT GUIDe: BANKRUPTCY & ReSTRUCTURING 2014
Hong Kong
Tom Pugh
[email protected]
+852 2843 2211
Investing in the PRC: Potential Vagaries of Using Variable Interest Entities, or VIEs
By Tom Pugh
W
hy do I Care?
Numerous NASDAQ and
NYSE listed PRC invested companies are structured as VIEs, a setup
designed to avoid restrictions on
foreign ownership of domestic companies operating in certain industry
sectors in the PRC.
U.S. and Hong Kong regulators have
recently required additional disclosures from VIE structured groups.
The basic issue is that foreign investors in a VIE acquire no direct ownership rights in the operating companies that run the business. All
they have are contractual claims to the
economic benefits
of ownership and to
control the business.
The enforceability of
these claims in the
PRC remains uncertain: investors in
these arrangements
must factor in the risks of the underlying operating companies, or
their creditors, simply ignoring the
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VIE control structure - with possible impunity.
How are VIEs Different?
A typical, non-VIE holding structure might involve an offshore (e.g.
BVI or Cayman) holding company
(“HoldCo”) owning a wholly foreign
owned enterprise (“WFOE”) in the
PRC which owns all or a controlling
interest in a PRC operating company (“OpCo”).
For restricted industries , this structure cannot be used, so VIE structures have developed which involve
contractual arrangements providing
for foreign investors
to enjoy economic
but not legal ownership and contractual
but not constitutional control of businesses in the PRC.
Under a VIE structure, the OpCo is
not injected into the HoldCo group,
given applicable foreign investment
restrictions. Instead, contractual
arrangements are put in place with
OpCo and its PRC shareholders
such that the OpCo’s operating results can, under applicable accounting standards, be consolidated as
part of the HoldCo group.
The potential nightmare for investors is that if the contracts are
breached, the accounting treatment
will fail and the public shareholders
will lose the VIE’s business.
The Contractual Arrangements
The main contractual documents
for effecting a VIE structure include:
I. To facilitate the transfer of the
economic benefits
• An exclusive services agreement,
under which the WFOE agrees to
provide services to the domestic
OpCo; and OpCo agrees to channel profits to WFOE as service fees.
Generally only the WFOE would
have the right to terminate this
agreement.
• An asset licensing agreement
whereby the WFOE licences assets
such as technology or intellectual
property rights to the VIE for royalty fees.
II. To facilitate control over the VIE
• A call option agreement, which
entitles the WFOE to require the
equity interest in OpCo to be transferred to it at nominal consideration
in the event that it becomes permissible under PRC law for the WFOE
to hold OpCo directly.
• A voting rights agreement or proxy
entitling the WFOE to control the
appointment of directors and the legal representative of OpCo.
• A pledge of the equity interest
in OpCo to secure OpCo’s performance of the VIE agreements.
Risks
Non-VIE investment in the PRC has
its own inherent risks. A VIE structure carries with it additional risks,
including:MARCH 2014
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Hong Kong
Regulatory: There are a number of
PRC regulations and guidelines
which may impact the use and enforceability of VIE structures, including circulars issued by the PRC
Ministry of Commerce, the State
Administration of Foreign Exchange
and pronouncements and rules of
other PRC bodies such as the China
Securities Regulatory Commission
and the National Development and
Reform Commission.
Asset heavy operations: Where most
of the assets and business are held
in the OpCo, the bulk of the profits will end up in it and if the OpCo
needs the cash more than the WFOE,
those profits may not find their way
upstream. That may also call into
question HoldCo’s ability to consolidate operations, particularly if there
appears to be limited intention for
HoldCo to receive profit distributions.
Foreign participant and competitor
risk: A structure involving a foreign investor with no links to the
PRC may carry greater risk than a
structure using a “Chinese” entity
to which the PRC authorities have
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shown past flexibility. Structures
that operate in a grey area of regulatory authority and licensing are
exposed to the risk of investigation
due to complaints by a competitor
or unhappy employees.
Control: The WFOE relies upon contractual arrangements to “control”
and “operate” the relevant businesses and such contractual arrangements are unlikely to provide as effective control as direct ownership.
If the VIE fails to perform its obligations under the contractual arrangements, the WFOE would likely
have to rely on PRC legal remedies,
which may not be adequate or effective. In one case, the PRC founder
(who controlled both the OpCo and
unusually the WFOE) took control
of chops, seals and business registration certificates so that the HoldCo
could not register the board minutes approving his removal, declare
dividends, approve service fee payments or conduct banking business.
The offshore entity effectively lost
control of the WFOE and was unable to gain access to any financial
information regarding the domestic
OpCos.
Tax: The WFOE could be subject
to adverse tax consequences where,
for example, the PRC tax authorities
were to determine that relevant contractual arrangements were not on
an arm’s length basis and therefore
amount to favourable transfer pricing and thus increase PRC tax liabilities, which might affect the upstreaming of profits to the WFOE.
Repayment of loans: Loans made by
the WFOE to the VIE, for example
to help it fund the VIE’s initial capitalisation, may be difficult to recover
(such as where the structure is challenged/unwound or enforcement of
the debt is required to be pursued in
the PRC).
Ownership: Foreign investors in VIE
structures do not retain any ownership rights to the equity in the operating companies or their assets. Accordingly realisation of such direct
interests is not available.
Termination: Ultimately, the PRC
authorities may instruct a VIE either to terminate the contractual arrangements or risk having its operating licences and permits revoked.
In one case, a group had to withdraw
its proposed IPO in the US after it
was advised by local government
authorities that its VIE structure
contravened PRC management policies relating to foreign-invested enterprises and, as a consequence, was
against public policy. HoldCo was
therefore reduced to a shell with no
operations and on termination of
the VIE arrangements the OpCo reverted to 100% control by the PRC
owners.
Current Concerns
In October 2012, China’s Supreme
People’s Court ruled, in relation to a
dispute between Chinachem Financial Services and China Small and
Medium Enterprise Investment Co.
Ltd., that certain contracts meant
to “conceal illegal intentions” were
invalid and unenforceable, so that
Chinachem’s assertion of ownership
of certain shares in a PRC bank via
an entrustment arrangement was
rejected.
In more recent months, commentators have suggested that the ruling
could by analogy be applied to VIE
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Hong Kong
structures, the rationale being that
a VIE structure may be construed
as being entered into solely to further the “illegal intentions” of the
offshore party. Investigations by
Chinese authorities may continue
to be triggered by various parties
including the domestic “partners”,
disgruntled employees and business
competitors.
However, given that the Chinachem
case did not involve a challenge to
the legality of VIE structures (but
rather related to entrustment arrangements), it is uncertain what if
any impact the decision will have on
VIE structures, although it is possible to see how the decision could be
extrapolated.
Conclusion
VIE structures continue to be used.
A recent example is the NYSE listing of Light-in-the-Box Holding Co.
Ltd last year, whose operations were
structured as a VIE.
A large number of China-based
operations listed on the NASDAQ
and New York exchanges are under88
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stood to be structured as VIEs, so a
declaration of invalidity in the PRC
would cause huge ripples.
With VIEs left as a grey area, China
can continue to attract foreign investment in certain key areas. However, the ability to clamp down on
the arrangements at some point if
the Chinese authorities feel it necessary/appropriate must be borne in
mind when (i) seeking to implement
a new VIE structure; or (ii) participating in a current VIE structure
where relations with OpCo appear
strained.
Mayer Brown is a global legal services firm advising clients across the
Americas, Asia and Europe.
Tom Pugh is a partner in Mayer
Brown JSM’s Restructuring, Bankruptcy and Insolvency practice in
Hong Kong, focusing on advising insolvency practitioners, creditors and
debtors in respect of cross-border
insolvencies, restructurings and distressed situations, with experience in
acquisitions and disposals; corporate
and distressed loan restructurings;
and schemes of arrangement.
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