Vie Structure Agreement
Variable Interest Entity (“VIE”) is a term first used by the U.S. Financial Accounting Standards Board (SASB) in Interpretation No. 46. In China, VIE Structure is also referred to as “control by agreement,” meaning that a listed foreign company controls a Chinese company through a series of contractual agreements to avoid China`s limitation and regulation of the initial arrival of foreign investment, foreign mergers and acquisitions, and overseas listing. In this article, the basic structure of the VI has been sketched out using a typical example. There are some variations of this structure that I will explain in future posts. In these interventions, I intend to present some of my research findings on how VIPs are actually used in China and outline some of the most important risks. The VIE structure has been particularly taken over in the field of electronic commerce. But also direct distribution and telecommunications, which require certain administrative authorizations. Renowned listed companies use a VIE structure. For example, the online media company Sina Corp or internet companies such as Alibaba (discounted by HKEx in 2012), Baidu, Ctrip, Youku and Tencent.
Despite its popularity, there are inherent deficiencies and risks in the life structure, which include: (a) the level of protection enjoyed by the beneficial owners of the VIE agreement is much lower than in the case of direct participation in the operating company; (b) the potential conflict of interest between the legitimate shareholders of the operating company and the beneficial owners; and (c) the degree of uncertainty as to the enforceability of contractual agreements between the controlling company and the operating company in the event of a dispute. The recent case of Alibaba, a very popular shopping site, successfully listed on the Hong Kong Stock Exchange in 2007, illustrates the potential risks of the life structure and illustrates the reason for possible state intervention in the future. Although there is currently no legislation or regulation that directly regulates the life structure, a new National Security Review (“NSR”) system put in place by the Chinese government can prevent foreign acquisitions of domestic enterprises if the aim is to circumvent state security verification. This system, like many other countries, gives the government the power to audit and approve a proposed foreign M&A transaction when it involves one of the key sectors (i.e., military, key technology, and agricultural products) that refer to China`s national security. However, given that these new safety review rules are, in practice, broad and highly discretionary, it is not certain that a foreign investment using a VIE structure in a key sector is constituted as an M&A operation and therefore has to go through an NSN procedure. From a legal point of view, the VIE model is essentially about controlling a company through agreements and not through the control of own funds. Since the origin of the application of the VIE model in China actually lies in the desire to avoid restrictions on foreign investment in certain sectors, the characteristic is that it is in itself defective. On the one hand, a VIE contract carries the legal risk of being deemed null and void, with the potential to be considered as a legal form covering an unlawful objective, prejudicing the public interest or contrary to the mandatory provisions of the law or regulation. It also significantly increases the controller`s exposure to moral hazard.
On the other hand, government authorities can strengthen the oversight of operating licenses of business units (removal of administrative authorizations or increase in the conditions for verifying these administrative authorizations), which significantly denies the VIE model directly from a commercial point of view. The life structure is often used to circumvent China`s restrictions on foreign investment in certain sensitive sectors….