On The Legal Risk And Perfection Of The Regulation Of The VIE Agreements

Variable Interest Entity (“VIE”) structure refers to a so-called red chip modethrough contractual arrangement to gain control and profit from the domesticoperation companies in mainland China to the offshore companies. Thanks toaccounting standards to the consolidated financial statements, the offshore companiescan consolidate the financial activities of the domestic Chinese entity called VIEwithout equity ownership, and realize the abroad financing and listing.VIE structure was first successfully applied by Sina.com to list its shares onNASDAQ Stock Exchange in2000to avoid the restrictions or prohibitions imposedon the foreign investments in specific industries by the Catalogue of IndustrialGuidance for Foreign Investment. Until now, the VIE structure is still widely used inthe Internet industry, and also extends into other restricted or non-restricted industries.After a rule entitled Provision regarding Mergers and Acquisitions of DomesticEnterprises by Foreign Investors was promulgated in2006, an increasing number ofcompanies tried to adopt VIE structure to circumvent the supervision forchange-of-control transaction in which a foreign investor takes control of a PRCdomestic enterprise and avoid advance approval prior to the SPV publicly listingsecurities on an overseas stock exchange.Different from the traditional red chip modes, the VIE structure allows the offshore parent companies to control the domestic Chinese entities through a series ofcontracts instead of entity ownership, which was born with its own huge risk. TheVIE structure was designed to assist the companies operate in restricted or prohibitedindustries and gained access to foreign capital markets while bypassing thegovernment’s restrictions on foreign ownership and control. Thus, the VIE contractswould be deemed void as “an illegitimate purpose is concealed under the guise oflegitimate act”. Additionally, the fact that VIE structures operate through contractsrather than equity ownership also creates the concern that if conflicts of interest arisebetween the Chinese nationals who incorporated the VIE and the controlling parentcompany, the Chinese nationals could simply walk away with the VIE or leave thecontracts unenforceable due to some objective circumstances occur. The domesticoperating entity controlled by New Oriental through VIE structure adjusted itsshareholding structure unilaterally, leading the SEC and foreign investors challengethe control power of the listed company, which is a case in point for the instability ofthe VIE structure.After all sorts of problems exposed, the VIE structure gradually causes theattention of the regulators. The government began to formulate correspondingregulations in both aspects of foreign exchange and specific investment. However, theoverall plan of foreign exchange regulation is “clearing” rather than “blocking”,which makes the supervision less effective. For the supervision related to investment,the regulations are relatively vague and narrow, leaving a lot of regulatory vacuum. Torectify the continuing uncertainty surrounding the VIE, the PRC government mustperfect the regulation of the VIE structure as soon as possible. The regulatoryauthorities must act to clarify the regulatory scope for the VIE structure, strengthenthe supervision of the financing behavior by refining the approval process, andpromote the establishment of the international regulatory cooperation mechanismaccordingly.