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China's VIEs: A political football

Author: Tim Burroughs
Asian Venture Capital Journal | 24 Apr 2013 | 15:24
Tags: China | Ipo | Regulation | Qiming venture partners | Walden international | Kpmg

The investment structure that has underpinned foreign investment in Chinas internet and telecom sectors is being questioned by
investors and regulators. Is the VIE dead and, if so, what could replace it?
Tudou finally went public in August 2011. The VC-backed company, then China's second-largest online video site, had filed its
IPO prospectus some 10 months earlier but was forced to delay due to a dispute between founder Gary Wang and Lei Yang, his
soon-to-be-ex-wife. Yang had filed a lawsuit against Wang, claiming a share of Quan Toodou, the onshore entity through which
offshore-incorporated Tudou held the license to operate its website and the online advertising and value-added telecom services
that underpinned its business model.
A settlement was reached in June 2011, with Yang giving up all rights to an equity interest in Quan Toodou, but the delay meant
the company missed the most opportune window for listing - it made its debut the week after 11 IPOs on US exchanges were
postponed due to market volatility and tumbled 12% on its trading debut. Tudou ended up merging with rival Youku last year.
It is a cautionary tale for investors that target Chinese industries in which direct foreign ownership of certain assets is prohibited,
necessitating the use of a variable interest entity (VIE) - an onshore vehicle that operates in parallel to the standard wholly foreignowned enterprise (WFOE) but is controlled by the founder and contractually tied to the WFOE. Yet it is territory where VCs are
reluctant to be heavy-headed, conscious of the need to preserve relations with their local business partners.
"Despite the personal issues as was the case with Tudou, we haven't started to ask founders to make sure ownership is separate,"
says Hans Tung, Beijing managing partner at Qiming Venture Partners. "We aren't comfortable regulating people's personal lives."
Christopher Xing, a tax partner with KPMG China, places the issue in starker commercial terms: The founder of a internet start-up
that has gone public on a foreign bourse is usually the majority shareholder of the offshore listed company; having him control the
onshore VIE as well can prompt regulators to question a VC investor's ability to consolidate financial statements of the various
entities; but relying on a wife to preserve the demarcation between onshore and offshore ownership can be problematic.
"If a family relationship is binding it all together you have to look at the divorce risk, the sell-out risk, and ask how concentrated it
is," Xing says. "Are you relying on one person or 20 people?"
A dirty word
Tudou is neither the first nor the last instance in which a foreign investor's legally hazy economic interest in a VIE structure has
come into question - those honors lie with web portal Sina and online gaming company GigaMedia, respectively, where investors'
efforts to replace founders were complicated by those same individuals controlling the onshore entities.
In between, Alibaba Group severed the VIE through which Yahoo and Softbank gained exposure to third-party payment service
Alipay and the Securities and Exchange Commission (SEC) started asking questions about the structure following a spate of
accounting scandals among US-listed Chinese companies, many of which use VIEs. There was also a leaked report drawn up by
the China Securities Regulatory Commission (CSRC) for the State Council calling for stricter regulation of the structure.
The VIE is responsible for much of the more than $5 billion in early-stage funding that has entered China's IT and telecom space
since 2000 - factor in growth capital as well and the figure soars past $20 billion - but its future is uncertain.

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"When foreign investors hear the term VIE they don't think it's the proper way to go about investing in China," Xing adds. "They
are somewhat wary of the connotations of what the VIE structure entails and there have been situations in which clients have
completely ruled them out early on, even though there is no legal prohibition. The negative press coverage and SEC investigations
don't help."
The structure can be traced back to the China-China-Foreign (CCF) model through which foreign telecom operators made their
doomed efforts to enter China in the mid-1990s. China Unicom, in need of capital to build out its network, invited the foreign firms
to form joint ventures with third-party companies tied to its subsidiaries. The foreign telecom firms were given proxy control over
the joint ventures, which were then contracted by China Unicom to provide services.
Beijing unilaterally cancelled the agreements in 1998, arguing that China's World Trade Organization accession obligations
required it to open up some industries to foreign investment, but not all. Class I telecom assets - networks and carriers - were
deemed off limits due to national security concerns. However, Class II assets, such as the internet and related services, were subject
to less rigorous oversight and a revised version of the CCF emerged.
Two years later, Walden International led a $7 million round of investment in Beijing Stone Rich Sight Information Technology,
which was set up by the former CEO of Sina, the Chinese internet portal. This was then merged with a US-based company called
Sinanet under a VIE structure and the resulting entity, Sina.com, listed on NASDAQ.
"We came up with a structure that worked," Lip-Bu Tan, chairman of Walden, told AVCJ last year. "It was a case of convincing
the Chinese government that it was a viable. Fortunately, I'd already made several investments in China and had demonstrated to
them that I have experience investing in China, so they were supportive. Then everyone started copying the model."
Brand new approach
It is perhaps a combination of overuse and misuse - plus an evolving regulatory landscape - that has put the VIE in the uncertain
position in which it now finds itself.
Rocky Lee, Asia managing partner at Cadwalader, argues that the structure has become so unpalatable to investors that a
replacement is required, and he has devised the multi-jurisdictional captive company (MJCC) to fill the void. It originates from
structures used by listed multinationals that are engaged in restricted industries in China and want a level of control over operations
beyond that conferred by onshore VIE service contracts.
Lee first worked on a transaction involving what he now refers to as an MJCC as early as 2004, although at the time the structural
solution only addressed the issue of greater legal protection and recourse for foreign investors and the better alignment of interest
with local business partners. The tax efficiency element, a priority for most major multinationals in China, came about later
through the addition of various cross-border structuring techniques.
Crucially, control of the parallel entity has been pushed into neutral territory. While the founders may still own the equity, there is a
custodian arrangement whereby the shares are held by a third party - not unlike a bank holding an agreed sum of money in escrow,
which is released to an investor if problems arise post-transaction - allowing the audit committee or independent directors to step in
if necessary.
"If a VIE structure is still utilizing PRC law with its core structural contracts, offshore stakeholders will have a tough time
obtaining any meaningful damage award from a local judge," Lee says. "The prescribed damage will not likely exceed the value of
registered capital of the VIE which is often around RMB10 million ($1.6 million). I cannot imagine any stakeholder, after having
succeeded in litigation in the PRC, would be all that satisfied with a RMB10 million prevailing judgment. It might not even cover
legal fees."
While the MJCC has yet to be tested, he estimates that the enforceable damage figure would be in the region of RMB500 million,
far closer to the market value of the company.
Not everyone is convinced, though. "What I'm seeing in many cases is not the abandonment of the VIE structure," says Thomas
Chou, partner and co-head of Morrison & Foerster's Asia private equity practice. "Instead, the emphasis has been on developing
more robust corporate governance in the domestic company to minimize the likelihood that a rogue' shareholder will be able to
disrupt the business of the overall group."
This can be achieved by structuring the onshore entity with a greater number of shareholders representing different constituents of
the group, as well as appointing directors who do not also serve as shareholders. Efforts are also being made to upgrade defensible
arms-length loan and consulting agreements in the event that the enforceability of VIE contracts is challenged.
Qiming's Tung is way of dispersing ownership of the onshore entity too widely, noting that, from an operational perspective,
management needs to feel empowered to move the business forward. Experienced managers are few and far between in the internet
space - most of those who have the requisite ability start their own companies - so it pays keep the incumbents happy.
"For internet companies in the US it tends to be that founders have the same number of board seats as the VCs and then the
independent board members are the tiebreaker," Tung says. "In China that is less common practice - the founder and management
control the board, 60-40. They worry they will be kicked out by the VCs for not being experienced enough."
Another option is a VIE hybrid of the foreign-invested telecom enterprise (FITE). The onshore entity within the traditional VIE
structure is replaced by a FITE, up to 50% of which is directly owned by the offshore parent, thereby securing some level of direct
and legal control. The remaining equity of the FITE is owned by the entrepreneur and is controlled through VIE arrangements.

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"While the process for obtaining FITE approval can be lengthy and regulatory approval is by no means guaranteed, a properly
implemented FITE hybrid would result in a more robust structure for foreign investors at the offshore level," says Chou.
Interestingly, while the venture capitalists are moving towards structures employed by multinationals, some multinationals are
looking even further to variations on the joint venture model. This might involve nothing more than a consultancy operation that
provides services to an onshore company. There are no structures designed to secure ownership or an economic interest in licenses,
but the foreign investor supplies intellectual property and finds other ways to extract value, such as overlaid profit sharing
arrangements.
"Those types of arrangements wouldn't entirely work for IPO situations where you want to capture the whole value chain and
therefore unify assets under a single umbrella," adds KPMG's Xing.
The long game
Given the confidentiality clauses in which investments are bound up, it will take several years before anecdotal evidence as to
which is the prevailing structure is replaced by something concrete and public. This is because company owners and their investors
are reluctant to spend time and money undoing existing arrangements. If a VIE is in place and those involved are comfortable with
it why introduce a new model?
An MJCC structure would most likely be found in a Series A or B round, with the documentation supporting the structure only
entering the public domain when the company in question files for an IPO. Lee doesn't expect this for at least three years, but when
it does the change will be plain to see in the SEC disclosure documents.
"US investors have made it clear they will no longer accept, as one hedge fund manager put it to me, Mickey Mouse structures,'"
he says. "The disclosure risks in the listing prospectus should be specifically addressed. If the improved MJCC structure can
remove many of the risks associated with a VIE structure, why wouldn't Chinese companies and investors consider the structure?"
The answer to that question - and, by extension, why the MJCC or equivalents to it have yet to gain widespread traction - lies with
the regulators and the entrepreneurs.
For all the concerns expressed about the CSRC's report on VIEs, no action has been taken. Indeed, Chinese government agencies
go out of their way not to express an opinion on the structure in the absence of a general consensus. It is worth noting that China's
big four internet companies, Baidu, Alibaba, Tencent and Sina, all major employers in a sector the government wants to develop,
rely on VIE structures and would like to see them remain.
And despite ongoing reservations as to whether companies with VIEs will still be allowed to go public, the Hong Kong Stock
Exchange continues to accept them, provided the structure is required to operate in the industry and a mainland legal counsel
endorses its use. The SEC's conflict with the CSRC as it seeks greater transparency from Chinese companies listed in the US is
delicately poised but there has been no definitive action.
In short, the VIE meltdown some were predicting hasn't happened, or at least not yet. "The discussion last year about replacing VIE
structures was a little bit too much," says Ray Zhu, a tax partner with PricewaterhouseCoopers. "The structure can still be applied
in future."
As for the entrepreneurs, Lee accepts that his approach remains a minority one in part because company founders don't understand
why there is a need for structural change. At the same time, mainland Chinese counsel aren't familiar with the structure because the
legal pressure points have been shifted.
The balance might be redressed as the slowdown in fundraising, particularly among renminbi-denominated funds, eases
competition for deals and allows managers greater leverage over deal terms. For now, though, this isn't happening.
"Setting damages to the market value of the holdco - as required under the MJCC - would be much harder to sell to the
entrepreneur," says Qiming's Tung, who is aware of the structure but has yet to use it. "If the entrepreneur is someone I like and
have worked with before, then I wouldn't feel the need to have them personally guarantee it. If I asked and it's not market practice,
then it becomes harder to compete on deals."
Momentum play
When the market moves, investors will follow - but it remains to be seen how much. KPMG's Xing holds the view that, rather than
being completely replaced, the VIE will become more sophisticated, with less focus on potentially fragile impersonal or contractual
undertakings. Lee, on the other hand, is adamant that tweaked versions of the existing structure cannot prevail as long as investors
are unable to have complete faith in mainland Chinese law.
If China's growth rate slows investors will inevitably start asking more questions about the structures and impose stricter terms
because projected returns no longer justify the risk being taken. This isn't necessarily an unhelpful development as it will raise the
bar and fewer weak companies will slip through the net. Strong players should benefit and confidence in China stocks would grow.
But for all the macro connotations, early-stage investments are dominated by micro issues and the VIE is good example of how
commercial and personal dynamics collide. "Are the investor's interests aligned with those of management? If not, then you can go
after them with lawyers but it's debatable what you get out of it," says Tung. "Ultimately, it's about whether you are comfortable
with management and what is going on."
SIDEBAR: VIEs, regulatory review

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When European buyout firm Alpha agreed a EUR300 million ($390 million) deal for Savio, a provider of winding machines to the
textile industry, China's Ministry of Commerce (MofCom) raised a red flag. The private equity player already held a 27.9% stake
in Ulster Technologies, which alongside Savio enjoyed a duopoly position in a particular market segment. If you want our approval
for the buyout, the ministry told Alpha, you have to divest Ulster first.
Though relatively small, the deal became a hot button topic among private equity investors because it indicated MofCom's
willingness to conduct Anti-Monopoly Law (AML) reviews even where minority stakes are concerned.
"They also looked at other factors such as board composition and veto rights, even the board's record of attending meetings and
whether it's acting like a rubber stamp," says Thomas Chou, partner and co-head of Morrison & Foerster's Asia private equity
practice. "Until the Alpha deal, many PE investors assumed minority deals would not trigger an AML review. Through a sustained
education process, our clients now examine potential filing and review requirements prior to making investment decisions."
Avoiding a review is particularly important for those investing in industries where direct foreign participation is restricted. The
workaround of choice is a variable interest entity (VIE) - an onshore structure controlled by local shareholders that exists for the
purpose of holding assets that a foreign player cannot - but MofCom is generally unwilling to approve any transactions that feature
such structures.
Together with the national security review - typically triggered by change of control transactions in designated key sectors like
agriculture, energy, infrastructure and technology - it is one of two approval thresholds that can kill deals. And all because
MofCom, like many Chinese regulators, doesn't want to be seen as taking a position on VIEs
The issue rarely arises in venture capital investments. An AML filing is only required if the two parties involved in the transaction
have aggregate global sales revenues in excess of RMB10 billion ($1.4 billion) during the previous fiscal year, or aggregate China
sales of at least RMB2 billion. Most VC deals are for minority stakes and the target companies are in their nascent stages, so the
revenue threshold isn't reached.
According to sources familiar with the transaction, the proposed $1.4 billion merger between web portal Sina and Focus Media
failed because MofCom delayed a review until the two parties lost patience. Now Focus Media is subject to a $3.7 billion buyout
by a consortium of private equity firms and the deal has apparently been structured so that no single investor will have a majority
stake, with a view to avoiding the need for an AML filing because there is no change of control.
It remains to be seen whether the Savio transaction serves as a precedent for a review. Legislation and case history don't offer much
guidance. "The term change of control' is quite difficult to pin down in Chinese in terms of the exact meaning," says Christopher
Xing, a tax partner with KPMG China. "There is a huge amount of interpretational latitude for the official and the legal counsel on
the transaction. And then you don't have a huge amount of precedent and transparency."
Wal-Mart's acquisition of a majority position last year in Yihaodian, China's largest online supermarket, is a case in point. In
granting AML approval, MofCom forbid the US retailer from using a VIE to turn Yihaodian into an e-commerce platform that
facilitates third-party transactions.
It was the first time MofCom had explicitly outlawed the structure, spooking foreign investors in the process, yet several industry
participants tell AVCJ that the situation was unique - more about curbing Wal-Mart's competitive advantage than taking a stand on
VIEs - and shouldn't be seen as the precursor to a trend.
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