The State Council, China’s cabinet, last week promised policies to boost e-commerce in China. Included in the proposed reforms is a promise to reduce shareholding restrictions on foreign investments.Premier Li Keqiang appears to be leading the effort.
Nearly all of China’s larger internet companies have Cayman Islands incorp-orated parent companies that were used to facilitate taking foreign capital and listing in overseas markets. Because current Chinese regulations severely re-strict foreign companies from participating in the internet sector, the much maligned variable interest entity (VIE) structure was created to circumvent the rules by operating E-commerce businesses in Chinese companies controlled through contracts instead of through ownership. Investors soon learned the painful lesson that contractual control is inferior to actual ownership.
In January, the Ministry of Commerce issued a proposed foreign investment law for public comment. The new foreign investment law makes it clear that the VIE structure does not circumvent the foreign investment restrictions. In other words, it doesn’t work. The proposed law has a twist – if the foreign company is Chinese controlled, then investment from that foreign company would be treated like domestic investment, and would not be subject to foreign investment res-trictions. The proposed solution works perfectly for many of China’s largest internet companies, like Alibaba and Baidu, which are controlled through corp-orate governance structures that leave voting control in the hands of minority Chinese shareholders (management).
I think the promise by the State Council to liberalize rules for foreign investment in e-commerce will be implemented through the proposed foreign investment law. I believe direct ownership in e-commerce companies will be allowed, pro-vided Chinese remain in control of the company.
Steve Dickinson of the China Law Blog says that the proposed rules mean China VIEs are Dead and I Told You So. I think he is right that VIEs are dead. I believe that regulators are going to stop looking the other way on VIEs as they have for the last 15 years.
For many of China’s internet companies and their investors, this is good news. They have been carrying the VIE structure around their necks like a millstone. Besides scaring off investors, VIEs proved to be an inefficient structure that made it difficult to manage taxes and move money around the group. While companies under Chinese control might continue to use existing VIE arrange-ments, I expect most will dump them, preferring instead to operate in wholly owned subsidiaries (WFOE). That will be a big win for shareholders, since they will finally own the assets that they think they own.
There are a number of Chinese internet companies where the Cayman Islands parent company does not have the type of corporate governance arrangement that fits the proposed law. Hong Kong listed Tencent is one, since Hong Kong does not allow arrangements that keep founders in control. I expect these companies will restructure to meet the requirements of the proposed law, or will seek special permission to have foreign control.
Some multinationals have used the VIE structure, and for them the future may be bleak. Some foreign companies, like Amazon and Pearson, have used VIEs to circumvent foreign investment restrictions. I have heard of a few situations where VIEs were used to circumvent investment approvals and to avoid taxes. . Steve Dickinson says that these VIEs will be required to either shut down or transfer their assets to Chinese entities. Those Chinese entities will have to be Chinese controlled, which likely leads to Chinese operations being deconsolid-ated. The various US Chambers of Commerce have asked China to provide a 25-year grace period for existing VIEs or to grandfather them completely. I think that request will be ignored in the final law. This is a great opportunity for China to bring the internet more completely under Chinese control, and to favor Chinese companies in the process. I don’t see them passing it up.