Apr 5, 2017
Since the early 2000s, the variable interest entity (“VIE”) structure has become a common tool used by both domestic PRC companies to access foreign capital and as a means for foreign companies to access otherwise restricted industries in China. A typical VIE structure essentially consists of a domestic PRC entity (i.e., the VIE), a wholly foreign owned entity (“WFOE”), and the WFOE’s offshore parent company (the structure’s beneficial owner). The domestic PRC company is established to engage in certain business activities restricted to WFOEs and other foreign-invested entities. The entities and the nominee shareholders of the domestic PRC company (who are PRC citizens) are then bound together by a series of agreements and legal instruments (“Control Documents”) aimed at providing the WFOE and its offshore parent with a threshold level of control over the domestic company. This control allows the domestic company’s financial statements to be consolidated with those of the WFOE’s offshore parent, while simultaneously allowing the domestic company to engage in the restricted business in compliance with PRC laws, regulations and rules.
Despite its increasing ubiquity, the VIE structure has been a constant source of debate in China. The debate recently seemed to be tilting against the validity of the structure, with the Ministry of Commerce’s release of a public comment draft of the Foreign Investment Law of the PRC (“Draft Foreign Investment Law”) in 2015, seemingly aimed at curbing the future establishment of VIE structures.
In July 2016, however, this may have changed with the PRC Supreme People’s Court’s decision in Changsha Yaxing Real Estate Development Company Limited v. Beijing Shida Ambow Education Technology Co., Ltd. (“Yaxing v. Ambow”). Ultimately, the Court in Yaxing v. Ambow declined to directly address the validity of the VIE structure or the Control Documents. However, the Court substantially addressed the VIE structure and a number of related issues that may make Yaxing v. Ambow a milestone in history of the VIE structure.
In 2009, Yaxing, a PRC domestic company, sold a 70% stake in two schools to Beijing Shida Ambow Education Technology Co., Ltd. (“Ambow VIE”), a VIE held by Ambow Education Holding Ltd. (“Ambow Holding”, formerly NASDAQ: AMBO). Ambow Holding and its WFOE, Beijing Ambow Online Software Co., Ltd (“Ambow WFOE”), controlled Ambow VIE through a series of Control Documents.
The parties undertook the sale through a cooperation framework agreement under which Ambow VIE paid a total consideration of RMB 160 million. Half of the consideration was paid in cash while the remainder was paid in shares of Ambow Holding. Following a sharp decline in Ambow Holding’ stock, however, Yaxing filed a lawsuit against Ambow VIE with the Hunan Provincial Higher People’s Court. Among other things, Yaxing claimed that the cooperation framework agreement should be deemed invalid as it was entered into in circumvention of PRC laws and industry regulations restricting foreign investment by Ambow VIE, an entity controlled by a foreign investor.
In the first instance, the Hunan court held in favor of Ambow VIE. In doing so, it expressly rejected an argument that Ambow VIE should be deemed a de facto foreign entity due to the existence of Control Documents. Instead, the Hunan Court found Ambow VIE to be a domestic company given that its shareholders were PRC natural legal persons.
The Supreme Court generally upheld the decision of the Hunan court in favor of Ambow VIE, however its approach was differed somewhat. First, the Court held that Ambow VIE was a domestic entity, rather than a foreign one. It made this determination based on the simple fact that Ambow VIE had been registered as a domestic company with PRC corporate registration authorities, due to its shareholders being two PRC citizens. The Court expressly rejected Yaxing’s arguments that Ambow VIE should be deemed a de facto foreign entity on the basis that its registered capital had been indirectly contributed by a foreign shareholder through Ambow VIE’s nominee shareholders. The Court further indicated that the contractual transfer of shareholders’ rights also does not make Ambow VIE a de facto foreign entity.
The Court also examined Yaxing’s claim that the cooperation framework agreement should be invalidated under the PRC Contract Law on the grounds that it violated the Regulations of the PRC on Sino-foreign Cooperative Education (“Cooperative Education Regulations”), the Catalog for the Guidance of Foreign Investment Industries (“Foreign Investment Catalog”) and the Regulations of the Ministry of Commerce on Implementing the Security Review System for the Acquisition of Domestic Entities by Foreign Investors. In response, the Court first indicated that the latter two are merely departmental regulations and therefore insufficient to serve as the basis for invalidating a contract under the PRC Contract Law.
With respect to the violation of the Cooperative Education Regulations, the Court sought the opinion of the Policy and Regulation Division of the PRC Ministry of Education (“MOE”). The division replied that:
the control of a domestically-funded enterprise by foreign capital through control agreements with shareholders is not tantamount to direct involvement with school operation and management, and therefore is beyond the regulatory scope of the Cooperative Education Regulations.
Based on both the Court’s determination that Ambow VIE is a domestic entity and the MOE’s reply, the Court held that the framework cooperation agreement should not be deemed invalid under PRC law.
This is not the first time that the use of VIE structures has been implicitly endorsed in the PRC. Around the time that SINA and a few other Chinese internet portals listed overseas in the early 2000s, the Ministry of Industry and Information Technology (“MIIT”, formerly known as the Ministry of Information Industry) tacitly consented to the overseas listings of companies with VIE structures.
Nevertheless, it was recently believed that official attitudes in the PRC towards the VIE structure had been shifting away from acceptance to more active regulation. A 2012 ruling of the PRC Supreme Peoples’ Court and a 2011 decision by the China International Economic and Trade Arbitration Commission Shanghai Branch both directly denied the legality of the VIE structure. As mentioned, the Draft Foreign Investment Law also appeared to reflect official denunciation of the structure.
While the Yaxing v. Ambow opinion may be an important development in the PRC Peoples’ Supreme Court’s attitude towards the VIE Structure, it is important to take a measured view on what was – and was not – determined in the Court. Below are some of the key takeaways.
Domestic vs de facto Foreign Entities. Certain provisions of the Draft Foreign Investment Law provided that whether a company is domestic or foreign will depend on the status of the parties actually controlling it. This means a company de facto controlled by a foreign entity or individuals may be deemed a foreign-invested enterprise, regardless of whether its actual shareholders are Chinese entities or individuals. As such, these provisions are widely believed to be aimed at preventing the establishment of VIE structures.
The Court in Yaxing v. Ambow, however, took a fairly narrow and formalistic view on whether an entity will be deemed domestic or foreign under PRC law. Rather than accept Yaxing’s argument that a VIE should be deemed a de facto foreign entity, the Court held that if an entity has domestic shareholders and is therefore registered with registration authorities as a domestic entity, then it will be deemed a domestic entity.
Industry-by-Industry Determinations. In Yaxing v. Ambow, the Court sought the opinion of the Policy and Regulation Division of the MOE to determine whether a domestic company operating under a VIE structure could engage in activities that cannot be undertaken by a foreign investor directly. The MOE’s response was generally affirmative: in certain cases, the participation of foreign investors in the PRC education sector through VIE structures appears to be permitted, at least for the time being.
There are at least two implications of the Court having done this. First, by allowing this issue to be decided by the MOE, the permanence of the decision is uncertain. Although PRC courts are not subject to relatively strict stare decisis obligations as in common law legal systems, judicial decisions nonetheless hold a degree of precedential value to which courts adhere. As a PRC government ministry, however, the MOE is permitted to change its policies as it deems fit. Therefore, by deferring to the MOE, the court essentially may have subjected this decision to further changes of public policy.
Second, by seeking the opinion of the MOE, the court may be signaling that, without clear laws or administrative regulations to the contrary, it will defer to regulators on whether foreign investment is permitted through VIE structures. Therefore, the validity of a VIE structure may vary from industry to industry.
In this regard, there are three key government authorities that govern industries in which VIE structures are typically used: the MIIT, the MOE and the State Administration of Press, Publication, Radio Film and Television (“SAPPRFT”). In the past, these authorities have varied in their tolerance towards foreign investors participating VIE structures. The MIIT has traditionally been the most accepting, the SAPPRFT has been the most conservative, and the MOE has fallen somewhere between the two. Following the decision in Yaxing v. Ambow, however, the MOE now appears to favorably regard foreign participation in the education sector via VIE structures.
No Direct Decision on Control Documents. In Yaxing v. Ambow, the Court was asked to determine the validity of a contract entered into between a VIE and a third party, not the Control Documents governing the Ambow VIE structure. Indeed, the Court expressly declined to judge the validity of the Control Documents, as doing so would be outside the scope of its decision.
That said, in Yaxing v. Ambow, the Court’s holdings may have indirectly impacted further challenges to Control Documents. Similar to Yaxing’s arguments against the validity of the cooperation framework agreement, a key argument raised against the validity of the Control Documents is that they violate mandatory provisions of PRC law, which make them voidable under the PRC Contract Law. The Court in Yaxing v. Ambow, however, weakened this argument in two respects. First, as mentioned above, the Court removed the possibility that a foreign investor’s control over a VIE would result in the VIE being deemed a de facto foreign-invested entity. In other words, unless specific legislation dictates otherwise, that fact that a VIE is controlled by a foreign investor will not place the VIE in violation of PRC law for engaging in business activities restricted to foreign investment. This means that it will be difficult to argue for the invalidity of the Control Documents on the basis that they serve as the basis for the VIE to violate PRC law.
Second, a common reason for foreign investors to adopt a VIE structure is to engage in industries otherwise restricted to foreign investment under the Foreign Investment Catalog. The Court in Yaxing v. Ambow, however, expressly stated that violations of the Foreign Investment Catalog would be insufficient to invalidate an agreement under the PRC Contract Law. Such an invalidation would require a violation of PRC law or administrative regulations, rather than a mere departmental regulation (such as the Foreign Investment Catalog). As such, it also possible that a violation of the Foreign Investment Catalog alone (as well as other departmental regulations) would be insufficient to invalidate one or more Control Documents; instead a violation of PRC law or administrative regulations would be required.