Sep 23, 2011 04:07 PM

Closer Look: On the Fence with VIEs

The Ministry of Commerce recently announced that it would consider making major revisions to regulations related to the use of variable interest entities in foreign investments. But many have already raised questions over the impact such moves could have on the foreign investment climate in China.

The VIE concept, adapted to circumvent rules on foreign investment in China, refers to a corporate ownership structure between a foreign-invested company and a domestic company. The domestic company exists only for the purpose of holding a license in sectors where foreign investment is barred by Chinese regulators.

Through several agreements, such as an asset operation agreement, an equity rights agreement and exclusive service agreement, the overseas-listed company ensures its control over the domestic firm.

While it is easy for regulators to review equity rights agreements, which must be filed with authorities, other agreements do not necessarily need to be filed with financial regulators. Moreover, it is hard to determine whether the two parties are in a VIE arrangement based on these agreements.

Currently, regulators effectively have oversight over listed companies due to mandatory disclosure rules, however, the same cannot be said for unlisted firms.

In 2006, the Ministry of Industry and Information Technology issued a circular banning domestic carriers from assisting foreign investors operate in the country's telecom industry in any covert manner.

Industry insiders noted the ruling was meant to target the abuse of the VIE structure. But the circular was never strictly enforced, particularly due to the massive impact it would have on the telecom industry.

But the selective enforcement of VIE regulations can go the other way as well.

Domestic media have begun to set their sights on the VIE ownership structure following the Alibaba and Yahoo debacle. To evade the new regulatory restrictions on online payment licenses, Alibaba, China's largest e-commerce company, last June sold its online payment service Alipay to a purely domestic company. Alipay was previously fully-owned by Alibaba, where Yahoo and Japan's Softbank hold, respectively, 39 percent and 29.3 percent of the company stake, with the rest owned by the Alibaba management, led by founder and CEO Jack Ma.

After the Alipay transfer, Alibaba still controlled Alipay via VIE agreements reached between Alibaba management, Yahoo and Softbank. But earlier this year, Ma terminated the VIE arrangement, roiling foreign shareholders and raising the question of whether VIEs can properly protect the interests of foreign investors in China.

At the moment, Chinese regulators remain hesitant to make any major changes which could make the foreign investment flutter away.

Currently, almost all Chinese internet companies continue to use VIE arrangements with their foreign investors. The uncertain legal status is a sword of Damocles hanging over them.

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