China Issues New Inbound M&A Rules. Is It Hammer Time for VIEs?

Ever since the Anti-monopoly Law was passed in 2008, we’ve been waiting for more information on how China will set up and implement a security review system for inbound mergers and acquisitions. The picture has gradually come into focus, although there are still many questions that remain unanswered. I wrote about Article 31 of the Anti-monopoly Law and the issue of security review back in February.

Last week, the Ministry of Commerce (MOFCOM), which has primary authority over the review process, issued implementing regulations pertaining to the security review of inbound M&A transactions (商务部实施外国投资者并购境内企业安全审查制度的规定). There is no English translation yet, and the link is to the Chinese version on the MOFCOM web site. The new rules go into effect on September 1.

The implementing regulations are fairly short, containing only twelve articles, and still leave a lot of issues unresolved. For the most part, the rules set out the general scope of review, timetables, application documents, and potential penalties. At first glance, this appears to be fairly standard and reminds me of similar language from the Anti-monopoly Law and 2006 M&A Law pertaining to MOFCOM review of transactions.

What does stand out, however, is Article 9:

第九条 对于外国投资者并购境内企业,应从交易的实质内容和实际影响来判断并购交易是否属于并购安全审查的范围;外国投资者不得以任何方式实质规避并购安全审查,包括但不限于代持、信托、多层次再投资、租赁、贷款、协议控制、境外交易等方式。

The second half of this provision takes us into interesting new territory. Beginning with the semi-colon, the language essentially states that foreign investors may not for any reason evade the security review process. Several possible ways that this might be attempted are listed, including entrustment, phased-in investment, leasing, loans and control agreements.

If you’re either in the foreign investment business or have been reading this blog for a while, that short list is just screaming out “VIE.”

Here’s a reminder of what a VIE structure is:

The structure is relatively simple. The core business in China, in which foreign firms are not allowed to operate subsidiaries, is a domestically-owned company, owned by one or more Chinese nationals. That entity holds the valuable operational licenses, for example a licence to operate an online game. This domestic firm is the VIE and treated as part of the overall business.

The rest of the operation is the foreign invested part. An offshore company is set up somewhere like in the Caymans or BVI, and that holding company then sets up a subsidiary in China, called a WFOE. The WFOE provides services to the Chinese firm described above, sucking revenue out of it, money which is then remitted offshore to the holding company.

The key here is that the VIE and the WFOE are bound together through a series of commercial agreements designed to ensure that the investor maintains a measure of control over the local enterprise. These control agreements often involve loans, service contracts and equity pledges. In other words, exactly the same things that MOFCOM put in Article 9 of the new regulations.

Obviously, MOFCOM does not want foreign investors using VIEs to circumvent the new security review mechanism. Global Times article on the new regulations included this comment:

Compared with previous tentative rules that govern the security review of inbound merger deals, the new regulation made it clear for the first time that foreign investors are not allowed to avoid the review by any means whatsoever, which includes using the variable interest entities (VIEs) model, a common practice in the Internet sector.

By using the VIE model, Internet companies usually register overseas, thus giving the overseas company real control over its domestic assets.

“The new regulation has solved a major loophole in the previous rules by noting that it is not allowed to use such tricks and any other means to avoid the review,” Mei Xinyu, a researcher at the Chinese Academy of International Trade and Economic Cooperation under MOFCOM, told the Global Times Sunday.

As I’ve said in the past, the use of the VIE structure to solve the problem of foreign investment restrictions in certain industries is well known, both in and out of government, but it’s always been sort of a shadowy entity, not discussed out in the open. The ground has shifted with these new rules, at least indirectly.

The big question here is what this means for foreign investors that are using, or thinking of using, the VIE structure. We need to look at this from both the perspective of the security review process as well as related areas of Chinese law.

With these new rules, MOFCOM is publicly stating, perhaps for the first time, that it is aware of widespread use of the VIE structure to circumvent foreign investment restrictions. This acknowledgment does not necessarily mean, however, that MOFCOM will be more likely to enforce existing rules in the future to the detriment of foreign investors. For example, as long as deals are submitted for security review according to the new rules, VIEs might still be tolerated.

Indeed, if we just look at the language of Article 9 and the logic of the implementing regulations, one could argue that MOFCOM is not planning to go after VIEs. Keep in mind that the rules are primarily about this new security review process. The purpose of Article 9 is to ensure that foreign investors do not avoid the new rules. Insofar as VIE structures could be employed to do so, they are specifically cited.

Moreover, if MOFCOM had a master plan to crack down on VIEs, in effect rendering them obsolete in the near future, there would be little reason to include them in Article 9 at all. Indeed, this language presupposes that VIEs will be around for a while, creating potential trouble for the security review process in the future.

But there is another potential problem here, one that lies outside the security review process. The purpose of a VIE structure is to avoid foreign investment restrictions. How do these restrictions come into play with M&A deals? If the deal involves an acquisition, then the 2006 M&A Law will probably apply, which carries with it a mandatory MOFCOM approval process (this is just one possible deal structure). Presumably, many of the deals that include VIE structures would not survive such a review, if all relevant information was disclosed to MOFCOM.

Moving forward, if MOFCOM is now saying that deals involving VIEs must undergo security review, which would include submission of information documenting the relationship between foreign investors and the licensed Chinese enterprise (in the quote above, the VIE and the WFOE), what will MOFCOM, wearing its hat of M&A regulator, do with that information? This also begs an additional question: will companies involved with M&A deals with a VIE component comply with the security review rules or not?

Therefore the big question here is whether MOFCOM will decouple security review from other aspects of regulatory approval of M&A deals, or whether this is going to shine a very uncomfortable light on VIEs.

This could be big, folks. All eyes are now on MOFCOM.

China Hearsay has more on China M&A and other topics. Also look for me on Google+ and Twitter.