Variable Interest Entity Risks and Governance.

• Author: Li, Yue

I.Introduction 145 II.Background 147 III.Analysis 153 A. An Overview of Risks Derived from the Contractual Nature of VIE Structure 153 B. Risks Imposed on Holding Companies, Markets, and Investors 155 1. Contractual Risk and Control Power Collapse 155 2. Policy Risks 155 C. Governance Approaches--Disclosure Requirement 160 IV. Recommendation 161 A. Improve Transparency with a Stricter Regulatory Framework 161 B. Establish Policy Risk Alert Mechanism 163 V. Conclusion 164 I. INTRODUCTION

A Variable Interest Entity (VIE) is an arms-length entity in which the investor holds a controlling interest not by having majority control of voting rights but through a series of contractual arrangements. (1) The investor's control over the VIE is established and ensured by agreements instead of holding shares. (2) The future transfer of assets, licenses, and equity interests are also governed by contracts to ensure the holding company's (the foreign-listed company) access to profit. (3)

The VIE structure provides benefits to both Chinese companies and foreign investors. It has been adopted by Chinese companies to be listed on stock markets overseas. (4) Foreign investors commonly use it to participate in industries that "are explicitly or practically restricted from foreign investment." (5)

The motivation behind the adoption of VIEs is the strict regulatory scheme for foreign investments in China. (6) Even after joining the World Trade Organization (WTO), China continued to implement the "Negative List in Foreign Investment" ("Negative List") as a regulatory approach to foreign investment that prohibits foreign investors from directly investing in some industries. (7) In accordance with the Negative List, there are several industries in which foreign investors--whether as corporations, entities, or individuals--are prohibited from investing. (8) As a result, the Chinese domestic companies operating businesses in those industries cannot seek global investment by going public on foreign stock markets. (9) To overcome this regulatory barrier, the VIE structure is broadly used to circumvent the regulatory effects of the Negative List. (10) Because, in the VIE structure, foreign investors do not hold any shares of the target domestic operating company that runs the business in China, the foreign investment from offshore stock markets would thus not fall under the "prohibited sectors" of the Negative List. (11)

Although the VIE is broadly adopted in commercial practice, it is inherently defective because there has been no clear and expressed endorsement of the VIE structure by the Chinese government and authorities. (12) Recently, the Chinese government and the U.S. Securities and Exchange Commission (SEC) demonstrated a tendency to implement stricter scrutiny and governance methods towards companies that have been, or seek to be, listed using a VIE structure. (13) Consequently, the stock prices of Chinese public companies that embedded this VIE structure are dropping drastically. (14) The goal of this Note is to contemplate the future governance of VIEs by analyzing the risks VIEs may impose upon the market and investors.

2. BACKGROUND

   In VIE structure, the business operation is ultimately controlled by investors, not through holding shares or ownership, but through a series of controlling agreements. (15) To circumvent investment regulations and restrictions, Chinese companies have become deeply involved with the VIE model. (16) It has been broadly used by Chinese companies to seek to obtain investments from overseas capital markets through an offshore public company to support and develop their business operated in the main market in China. (17)

   Chinese central government has long enforced a three-tiered regulatory scheme on foreign investment through the national Negative List. (18) Under this regulatory scheme, the Chinese market is divided into a tripartite regime: Encouraged Sectors, Restricted Sectors, and Prohibited Sectors. (19) The difference between each category is whether the foreign capital would be encouraged, restricted, or prohibited from investing in companies or programs in a specific industry. (20) The Negative List is updated annually and "provides guidance and governs industry sectors in which foreign investment is prohibited or where possible restrictions may apply." (21) If the industry sector does not fall within the listed categories in the Negative List, foreign investors are entitled to the same treatment as domestic enterprises. (22)

   Usually, the VIE structure would be considered the most convenient and effective method when a Chinese domestic operating company intends to seek foreign investment for their business which falls into the category of the restricted or prohibited sectors. (23) The adoption of the VIE structure enables foreign investors to invest in a restricted or prohibited business market through the foreign listed company. (24) It provides foreign investors access to the investment opportunities in those sensitive business markets in China, which were categorized into the restricted or prohibited sectors, such as the internet and media industry. (25)

   Effective use of the VIE is grounded on the contractual and shareholding relationship between the offshore holding company, its subsidiaries (both offshore and onshore), and the onshore company operating the business in the Chinese market. (26)

   Separating the operation and control is an essential feature of the VIE structure. (28) In a VIE structure, an offshore holding company, the public company listed overseas, does not operate the business alone. (29) Instead, the offshore holding company would set up a subsidiary in China in the form of a Wholly Foreign Owned Enterprise (WFOE). (30) The WFOE would control a Chinese domestic company that operates the actual business--this WFOE is known as the "operating company" (31) and such a domestic operating company is the VIE of the offshore holding company. (32)

   In a typical VIE structure, the offshore holding company maintains control of its subsidiary by holding shares. (33) Such a subsidiary would be a Special Purpose Vehicle (SPV) established to facilitate the listing process. (34) The SPV obtains and maintains its control over the WFOE by holding its share fully or partially. (35) The WFOE, an onshore company registered in China, maintains control of the business operation by contractual agreements. (36) Usually, there are more than two parties involved in such contractual arrangements (37) to ensure the WFOE's control over the Chinese operating company and its business from different resources. In a typical VIE structure described in Chart 1, (38) the WFOE would enter into contracts with both the business operating company and its shareholders at the same time. (39) The operating company often owns all operating licenses to perform the business and participate in the Chinese market. (40)

   Although in a VIE structure, investors do not possess the direct ownership state of the VIE (the entity itself), they have a series of contracts to specify rules and percentages of profits. (41) The contractual arrangements usually are designed to confer upon the WFOE, the offshore subsidiary, and its parent company:

   1. the right to all the economic benefits of the operating company, to exercise management control over the actual business operation, and to prevent leakages of assets and values to shareholders of the operating company; (42)

   2. the right to all intellectual properties through the assignments from the operating company; (43)

   3. the right to consolidate the financial results of the operating company as if they were wholly owned subsidiaries of the holding company's subsidiary for accounting consideration; (44)

   4. the right to acquire the equity interests in and/or assets of the operating company for a nominal price or a pre-paid amount; and (45)

   5. the priority security interest in the operating company's shares. (46)

   In terms of access to the operating company's business profit, the offshore holding company would be able to consolidate the VIE's financials into the group's overall financial statements under applicable accounting standards. (47) The contractual arrangements include agreements providing effective control over the VIE and agreements providing for the transfer of substantially all of the economic benefits of the VIE to the WFOE. (48)

   The control over the VIE is achieved by a series of agreements instead of ownership. (49 ) This trait makes the VIE distinct from other controlling structures and results in a different level of risk for the investor who holds the share or stock of the offshore holding company. (50) For example, DIDI Global Inc.'s (Didi) IPO fallout (51) definitely reminded the market about the policy risks behind the operation and investment mode of Didi and its affiliated companies. (52) Didi adopted the VIE approach to become listed overseas. (53)

   After being listed on the New York Stock Exchange (NYSE), (54) Didi's stock price drastically decreased due to the effect of a regulatory intention expressed by the Chinese Central Government. (55) Didi, the offshore holding company in the VIE structure, is registered in the Cayman Islands. (56) It is not the entity practically operating the app-based transpiration business in China and worldwide. (57) Instead, Didi, as the offshore holding company, maintains control over the operating company through a complex contractual arrangement. (58)

   Beijing Didi Infinity Technology and Development Co, Ltd. (Beijing Didi) is a WFOE set up by Didi through a Hong Kong incorporated company. (60) The entity that operates the business for Didi is Beijing Xiaoju Science Technology Co., Ltd. (Beijing Xiaoju), which is the VIE in this structure. (61) Beijing Xiaoju is held by five individual shareholders. (62 ) There is no shareholding relationship between Didi or Beijing Didi with Beijing Xiaoju. (63 ) However, Beijing Didi...