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Chinese Companies and the VIE Structure: Key Legal Risks and Recommendations for Investors
Amy Chin / Kai-Hua Yu Despite the market turmoil of the past year, China still remains a key destination for foreign capital. Investors often find, however, that key industries in the PRC are closed to foreign direct investment. Foreign investors thus frequently invest in a holding company with contractual control over the business operations, but no actual equity ownership in the operating entity. The operating entity is known as a variable interest entity, or VIE, and the resulting company structure is typically called a VIE structure. In 2000, became the first PRC company to successfully complete a U.S. IPO with a VIE structure. Since then, the VIE structure has become a common feature among PRC companies looking to attract foreign capital from Taiwan

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and elsewhere. As of April 2011, 42% of U.S. listings by PRCbased companies used the VIE structure, including major names such as Sohu, Baidu, Ctrip, NetEase and Tudou.1 Within the past year, however, the struggling market performance of Chinese companies and the emergence of several key disputes involving VIE companies has led to increased scrutiny of the VIE structure. Investors are becoming more aware of the need to fully understand the VIE structure and its risks in order to adequately evaluate their investment. In this article, we present the background of the VIE structure and an overview of its key components, highlight several key risks of the VIE structure, and suggest some key considerations for investors in VIE companies.

Background of the VIE Structure

The VIE structure developed from accounting rules dening the circumstances under which a company would need to present consolidated nancial statements and include another
 Fredrik qvist, Statistics on VIE usage, China Accounting Blog, April 11, 2011, available at html. (02)2705-5066

entity in its nancial statements. Generally, a company will be required to consolidate another entity if such entity is controlled by the company. Traditionally, control has been viewed as ownership of more than 50% of the entitys voting interests. This is the typical parent-subsidiary relationship in which the parent company owns a majority (or all) of the shares of the subsidiary company, and thus the parent company must consolidate the subsidiary in its nancial statements. The collapse of Enron in 2003 exposed issues with this traditional definition of control. Enron set up a complex network of relationships with special purpose entities. Enron entered into various contracts with these special interest entities under which Enron had the ability to manage these entities and guaranteed their loans. Actual ownership of these entities, however, belonged to Enron employees and other outside parties. Enron itself had no ownership interest in these entities. Thus, under the traditional definition of control, Enron was not required to consolidate these special purpose entities in its financial statements. As a result, Enron was able to give a misleading impression of its financial performance simply by moving substantial amounts of liabilities to these special purpose

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entities.2 In response, in 2003 the United States Financial Accounting Standards Board (FASB) coined the term variable interest entity. FASB defines a VIE as an entity in which the equity owners lack one or more of the following essential characteristics of a controlling nancial interest: 1. The direct or indirect ability to make decisions about the entitys activities through voting rights or similar rights; 2. The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to nance its activities; or 3. The right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses.3 In these cases, the VIE is said to be controlled by the entity that actually has such rights or obligations to the VIE. If such a relationship exists, the controlling company must consolidate the

 Staff of J. Comm. on Taxation, 108th Cong., Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues and Policy Recommendations (Comm. Print 2003) (JCS-3-03).  Financial Accounting Standards Board, FASB Interpretation No. 46: Consolidation of Variable Interest Entitiesan interpretation of ARB No. 51, 2003.

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VIE in its nancial statements, even if the controlling company has no actual shares or ownership interest in the VIE. FASBs adoption of a VIE rule was intended to limit a companys ability to hide off-balance sheet transactions. Chinese companies discovered, however, that the VIE structure could also be a unique opportunity to maintain separate structures for equity ownership and financial control. A VIE structure meant that a holding company could include in its consolidated financial statements other operating companies that it did not actually own, and present them as if they were actual subsidiaries of the holding company. At the same time, investors who were eager to get a piece of Chinas hot internet market could invest in the holding company, and thereby get around restrictions by Chinese government regulations on foreign ownership.

Typical VIE Structure

A typical VIE structure is depicted in the illustration below:

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Operating Company Ownership

Foreign Investor Ownership Foreign Investors

PRC Founders

PRC Founders

Holding Company (Listing Company)

Licensed Operating Company (VIE)

PRC Subsidiary

A VIE company typically begins with one or more Chinese founders who form an operating company in China. Because the operating companys owners are mostly or all PRC citizens, the company is able to acquire the business licenses and permits necessary to operate the business in a restricted sector, such as the internet sector. Eventually, the company and the Chinese founders may desire to attract foreign capital, but foreign direct ownership of the operating company may be prohibited or restricted in the sector. To work around this restriction, the Chinese founders and

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the new foreign investors set up the holding company structure on the right side of the diagram. The foreign investors and the Chinese founders invest in an offshore holding company, which in turn establishes a Chinese subsidiary. The Chinese subsidiary then enters into several control agreements with the operating company, which effectively give the holding company control over the operating company. This control, however, is governed exclusively through the control agreements. The original Chinese founders still control 100% of the equity interests in the operating company. Further, if the company decides to pursue a listing on a stock exchange, it will be the holding company that applies for the listing, not the operating company.

Key Provisions of Control Agreements

Because the foreign investors in a VIE do not directly own any of the equity or voting shares of the VIE, the VIE structure is completely dependent on the effectiveness and enforceability of the control agreements. The control agreements can come in a number of different forms, but the following key provisions should be included in all VIE structures:

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1. Management control : The holding company must have the right to appoint all of the key officers of the VIE, and to replace such officers at any time. The VIE must also be required to follow any instructions from the holding company regarding employment, business and financial management. The VIE may not be permitted to take any major actions without the consent of the holding company. 2. Economic sharing: The holding company must be entitled to the economic benets of the VIE. This is often done through a consulting agreement, service agreement or similar agreement, where the VIE agrees to distribute its profits or revenues to the holding company in exchange for the holding companys services. Economic sharing can also be accomplished through the equity pledge (discussed below), by giving the holding company the right to any dividends and distributions during the term of the equity pledge. 3. Equity pledge: The Chinese founders who retain ownership of the VIE typically pledge their shares to the holding company to guarantee their obligations under the control agreements. This is typically the primary or only means by which the foreign investors can ensure that the Chinese founders adhere to the control agreements, and thus its enforceability is critical.

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4. IP agreements: Because the VIE structure is frequently used in internet, education and media sectors, the companys intellectual property is often a key component to the business. The holding company typically holds ownership of the companys trademarks, domain names, and other intellectual property, and grants a limited license to the VIE for use in its operations.

Key Risks of the VIE Structure

The VIE structure has always been subject to significant risks because of legal and regulatory uncertainties and the absence of direct equity ownership over the VIE. During the past year, these risks have become particularly apparent, and there have been major incidents involving the VIE structures of several well-known public companies. Some of the key risks of the VIE structure are as follows: 1. Difficulty Asserting Full Control Over the VIE: The VIE structure is dependent on the holding company s ability to control the VIE, but because the Chinese founders are the actual owners and generally in charge of day to day management, the holding company may have difficulty

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asserting full control if there is a dispute with management. In a publicized case, GigaMedia, a Nasdaq-listed company based in Taiwan, attempted to remove a senior manager at its China VIE. However, the manager had possession of the VIEs registration certicates, business licenses, and company chops, and refused to turn them over to GigaMedia. Without these documents, GigaMedias VIE could not distribute its prots, enter into contracts, or conduct any ofcial corporate action, and GigaMedia could not even officially register the removal of the manager.4 2. Risks to the Founders Ownership of the VIE: The VIE structure depends on the continuing cooperation of the founders that hold full ownership of the VIE. Although the control agreements will ensure that the founders are not permitted to transfer their ownership to others, such transfers could still happen involuntarily in the event of the founders death or other legal reasons. Tudou, which completed its IPO on Nasdaq in August 2011, is an illustrative example. Tudou had submitted its original IPO filing in November 2010, several days earlier than its rival

 Form 6-K for GigaMedia Limited led on November 15, 2010.

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internet video site Youku. However, Youkus IPO launched in December 2010, whereas Tudou lagged eight months later. A key factor in the delay, revealed in Tudous public lings, was a divorce ght between Tudous founder and his ex-wife, who was demanding a share of the founders ownership interests. For a typical public company, such a dispute typically would not slow down a deal, since the founder is typically only one of several major shareholders in a listed company. However, Tudous VIE structure meant that the founder owned virtually 100% of the underlying VIE, which was the only entity of value to the listing company. If the ex-wife succeeded in acquiring a large stake in the VIE, the holding company would have lost out on its revenue and prot sharing, and potentially been unable to consolidate the VIE altogether. Even though a settlement was eventually reached and Tudous IPO completed, the company continues to include its public lings a number of disclosures about the risk of such legal proceedings.5 3. Improper Structuring of the Control Agreements: The control agreements are the only link between the holding company and the VIE. It is thus critical that the control
 Prospectus Filed Pursuant to Rule 424b (4) for Tudou Holdings Ltd led on August 17, 2011.

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agreements are not only comprehensive and precise, but also that all necessary procedures are completed so that the agreement can be properly enforced. In the case of GigaMedia s dispute with its manager, GigaMedia disclosed a major setback when it discovered the parties had neglected to register the pledge agreements with PRC government authorities as required by PRC law. As discussed above, the equity pledges are generally the primary or only security that the holding company has to ensure control over the VIE. Without the necessary registration, GigaMedia would most likely be unable to enforce the equity pledge agreements against the manager. Had GigaMedia discovered this issue before the dispute, it could have taken steps to correct the defect and gain a stronger position in enforcing the control agreements. 4. Uncertain Future of the VIE Structure: Even when all necessary procedures are followed, the legal and regulatory uncertainty surrounding VIEs means that enforceability can never be completely assured. In recent months, different levels of the PRC government have expressed strong reservations about the permissibility of the VIE structure. At the same time, PRC lawyers have become increasingly careful about

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opining about the legality of VIE control agreements. Given the complex attitudes of PRC authorities towards the VIE structure, the uncertainties are likely to persist for some time. One publicized instance occurred in March 2011, when Buddha Steel, a PRC steel company, suddenly withdrew its application for a Nasdaq IPO, which had been in process for several months. Buddha Steel disclosed that local authorities in Hebei Province had apparently warned the company that the companys VIE structure violated PRC policies relating to foreign-invested enterprises and were against public policy.6 Since then, official statements from other PRC authorities have been more restrained, and Tudou and several other VIE companies were able to complete their IPOs. However, it is clear that PRC authorities will continue to evaluate the VIE structure, and its future remains uncertain.

Key Considerations for Investors in a VIE

Despite these risks, the VIE structure is still prevalent among PRC companies seeking foreign capital, and in some

 Form 8-K for Buddha Steel, Inc. led on March 28, 2011.

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cases, it may be the only way for investors to access certain sectors of the PRC economy. The following are some key considerations for investors to keep in mind, both when deciding whether to invest in a VIE, and during the investors term as a shareholder: 1. Recognize if a VIE Structure Exists: Because the VIE is consolidated as if it were a subsidiary, investors may not immediately recognize that a VIE structure exists. The company s own disclosures may also vary. As described above, VIEs are a U.S. accounting concept, and companies that report under IFRS or other accounting standards may use different terminology to describe VIEs. Investors need to fully understand the chain of ownership and contractual arrangements within the companys structure. 2. Determine if the VIE Structure is Necessary: PRC founders typically insist that VIE structure is necessary since regulations require that the founders have full ownership of the operating company. However, even in restricted sectors, PRC regulations often allow at least some degree of foreign ownership, sometimes 50% or more. Foreign investors will have signicantly more certainty if the holding company is an actual shareholder of the VIE, even if the shareholding is only

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. -- . -- ,2012.01 ISBN 978-986-121-727-7 1.2.3. 580.7 100023642


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