China Technology Quarterly

February 2012 | Volume 1, No.1

Are VIE Structures Still Viable?

Are variable interest entity (VIE) structures still viable as an investment structure in the Peoples Republic of China (PRC)? VIE structures became an investment structure for China in the late 1990s with the US listing of Sina. But since the fall of 2011 with the Ministry of Commerce (MOFCOM) issuing regulations on national security review procedures and unsubstantiated rumours of a China Securities Regulatory Commission (CSRC) internal report calling for a crackdown on VIE structures, there has been uncertainty in the China legal and investment market as to their continued viability. Many US technology companies (particularly online / Internet companies) are already familiar with VIE structures, which channel investment in Chinese businesses that are restricted or even prohibited to foreign investment. Chinese entrepreneurs have often used them to raise offshore financing from foreign investors, because they offer foreign investors a tried-and-true way to exit their investments through trade sales or initial public offerings on exchanges outside China (without Chinese regulatory approvals in most instances). VIE structures are also popular with PRC founders, as start-up companies in China have traditionally been unable to raise substantial financing from onshore investors and exit through A-share listings, because companies listing domestically must meet requirements (such as prior profits) which startups likely cannot meet. This diagram illustrates a typical VIE structure:
Foreign Investors PRC Individuals

In This Issue
Are VIE Structures Still Viable? New Catalogue for Guiding Foreign Investment in Industry: Implications for Technology, Media and Telecommunication Sector New Rules on Curbing Internet Services Abuses NEWS BYTES

Hong Kong 14th Floor, Hutchison House 10 Harcourt Road Central, Hong Kong 23rd Floor, One Pacific Place 88 Queensway, Hong Kong Tel: +852 2846 1888 Fax: +852 2845 0476 Beijing Suite 3401, China World Office 2 China World Trade Centre 1 Jianguomenwai Dajie Beijing 100004, PRC Tel: +86 10 6535 3800 Fax: +86 10 6505 2309 Shanghai Unit 1601, Jin Mao Tower 88 Century Avenue, Pudong Shanghai 200121, PRC Tel: +86 21 6105 8558 Fax: +86 21 5047 0020 Chicago One Prudential Plaza 130 East Randolph Drive Chicago, Illinois 60601, USA Tel: +1 312 861 8000 Fax: +1 312 861 2899 Palo Alto 660 Hansen Way Palo Alto, California 94304, USA Tel: +1 650 856 2400 Fax: +1 650 856 9299

Holding Company
100% Offshore Onshore

Contractual Arrangements

Contractual Arrangements

Technical Services WOFE

PRC Individuals
100%

Contractual Arrangements

Domestic Company

This article will not discuss VIE contractual arrangements in detail, but typically the holding company or the technical services wholly foreignowned enterprise (WFOE) loans funds to PRC individuals (domestic shareholders) who in turn set up a PRC entity. In return for the loans and/ or guarantees of full performance of various contractual arrangements, the PRC individuals pledge their shares in the PRC entity to the technical services WFOE and grant options to the holding company and/or the technical services WFOE to transfer their shareholding in the PRC entity to any designee at any time, or alternatively to convert the PRC entity into a foreign-owned entity when PRC laws and regulations permit. The technical services WFOE also enters into a series of service agreements with the PRC entity whereby income of the PRC entity is moved into the WFOE and control over the PRC entitys operations is granted to the WFOE. PRC regulatory developments have made VIE structures more prevalent. MOFCOMs 2006 M&A regulations require MOFCOM approval1 of reverse investment structures whereby Chinese individuals set up offshore holding companies to acquire businesses in China. Before the 2006 M&A regulations, PRC individuals could quite easily inject their onshore businesses into offshore holding vehicles which could be used for further financing, trade sales or initial public offerings (as they could be sold or listed without PRC government approvals or visibility). Ironically the 2006 M&A regulations increased the use of VIE structures for China exits. It was simply not possible in practice to procure MOFCOM approval to inject onshore assets into offshore holding vehicles.2 So investors and investment banks opted for the VIE contractual control structure, where the offshore holding company holds no equity in the key PRC entity holding the required regulatory licenses to operate the business, and VIE structures spread from their original uses in new economy businesses like e-commerce to many other industries: online education, pharmaceutical distribution and even heavy industry. As use of VIE structures increased, MOFCOM elaborated a merger control regime with a national security review of China acquisitions (including acquisitions of offshore companies with China assets and turnover). In 2011, State Council Circular 6 and MOFCOMs implementing regulations set out specific procedures for the national security review, somewhat similar to the CFIUS review regime in the US. The August 2011 implementing regulations for the first time contained specific antiavoidance language: whether a transaction is subject to national security review will depend on the transactions actual content and impact, and foreign investors must not avoid review by structuring transactions as nominee holdings, trusts, multiple levels of re-investment, leases, loans, agreements granting control, offshore transactions, and other forms (emphasis added).
1 This was an attempt to stop onshore businesses (often improperly converted from State-owned into privately-held companies) leaking into offshore holding vehicles beyond government control, then being sold offshore without paying PRC taxes. The only reported exception was Poly Group, which reportedly had Peoples Liberation Army backing and investment.

2
2

China Technology Quarterly | February 2012, Volume 1, No.1

This increases complexity and uncertainty for foreign investors acquiring or holding China businesses through a VIE structure. Foreign investors already invested in VIE structures may face this review if they increase their shareholding. MOFCOM has not issued an official blacklist of sensitive industries (though some local commerce authorities did publish a list online), so investors and their advisors are left trying to assess whether an M&A transaction should apply for national security review. Most investors seem to be taking a wait-and-see approach and have not actively sought national security reviews of their transactions. Besides this uncertainty over M&A approval, some speculate that this regulation suggests that MOFCOM will eventually crack down on VIE structures. Concern increased when a research paper (purportedly a CSRC report to the State Council but possibly just a trial balloon floated by certain PRC government personnel) advising a crackdown on VIE structures was published online last fall. The report sees foreign participation in Chinese businesses via VIE structures as illegally circumventing PRC foreign investment regulations and potentially threatening national security (as foreign investors effectively control crown jewels of the PRC internet market, threatening network security). The report recommends that the CSRC and MOFCOM vet future VIE structure listings on overseas securities exchanges, and advises other governmental departments not to accept or confirm these VIE structures. Regardless of its veracity, this CRSC internal report should give pause to companies considering using VIE structures in China investments (greenfield or acquisitions). Even before last fall, VIE structures were not risk-free. Although there is still no specific Chinese law or regulation clearly stating that using VIE structures to circumvent PRC foreign investment restrictions is illegal (as there is in some jurisdictions), they are at least arguably contrary to existing PRC rules. In the mid-1990s, PRC regulators forced the termination of 20 joint ventures by foreign companies using a form of VIE structure to invest in China Unicoms telecommunications infrastructure and services in China. If Chinese regulators have not unwound other VIE structures since, it is not for lack of a legal basis to do so, but rather because (at least until recently) the government apparently did not consider foreign investment in e-commerce and online or other service-oriented businesses excessively sensitive or contrary to the interests of State-sponsored champions in key businesses like financial services, telecommunications and other key industries. The fear generated by the MOFCOM regulation and supposed CSRC internal report last fall has died down, though there are continued rumours of possible government regulatory action (e.g. requiring disclosure / approval of VIE structures). But it may be hard to craft a workable policy. It would be difficult to differentiate between VIE structures set up by Chinese individuals (the Ma Yuns and Robin Lis of this world) and those set up by foreign technology companies, and any attempt to exempt Chinese founders from regulation would lead to a huge outcry from US and European business interests. Disclosure or
February 2012, Volume 1, No.1 | China Technology Quarterly 3

approval requirements may hurt the Chinese economy by increasing delay and uncertainty for Chinese companies listing overseas at a time when onshore financing and exits are still very difficult for start-ups in China. Various regulatory agencies (like CRSC, MOFCOM and the State Administration of Foreign Exchange) have widely divergent views, so reaching consensus will take time. For now there still seems to be a place for VIE structures as one option for companies considering PRC investments. While acquisitions of VIE structures potentially face a MOFCOM national security review, investors are still using them in greenfield investments. But given the new uncertainties, companies need to examine direct acquisition or purely onshore investment structures more carefully before opting for the ease of a VIE structure. One key to assessing the viability of a VIE structure is the associated industry-sector risks: certain industries and sectors are less sensitive than others, and investment in new economy sectors and businesses through VIE structures is likely to be less risky than their use (in exactly the same form) in more sensitive sectors like heavy industry. Another factor is the relationship with the PRC shareholders (or founders in some cases): VIE structures with very active PRC shareholders or founders could be more at risk, because it is unclear whether Chinese courts will enforce VIE agreements in cases of major conflict (e.g. over control) between such foreign investors and the PRC shareholders.

New Catalogue for Guiding Foreign Investment in Industry: Implications for Technology, Media and Telecommunication Sector
The PRC State Councils new Catalogue for Guiding Foreign Investment in Industry (Revised 2011) (New Catalogue) replaces the previous version in effect since December 2007 (2007 Catalogue). The New Catalogue seeks to encourage foreign investment in high-end manufacturing, high and new technologies, modern services, and new energy, energy-saving and environmentally friendly industries. Like earlier Catalogues, the New Catalogue lists specific industries in which foreign investment is encouraged, restricted or prohibited. For industries not listed, foreign investment is permitted. Newly added encouraged industries include logistics information consulting services, intellectual property services, marine ecological restoration technologies, and establishment of venture capital enterprises. With respect to technology, media and telecommunications related industries, in the restricted category, distribution of audio and video products (limited to cooperative joint ventures) is no longer subject to the requirement that the Chinese party must hold a controlling interest. In the prohibited category, the 2007 Catalogue prohibited foreign investment in news websites, network audio and video programme services, internet access service venues, and internet cultural operations. The New Catalogue specifically removes music from that prohibition.
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This relaxation on foreign participation in audio and video product distribution (specifically music) was the result of a US-initiated suit against China at the WTO. China was required to liberalize the distribution of audiovisual products (including music recorded in an electronic form and distributed online) by 19 March 2011 (within 14 months of 19 January 2010, the date the Dispute Settlement Body adopted the final WTO ruling). The New Catalogue took effect on 30 January 2012.

New Rules on Curbing Internet Services Abuses

The Several Provisions on Regulating the Order of the Internet Information Service Market (Provisions) issued by the Ministry of Industry and Information Technology (MIIT) of the PRC will come into force on 15 March 2012. The Provisions require internet information service providers to curb illegal or inappropriate business practices and activities which have been widely reported in the Chinese media, and to better protect online users personal data. In practice, internet information service providers are likely to be considered website operators who either hold a commercial Internet Content Provider (ICP) licence or have filed as a non-commercial ICP. Therefore, all operators of websites operated within China will need to comply with the Provisions. The Provisions key features are: explicitly promoting fair competition in the internet information services sector by prohibiting activities that violate other service providers legitimate rights and interests, such as maliciously disturbing their services or making up or spreading false rumors about them; prohibiting service providers from harming internet end users rights and interests by, for example, refusing to provide services or delaying in providing them without a good reason, restricting the use of other service providers services or products, or fraudulent or misleading advertising; requiring service providers to give users clear and complete information on services offered and obtain their users consent before downloading, installing, running, updating, or uninstalling software on the users terminal. better protection of the security of personal data collected or processed on the internet. Service providers: must obtain users prior consent when collecting their personal data must disclose what information will be collected, and how and why it will be collected and processed;

February 2012, Volume 1, No.1 | China Technology Quarterly

may not collect any information not needed to conduct their services, or which can be used alone or in combination with other information to identify the user; must keep user information secure and not provide it to third parties without users consent.

Sanctions for violations include warnings, fines of up to RMB30,000, and public disclosure of the violation. Li Guobin, an official with the MIITs legal department, commented that in recent years the internet information service industry has seen an endless stream of illegal behaviors which have seriously harmed the market and the rights of other market players and end users. The Provisions are expected to provide a clearer code of conduct for internet service providers, and create a better market order and environment in the digital world of the internet.

NEWS BYTES
1. China: New Legislation Shows Personal Data Protection is Increasingly Important
The legislative landscape in China has been changing in recent years to provide more legal and regulatory protection of personal data. People and businesses in China are increasingly aware of data protection issues and expect personal data to be protected, with more criminal prosecutions for sale and purchase of personal data, and strong public reaction to abuses, such as the recent cases of large amounts of user data leaked from various social networking sites. Two recent developments consistent with these trends are the Jiangsu Province Information Technology Regulations (Jiangsu Regulations) and the amended PRC Law on Resident Identity Cards (PRC ID Card Law). In the absence of a national law on personal data protection, the Jiangsu Regulations, effective from 1 January 2012, impose restrictions on the collection and use of personal data in Jiangsu Province. Jiangsu is the first province to implement personal data protection regulations not limited to a particular industry sector. The Jiangsu Regulations impose penalties (including criminal sanctions where applicable) on organisations or individuals who illegally collect personal data, or illegally disclose, sell or provide personal data collected. Amendments to the national PRC ID Card Law, also effective from 1 January 2012, provide penalties (including criminal sanctions where applicable) for government agencies, financial institutions, telecommunications and transport service providers, educational institutions and medical institutions or their employees if they disclose any personal data obtained from resident identity cards in the course of performing their duties or providing their services. The violator is also subject to civil liability if its actions result in damages. Another amendment requires registration of fingerprint data when applying to obtain, renew or replace a resident identity card.
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2. Hong Kong: Application of the Unsolicited Electronic Messages Ordinance to Messages sent by New Electronic Means
The Office of the Telecommunications Authority of Hong Kong recently confirmed that the Unsolicited Electronic Messages Ordinance (Cap. 593) (UEMO) applies to unsolicited commercial electronic messages (CEMs) sent via new electronic means such as mobile messaging applications. This means that as long as an unsolicited CEM (which does not include a person-to-person call with no pre-recorded or synthesized elements) is sent from Hong Kong, to a person in Hong Kong or to a Hong Kong number, the UEMO will apply whatever electronic means the sender uses to send the message. The UEMO requires senders of unsolicited CEMs: (a) to provide accurate sender information; (b) to provide unsubscribe information and facilities; (c) to honour an unsubscribe request within 10 working days; and (d) not to send messages to an electronic address listed in the do-not-call register.

3. Hong Kong: Banks Privacy Practices Undergo Investigation in 2011; Lessons for 2012
The Hong Kong banking industrys privacy practices was put under scrutiny in 2011: the Privacy Commissioner investigated complaints against five Hong Kong banks and condemned their personal data collection, retention, use and disclosure practices in published reports in June and December. See further details in our Privacy Matters Newsletter (January 2012) (Enforcement Action , first item).

4. Hong Kong: New Guidance Notes on (1) Personal Data Erasure and Anonymisation and (2) Collection and Use of Personal Data through the Internet
The Privacy Commissioner of Hong Kong issued these new Guidance Notes in early January to give data users non-binding practical guidance on how to comply with their legal obligations. There is no penalty for noncompliance with the specific guidance, but the Commissioner will take non-compliance into account in determining if the Personal Data Privacy Ordinance (Cap. 486) has been breached. See further details in our Privacy Matters Newsletter (January 2012) (Legal Developments, first item).

5. Europes New Data Protection Proposals Affect Data Controllers/Processors outside the EU
On 25 January, the European Commission proposed a comprehensive reform of the EUs privacy and data protection laws. Why are you reading this in the China Technology Bulletin? Because one of the proposed changes is an attempt to promote global standards in protecting data flows around the world. The Commissions factsheets on the data
February 2012, Volume 1, No.1 | China Technology Quarterly 7

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To find out more about how our Technology, Media and Telecommunications Group can add value to your business, please contact: Lothar Determann +1 650 856 5533 lothar.determann@bakermckenzie.com Nancy Leigh +852 2846 1787 nancy.leigh@bakermckenzie.com Howard Wu +86 21 6105 8538 howard.wu@bakermckenzie.com Anna Gamvros +852 2846 2137 anna.gamvros@bakermckenzie.com

protection reform highlight that data can be processed in Beijing, stored in Boston and accessed in Budapest But not all countries provide the same level of protection for personal data. The Commission is proposing a system to ensure data transferred out of the EU and data within the EU enjoy a similar level of protection. EU data privacy laws are widely acknowledged as the global high water mark. The key changes proposed include clear rules on when EU law applies to companies and organisations established outside the EU. In particular, EU rules will apply whenever a data controllers activities outside the EU are related to the offering of goods or services to EU individuals or the monitoring of their behaviour. The proposals must be approved by the EU Member States and ratified by the European Parliament, so they could take around two years to adopt. In the meantime, they will be subject to lobbying, so details may change. We will be monitoring developments. Further information is available on the European Commissions Europa website.

Upcoming Seminar
Information Governance Managing Personal Data and Understanding the Risks
Baker & McKenzie will be hosting a seminar on information governance risks. As the amount of personal data businesses are collecting each day grows exponentially, the regulatory environment gets more and more complex especially for organizations operating globally or regionally. In this seminar, speakers from the PRC, Hong Kong, Canada and Australia who have a breath of experience will cover developments, risks and compliance on a whole range of information governance issues including data management, protection, security and leakage faced by companies. The seminar will cover: Overview of data protection laws Details of recent developments in data protection laws in Europe Regional developments in Asia What laws apply in the PRC and Hong Kong ow to navigate these laws from an operational perspective to H minimize the risks of non-compliance

The same seminar will be offered in three alternative sessions in Beijing, Shanghai and Hong Kong on 27 February, 29 February and 1 March respectively. For further information or to register, please visit http:// bakerxchange.com/ve/ZZ839182j816676Dc31853 or contact one of the lawyers listed in this bulletin.
This client alert has been prepared for clients and professional associates of Baker & McKenzie. Whilst every effort has been made to ensure accuracy, this client alert is not an exhaustive treatment of the area of law discussed and no responsibility for any loss occasioned to any person acting or refraining from action as a result of material in this client alert is accepted by Baker & McKenzie. If advice concerning individual problems or other expert assistance is required, the services of a competent professional adviser should be sought. Data Privacy Please contact Jane Lee by telephone +852 2846 1635 or e-mail: jane.lee@bakermckenzie.com should you wish your details to be added, amended or deleted from our mailing list. 2012 Baker & McKenzie. All rights reserved. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a partner means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an office means an office of any such law firm. This may qualify as Attorney Advertising requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome.

China Technology Quarterly | February 2012, Volume 1, No.1