Emory Corporate Governance and Accountability Review

Basic Corporate Governance Pattern in Variable Interest Entities
Zhiyuan Liu *Emory University School of Law, J.D. Candidate, 2017; Managing Editor, Emory Corporate Governance and Accountability Review; LL.B.; B.A. Business Management, Renmin University of China. I would like to thank Heidi Hegewald for providing valuable thoughts and editing my work and Liu Chen for helping me craft and refine my work throughout its many drafts.

Introduction

The concept of Variable Interest Entities (“VIE”) originated from United States accounting principles. For recent decades, Chinese entrepreneurs borrowed the concept of VIE to develop their own businesses under the Chinese government’s special regulatory environment. 1Mengwei Ma, The Perils and Prospects of China’s Variable Interest Entities: Unraveling the Murky Rules and the Institutional Challenges Posed, 43 H.K. L.J. 1061, 1064 (2013). Currently, the foreign direct investment market is not completely open to foreign investors. 2See Xianwu Zeng & Lihui Bai, Variable Interest Entity Structure in China, China L. Insight (Feb. 9, 2012), http://www.chinalawinsight.com/2012/02/articles/corporate/foreign-investment/variable-interest-entity-structure-in-china/. Many foreign investors are not permitted to invest in prohibited industries, and there are also restrictions on the percentage of foreign shares allowed in a domestic company. 3See Waishang Touzi Chanye Zhidao Mulu (2011 Nian Xiuding) (外商投资产业指导目录(2011年修订)) [Catalogue for the Guidance of Foreign Investment Industries (Amended in 2011)] (promulgated by the Ministry of Commerce & Nat’l Dev. & Reform Comm’n, Dec. 24, 2011, effective Jan. 30, 2012) Ministry Com. China (Feb. 21, 2012, 7:51 PM), http://english.mofcom.gov.cn/article/policyrelease/aaa/201203/20120308027837.shtml. For the purpose of attracting foreign investors and circumventing restrictions on foreign direct investment, the VIE structure is widely used by Chinese companies to enter foreign capital markets; the same is also true of foreign companies attempting to obtain control over Chinese companies. 4Zeng & Bai, supra note 2. The most recent and pertinent case arose in 2014 regarding Alibaba’s utilization of VIE to issue stock in the New York Stock Exchange and successfully connect its United States’ entity with Chinese-domestic business. 5Gregory J. Millan, Alibaba’s IPO Puts VIE Structure in the Spotlight, Wall St. J. (Sept. 22, 2014, 9:46 AM), http://blogs.wsj.com/riskandcompliance/2014/09/22/alibabas-ipo-puts-vie-structure-in-the-spotlight/. Understanding how VIEs’ structure achieves the goal of controlling the desired domestic company and what are the differences in its corporate governance in comparison to traditional United States governance methods is important. This comment will parse through these questions and provide a brief analysis under both historic and current regulation trends.

I. VIE and Corporate Governance Contracts

The structure of a VIE functions to circumvent the heavy restrictions set by the Chinese government on foreign ownership and enables the companies to be listed on the overseas stock market. 6Kenneth Kan, Alibaba and the Variable-Interest Entity, Mkt. Mogul (Sept. 12, 2014), http://themarketmogul.com/alibaba-and-the-variable-interest-entity/. Typically, there are four parties under a VIE structure: (1) a company listed on the overseas stock market (“ListCo”), which owns (2) a wholly foreign-owned company (“WFOE”); (3) a Chinese domestic company which operates the substantive business (“OpCo”), the VIE itself; and (4) Chinese owners of the OpCo/VIE. 7See Li Guo, Chinese Style VIE: Continuing to Sneak Under Smog?, 47 Cornell Int’l L.J. 569, 577–78 (2014); Serena Y. Shi, Dragon’s House of Cards: Perils of Investing in Variable Interest Entities Domiciled in the People’s Republic of China and Listed in the United States, 37 Fordham Int’l L.J. 1265, 1277–78 (2014); Ma, supra note 1, at 1063–64. The OpCo is the company holding the prerequisite license to conduct business in the industry, barring or restricting foreign investors, and generating value from its operation of the business. 8Guo, supra note 7, at 578. On the other hand, the WFOE is basically a shell company holding a license allowing it to conduct consulting business with OpCo, as its only client. 9Id. at 577. The owners of the OpCo are usually the founders who retain majority ownership in the substantive business. 10David Roberts & Thomas Hall, VIE Structures in China: What You Need to Know, O’Melveny & Myers LLP 1, 2 (Oct. 2011), http://iis-db.stanford.edu/evnts/6963/TICL_-_VIE_Structures_in_China.pdf.

With the parties being identified and duly organized, the essential part of the VIE structure comes into play: the contractual arrangement. Generally, in lieu of equity interests, the pivotal contractual arrangement constitutes the structural core between the WFOE and the OpCo. 11Kan, supra note 6. The primary purpose of this contract is to transfer the OpCo’s profits to the shell WFOE as the former’s primary beneficiary in the form of fees and royalties, 12Id. while also providing de facto control over the OpCo. 13Ma, supra note 1, at 1063. The WFOE and even the ListCo can be viewed as shareholders of the OpCo, demanding returns or “dividends” on their investment. 14Ma, supra note 1, at 1068. The legal majority shareholders, as well as the founder and effective controller of the OpCo, 15Roberts & Hall, supra note 10. are akin to directors and managers of a corporation because both control the operation of the invested business, and foreign investors’ interests are largely dependent on the owners’ management and operation. 16See, e.g., Shi, supra note 7, at 1292. Under the effective corporate governance mechanism, Chinese owners are expected to owe fiduciary duties to the foreign investors. This is not always the case; the current uncertainty of VIEs’ legal status and the absence of clear legal resort once the contracts are breached essentially render the interest of ListCo and WFOE at the mercy of the Chinese owners. 17See id. at 1291–94 (discussing the notion that misalignment of interests can prompt Chinese owners to walk away with important interests in the VIE but foreign investors are limited in pursing recovery); see also Guo, supra note 7, at 584. Regardless of the risks posed by regulatory uncertainty, it is still necessary to recognize what function these contracts play in VIE’s corporate governance.

A. Call Option Agreements

The Call Option Agreement grants the WFOE the right to purchase the OpCo’s shares from its owners through one or a series of transactions. 18See Guo, supra note 8; Roberts & Hall, supra note 10. The purchase price is predetermined and typically set as “the lowest permissible price under the People’s Republic of China (“PRC”) law.” 19Id. The WFOE will have difficulty exercising this right if there are still prohibitions or strict restrictions on the foreign investment in the OpCo’s industry. 20Guo, supra note 14.

In lieu of recent events, such as the newly drafted Foreign Investment Law by China’s Ministry of Commerce 21Major Tian, What’s Next for the Variable Interest Entity Structure?, CKGSB Knowledge (Feb. 5, 2015), http://knowledge.ckgsb.edu.cn/2015/02/05/finance-and-investment/whats-next-for-the-variable-interest-entity-structure/. and the relaxation on foreign investment in previously restricted industries, 22See Daniel Chan & Peng Tao, China Removes Foreign Investment Cap on E-commerce Business in the Shanghai Free Trade Zone, DLA Piper (Jan. 21, 2015), https://www.dlapiper.com/en/china/insights/publications/2015/01/china-removes-foreign-investment-cap/; Karen Ip, Damien Bailey & James Gong, New MIIT Measures to Lift Restriction on Foreign Ownership of E-commerce Companies, Lexology (June 29, 2015), http://www.lexology.com/library/detail.aspx?g=9d7a72a3-2b37-4966-a7f3-9fd42bc70070. such call-option rights might be substantiated in the future. The newly drafted law has been interpreted to indicate that so long as the effective controllers of the VIE are Chinese nationals, the existing VIE in the restricted industries will survive. 23Tian, supra note 21. Able to acquire up to one hundred percent of the shares in an e-commerce business, 24Ip, Bailey & Gong, supra note 22. the WFOE can effectively exercise its rights to purchase shares in the OpCo without worry of it being invalidated later. This expectation means that once the foreign investors are capable and willing to exercise purchase rights under the Call Option Agreements, foreign investors can effectively gain control over the company and even prevent Chinese owners from manipulating business operations or triggering a management change resembling a takeover.

B. Loan Agreements, Services Agreements & Equity Pledge Agreements

Loan agreements, services agreements, and equity pledge agreements go hand-in-hand. 25See Guo, supra note 8; Ma, supra note 1, at 1067–68. The loan agreements between Chinese owners and the WFOE act as the main investment; the former shall repay the latter out of the OpCo profits. 26Id. The consulting services agreement or functionally equivalent contracts, such as know-how or trademark licensing contracts, disguise WFOE profits as fees and royalties. 27Ma, supra note 1, at 1067. On the other hand, equity interests of the OpCo are viewed as security for the loan and other compliance components of the VIE arrangements. 28Ma, supra note 1, at 1067.

In theory, managers of a corporation only owe fiduciary duties to shareholders as the residual claimants of the corporate value 29Leo E. Strine, Jr, One Fundamental Corporate Governance Question We Face: Can Corporations Be Managed for the Long Term Unless Their Powerful Electorates Also Act and Think Long Term?, 66 Bus. Law. 1, 8 (2010). and creditors of the corporation. In the case of a WFOE , shareholders can require stringent covenants in the loan agreement such as limits on repayment methods and acceleration clauses to enforce the VIE structure as a whole. 30Roberts & Hall, supra note 10, at 3. By using debt, agency costs are reduced through various monitoring and bonding mechanisms. 31Michael Jensen & William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3 J. Fin. Econ. 305, 334 (1976). The effectiveness of these contractual provisions is predicated by the ability to enforce such agreements. The underlying contract might be rendered unenforceable by PRC courts if it is viewed as “concealing illegal intentions with a lawful form.” 32Ma, supra note 1, at 1070. Under the current regulatory trend, while possessing interests in a certain industry by foreign investors may not continue to be viewed as “illegal intentions,” contractual provisions are still limited in their ability to create change at the board and management levels. 33Edward Drew Dutton & Niping Wu, Investing in China: New Risks?, Debevoise & Plimpton Private Equity Report 3, 4 (Summer 2011), http://www.debevoise.com/~/media/files/insights/publications/2011/09/the%20private%20equity%20report/files/view%20private%20equity%20report/fileattachment/pereportsummer2011.pdf. The most high-profile case echoing these concerns is the dispute between Alibaba and Yahoo, regarding the split of Alipay from its offshore holding company. Yahoo, a major investor of Alibaba’s ListCo, could do nothing but reach a settlement in that instance. 34Kaitlyn Johnson, Variable Interest Entities: Alibaba’s Regulatory Work-around to China’s Foreign Investment Restrictions, 12 Loy. U. Chi. Int’l L. Rev. 249, 255–56 (2015).

C. Voting Rights Agreements or Power of Attorney Proxy

It is difficult to monitor important corporate decisions of the OpCo by either the WFOE or the ListCo. While it is possible that parties would manage to agree on assigning to the WFOE all of the usual shareholder rights, including voting, attending shareholder meetings, and acting as necessary to execute the call option agreement, there are still governmental hurdles 35Guo, supra note 8, at 579. As discussed, without the Chinese government’s confirmation on the legality of foreign shares, there will always be a chance that corporate decisions will be nullified. A proxy arrangement involving such a situation was recently held unenforceable by the Supreme People’s Court. 36See Ma, supra note 1 at 1069–70 (discussing that a Hong Kong ListCo’s request of enforcing a proxy arrangement was refused by the Supreme People’s Court on the ground that the arrangement intended to bypass China’s investment restrictions and was consequently invalid because it was “concealing illegal intentions with a lawful form”).

Conclusion

If the Chinese legal environment remains stagnant in restricting foreign investment in selected industries, the VIE can only achieve a minor improvement to corporate governance. ListCos can continue to try to maximize financial arrangements without participating in any form of the decision-making process of VIE. As the PRC government starts to reduce restrictions, it may appear unnecessary to set up a new VIE since foreign investors could directly purchase equity interests in Chinese companies. Such liberalization would affect the existing VIE by transforming contractual rights of WFOEs to shareholders, thereby granting them ordinary corporate governance capability.

Footnotes

1Mengwei Ma, The Perils and Prospects of China’s Variable Interest Entities: Unraveling the Murky Rules and the Institutional Challenges Posed, 43 H.K. L.J. 1061, 1064 (2013).

2See Xianwu Zeng & Lihui Bai, Variable Interest Entity Structure in China, China L. Insight (Feb. 9, 2012), http://www.chinalawinsight.com/2012/02/articles/corporate/foreign-investment/variable-interest-entity-structure-in-china/.

3See Waishang Touzi Chanye Zhidao Mulu (2011 Nian Xiuding) (外商投资产业指导目录(2011年修订)) [Catalogue for the Guidance of Foreign Investment Industries (Amended in 2011)] (promulgated by the Ministry of Commerce & Nat’l Dev. & Reform Comm’n, Dec. 24, 2011, effective Jan. 30, 2012) Ministry Com. China (Feb. 21, 2012, 7:51 PM), http://english.mofcom.gov.cn/article/policyrelease/aaa/201203/20120308027837.shtml.

4Zeng & Bai, supra note 2.

5Gregory J. Millan, Alibaba’s IPO Puts VIE Structure in the Spotlight, Wall St. J. (Sept. 22, 2014, 9:46 AM), http://blogs.wsj.com/riskandcompliance/2014/09/22/alibabas-ipo-puts-vie-structure-in-the-spotlight/.

6Kenneth Kan, Alibaba and the Variable-Interest Entity, Mkt. Mogul (Sept. 12, 2014), http://themarketmogul.com/alibaba-and-the-variable-interest-entity/.

7See Li Guo, Chinese Style VIE: Continuing to Sneak Under Smog?, 47 Cornell Int’l L.J. 569, 577–78 (2014); Serena Y. Shi, Dragon’s House of Cards: Perils of Investing in Variable Interest Entities Domiciled in the People’s Republic of China and Listed in the United States, 37 Fordham Int’l L.J. 1265, 1277–78 (2014); Ma, supra note 1, at 1063–64.

8Guo, supra note 7, at 578.

9Id. at 577.

10David Roberts & Thomas Hall, VIE Structures in China: What You Need to Know, O’Melveny & Myers LLP 1, 2 (Oct. 2011), http://iis-db.stanford.edu/evnts/6963/TICL_-_VIE_Structures_in_China.pdf.

11Kan, supra note 6.

12Id.

13Ma, supra note 1, at 1063.

14Ma, supra note 1, at 1068.

15Roberts & Hall, supra note 10.

16See, e.g., Shi, supra note 7, at 1292.

17See id. at 1291–94 (discussing the notion that misalignment of interests can prompt Chinese owners to walk away with important interests in the VIE but foreign investors are limited in pursing recovery); see also Guo, supra note 7, at 584.

18See Guo, supra note 8; Roberts & Hall, supra note 10.

19Id.

20Guo, supra note 14.

21Major Tian, What’s Next for the Variable Interest Entity Structure?, CKGSB Knowledge (Feb. 5, 2015), http://knowledge.ckgsb.edu.cn/2015/02/05/finance-and-investment/whats-next-for-the-variable-interest-entity-structure/.

22See Daniel Chan & Peng Tao, China Removes Foreign Investment Cap on E-commerce Business in the Shanghai Free Trade Zone, DLA Piper (Jan. 21, 2015), https://www.dlapiper.com/en/china/insights/publications/2015/01/china-removes-foreign-investment-cap/; Karen Ip, Damien Bailey & James Gong, New MIIT Measures to Lift Restriction on Foreign Ownership of E-commerce Companies, Lexology (June 29, 2015), http://www.lexology.com/library/detail.aspx?g=9d7a72a3-2b37-4966-a7f3-9fd42bc70070.

23Tian, supra note 21.

24Ip, Bailey & Gong, supra note 22.

25See Guo, supra note 8; Ma, supra note 1, at 1067–68.

26Id.

27Ma, supra note 1, at 1067.

28Ma, supra note 1, at 1067.

29Leo E. Strine, Jr, One Fundamental Corporate Governance Question We Face: Can Corporations Be Managed for the Long Term Unless Their Powerful Electorates Also Act and Think Long Term?, 66 Bus. Law. 1, 8 (2010).

30Roberts & Hall, supra note 10, at 3.

31Michael Jensen & William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3 J. Fin. Econ. 305, 334 (1976).

32Ma, supra note 1, at 1070.

33Edward Drew Dutton & Niping Wu, Investing in China: New Risks?, Debevoise & Plimpton Private Equity Report 3, 4 (Summer 2011), http://www.debevoise.com/~/media/files/insights/publications/2011/09/the%20private%20equity%20report/files/view%20private%20equity%20report/fileattachment/pereportsummer2011.pdf.

34Kaitlyn Johnson, Variable Interest Entities: Alibaba’s Regulatory Work-around to China’s Foreign Investment Restrictions, 12 Loy. U. Chi. Int’l L. Rev. 249, 255–56 (2015).

35Guo, supra note 8, at 579.

36See Ma, supra note 1 at 1069–70 (discussing that a Hong Kong ListCo’s request of enforcing a proxy arrangement was refused by the Supreme People’s Court on the ground that the arrangement intended to bypass China’s investment restrictions and was consequently invalid because it was “concealing illegal intentions with a lawful form”).

*Emory University School of Law, J.D. Candidate, 2017; Managing Editor, Emory Corporate Governance and Accountability Review; LL.B.; B.A. Business Management, Renmin University of China. I would like to thank Heidi Hegewald for providing valuable thoughts and editing my work and Liu Chen for helping me craft and refine my work throughout its many drafts.