By Gregory J. Millman
Major foreign companies and several Chinese Internet companies
with U.S. stock-exchange listings are using a corporate structure
in China in a way that may be rendered illegal under a proposed
law.
The Wall Street Journal, working with Dow Jones Risk &
Compliance, identified companies that appear to be at risk from the
proposed law. These include Chinese operations of Amazon.com Inc.,
Pearson PLC and CBS Corp. They also include three major U.S.-listed
Chinese Internet companies: Sina Corp., Autohome Inc. and Weibo
Corp., which are threatened because foreign investors control them.
Most Chinese Internet companies listed abroad, such as Alibaba
Group Holding Ltd. and Baidu Inc., also use the structure but don't
seem to be at risk because they are ultimately controlled by
Chinese nationals.
All these companies use a structure called a variable interest
entity, or VIE, to do business in sectors of the economy where
foreign investment is restricted by the Chinese government. But
under the law, proposed by the Ministry of Commerce of the People's
Republic of China, known as MOFCOM, in January, they may not be
able to continue those operations or may have to sell controlling
stakes in the operations to Chinese nationals, attorneys say.
VIE structures are especially common among U.S. technology
companies. "You can't walk down the street in Palo Alto without
tripping over a VIE situation, because if you are in the Internet
space and looking at China you are looking at VIE," said Tom
Shoesmith, head of the China practice at law firm Pillsbury
Winthrop Shaw Pittman LLP.
Typically, a company based outside of China sets up what is
called a Wholly Foreign-Owned Enterprise in China. The WFOE in turn
signs contracts with a Chinese-owned operating company, the VIE,
which invests in the restricted sector. The contracts give the WFOE
effective control of the operating company but not ownership.
China has heretofore had a number of laws regulating foreign
investment. The newly proposed law would draw a simpler distinction
between sectors where foreign investors will get the same treatment
as Chinese investors, and a "negative" list of restricted and
prohibited sectors, where only companies controlled by Chinese
nationals could operate, even if structured as VIEs.
Without regulatory relief, "the foreign-controlled VIE entity
would have to either sell its controlling stakes in the VIE entity
to Chinese nationals [so that the stakes would be controlled by
Chinese nationals] or liquidate the VIE entity under applicable
Chinese law," said Winston Zhao, a partner in the law firm of
McDermott Will & Emery LLP.
The Wall Street Journal and Dow Jones Risk & Compliance
identified companies using the VIE structure by searching public
sources and securities filings and conducting interviews. Dow Jones
Risk & Compliance is owned by News Corp's Dow Jones & Co.,
which publishes The Wall Street Journal.
Amazon.com paid $75 million in 2004 to acquire Joyo.com, which
was structured as a VIE, later changing its name to Amazon.com
China Ltd. In its Securities and Exchange Commission filings on the
deal, Amazon mentioned the possibility of regulatory risk to the
VIE structure. The company didn't respond to requests for
comment.
In 2011, Pearson bought VIE-structured Global Education &
Technology Group Ltd., a provider of test-preparation services in
China, in a $294 million deal. Global Education used a VIE
structure, according to its SEC filings. A Pearson spokesman said,
"Like all businesses with a substantial presence in China, we are
following the development of the new regulations closely. These
regulations are still under review."
Expedia Inc. controls 82% of eLong Inc., a Nasdaq-listed
provider of travel services in China that reported about $167
million in revenue in 2013, the most recent annual report
available, where it also described its VIE structure. Expedia
declined to comment.
CBS Corp.'s CNET Networks Inc. uses the VIE structure for its
operations in China, according to the last annual report issued by
CNET Networks before its $1.8 billion acquisition by CBS Corp. in
2008, as well as a spokeswoman for CBS who confirmed the structure
is still in place but declined to comment further.
Among the Chinese companies, Sina and Weibo didn't respond to
requests for comment. A spokesman for Autohome confirmed that
Australia's Telstra Corp. owns a controlling share in the company
but declined to comment on the implications of the proposed
law.
To be sure, the legality of using the VIE structure has long
been ambiguous, attorneys who spoke with Risk & Compliance
Journal agreed. "The VIE structure has never been legal per se,"
said Zhang Ning, a counsel in the Beijing office of the law firm
O'Melveny & Meyers. The proposed legislation would remove the
ambiguity by legalizing some VIE operations that are controlled by
Chinese nationals, but for others, "this law would make them pretty
clearly illegal," Pillsbury's Mr. Shoesmith said.
In a joint statement on the new law, the U.S. Chamber of
Commerce, the American Chamber of Commerce in China and the
American Chamber of Commerce in Shanghai called for a 25-year grace
period or the grandfathering of existing VIEs.
Attorneys caution that the draft law was published for comment
just this year, is subject to change, and will probably not become
law in any form for at least two years. It also proposes to
liberalize investment, and such liberalization could open up some
of the sectors where foreign investors currently face restrictions,
reducing or eliminating the threat to them. "It's a little bit too
early to say they are in great danger," said Mr. Zhao of McDermott
Will & Emery. However, he noted that there have been other
challenges to the VIE structure in China.
In 1999, Chinese regulators announced that a similar structure,
called China-China-Foreign, used by China Unicom Ltd. to bring
foreign investment into China's mobile-telecommunication sector was
illegal. "A huge amount of money was lost in that process by
foreign investors," Mr. Zhao said.
That precedent hasn't deterred foreign investment in restricted
businesses, although the VIE structure is "exactly the same
creature" with one exception, according to Prof. Nicholas C. Howson
of the University of Michigan law school. A pivotal part of the
so-called China-China-Foreign, or CCF, structure was a joint
venture domiciled in China. The equivalent in the VIE is a wholly
owned foreign corporation, "which probably protects the VIE
structures less," Prof. Howson said.
According to Mr. Zhang, "It is time [for companies] to consider
restructuring the VIE."
On the one hand, Chinese regulators may decide to open to
foreign investment some sectors that are currently restricted, in
which case entities operating in those sectors through a VIE
structure could eliminate the contractual complexity by
restructuring. On the other hand, if their sector remains on the
negative list, they might have the opportunity to apply for a
grandfathered status, or to bring in Chinese investment in order to
bring control into line with the provisions of the law.
"It's not a cause for panic," he said.
Write to Gregory Millman at gregory.millman@wsj.com
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