This post was originally an Op-ed in the South China Weekly. Translated into English by iChinaStock.
Introduction: The VIE (Variable Interest Entities) model, which enables foreign capital to invest in China’s Internet companies, had functioned for over ten years, creating a golden decade of China’s Internet industry. Despite the fact that nobody knows exactly what the consequences will be should the model disappears, rumors of its prohibition have spread around. What’s the intention behind such demagoguery?
“The early bird catches the worm,” sighed He Zhang, CEO of Domob, a mobile Internet advertising firm. Zhang, in a meeting with investors, worried about the negative impact that the VIE panic may have upon his company, which aspires to an overseas IPO.
A Reuters article on September 18 triggered an immediate panic over VIE across capital markets and the Internet industry. The article claimed that an internal report submitted to the State Council, or Chinese cabinet, by China Securities Regulation Commission (CSRC) had suggested the gradually abolition of the VIE model, although exempting existing listed companies.
Ten days later, another article on Shanghai Securities News (SSN, one of the official newspapers to expose information on listed companies) played down the news as rumors.
According to SSN, the reported internal report is only a research note by a research fellow at CSRC and the note was neither an official report nor submitted to the State Council. The report said the paper was leaked to media through non-official channels, creating widespread misunderstandings.
The Internet industry, however, is still not at ease.
Liu Qiangdong, founder of 360buy.com, claimed on his personal Weibo (Microblog) that all Chinese Internet firms with venture capital investments, listed or not listed, including his own company, operate under VIE structures. Wiping out the VIE will cause a wave of turbulence across the industry, bringing E-commerce to an abyss, he said.
Yet those most concerned about the policy changes are new entrepreneurs, who just signed their contracts with investors but have yet to receive funding. They worry that they might never get their investment should VIE regulations suddenly tighten.
Zhu Xiaohu, partner of GSR Ventures, said it used to take two to three months for entrepreneurs to receive their investments after signing the contract. But it now takes four to six months.
“Regulations have not changed yet, but the sanctioning process is slower,” said Zhu. He believes that CSRC will open another door if it closes the VIE door. In the worst case, it would do nothing more than require some extra regulation and administrative processes to sanction VIEs, according to Zhu.
The Origin of VIEs
For the past decade, many of China’s top Internet firms have been listed in foreign capital market via VIEs.
The structure stems from China’s complicated licensing regulations. When foreign capital is banned from entering some of the regulated industries, VIEs are adopted to bypass the authority. VIE usually consists of a set of contracts signed between foreign companies and the domestically-owned companies.
The Chinese government adopted a licensing system in many “sensitive” industries, including Internet and media. Foreign capital, though interested in these industries, is prohibited from investing. Domestic companies, on the other hand, have licenses and qualifications but lack funding.
Moreover, stringent domestic IPO requirements make it nearly impossible for these companies to list in Chinese stock market. The marriage between foreign investments and domestic companies thus seems natural.
Foreign investors gain profits mainly by selling stocks on second-tier markets after IPOs. Thus many domestic companies eager for foreign investment must be listed overseas. Both parties need foreign entities as IPO entities. So a set of contractual controls through which the profits of domestic companies can be conveyed to these IPO entities have been invented.
The detailed process is as follows: a founding team sets up a shell company in the British Virgin Islands. The company then founds another shell company with investors (Venture Capitals or Private Equity) in the Cayman Islands as the listed-entity. The Cayman Islands company later establishes a third shell company in Hong Kong and holds it under controls through contract arrangements.
The shell companies are located in countries where taxes are low or non-existent. Setting up a foreign entity requires only half a month and $50,000 as registered capital.
Finally, the shell company in Hong Kong sets up a wholly-owned foreign enterprise (WFOE) in China, which signs a series of contracts with the domestic company operating the actual businesses. This final Chinese firm, under contractual control by the WFOE, is called a variable interest entity (VIE).
The VIE structure allows domestic companies to send their profits to foreign entities. The US capital market regulations regard such controls as legal, so the financial reports of domestic companies can be merged with those of listed foreign entities.
That is why the dispute over VIEs has caused a plunge of stock prices of Chinese Internet firms listed overseas. If the VIE is outlawed, financial reports of the listed foreign entities will look terrible when they are not allowed to merge financial report with the ‘contractually controlled’ domestic companies under the VIE structure.
The earliest VIE was operated by Sina. In late September 1999, when Sina was preparing to issue IPO overseas, Wu Jichuan, the then Minister of Industries and Information Technologies announced in a speech that the provision of Internet content would be regard as a value-added service in the telecom industry, into which foreign capital is not allowed to enter.
Sina later rushed to produce a restructuring blueprint, removing ICP and relevant assets from the mother company Stone Rich Sight Information Technology Ltd and setting up a new domestic company.
After the restructure, only Stone Rich Sight Information Technology was listed on the overseas market. But the company actually controls the ICP and relevant asset companies through a set of contracts on software technologies, consulting services and stock mortgages.
Liu Xiangning , an analyst at Huatai Securities, said the VIE has boosted a golden decade for TMT (Telegraph, Media and Technology industries) in China. TMT companies can be listed and get foreign VC/PE fundings even the regulations prohibit foreign capital. As a result, entrepreneurship has thrived, and T-M-T became prosperous industries.
All of China’s most excellent Internet firms, including Sohu, NetEase, Baidu, Tencent, Alibaba, used variants of the “Sina Model” to launch overseas IPOs. VIE structures, initially used for Chinese IPOs in the US and only for companies at telecom and IT firms, gradually expanded to media, finance, and even education businesses. New Oriental Group, China’s leading education firm, also has VIE structures.
Who Regulates?
Throughout this golden decade, however, Chinese regulators have remained ambiguous, and mostly silent, as to their views on de facto VIE structures.
Strictly speaking, there is NO clear and solid sanctioning process for VIEs, as they are in essence evasive maneuvers against sanctions and regulations. One of the most critical maneuvers is bypassing the restrictions of the “Directory of Industry Regulations Regarding Foreign Investments”.
This document categorizes China’s industries as “foreign investment encouraged”, “foreign investment restricted” and “foreign investment prohibited”. To enter into the second and third category industries, foreign capitals needs to use VIE structures.
Many of China’s state administrative departments such as the Ministry of Commerce and State Administration of Foreign Exchanges (SAFE), have attempted to incorporate VIE under their jurisdictions and clarify the ambiguity.
In October 2005, SAFE issued the No. 75 document. It stipulates that domestic companies, when setting up Special Purpose Vehicles or making returning investments, could only apply to local foreign exchange administrations, instead of reporting to both Ministry of Commerce and SAFE.
On August 8, 2006, Ministry of Commerce, together with State-owned Assets Supervision and Administration Commission, State Administration of Taxation, State Administration of Commerce and Industry, CSRC and SAFE issued the Regulations Regarding Foreign Acquisitions of Domestic Firms, or the No. 10 document.
It required domestic companies to apply to MOC for approval when setting up special-purpose vehicle (SPV) and to CSRC for stock exchange listings. The No. 10 document also requires applicants to provide the supreme controller ID documents and proposal of overseas IPO to MOC before registration with CSRC.
CSRC, on the other hand, shared its own voice too. Provision No. 40 of the No. 10 document stipulated that SPVs should also apply separately for stock exchange sanctions to CSRC. It is said that this provision was inserted by CSRC prior to the release of document.
An anonymous source at a foreign VC firm said that VIEs in recent years were actually ‘subtly’ administered. SAFE, for example, when administering through No. 75 document, sanctioned all applications without the term “VIE”. But there was little doubt that they knew they were allowing VIEs.
These departments were trying to expand their jurisdictions after the infighting over Alipay ignited the VIE debate. Shen Danyang, spokesman of Ministry of Commerce, revealed in a routine press conference on September 20 that the MOC “will research with relevant departments on how to regulate the VIE.”
Before long the “internal report of CSRC” began to circulate around the industries. The document, titled “Report On Foreign IPOs of Tudou.com and Other Domestic Companies”, suggested from a CSRC perspective that while existing VIE structures should temporarily be allowed, new VIE applications should not be accepted.
“The real purpose of regulators is to collect protection fees, ” said an anonymous VC source. “But I think we can accept that. It’s better than ambiguity, after all.” He believed the relevant departments are releasing signals of enhanced regulations to probe the industry, in which the ultimate goal is the expansion of regulatory turf.
Turning to RMB Funds?
The implications of the VIE debates for the general public, after all, is that Internet companies must prevent their cash flow from being cut off as well as a retreat of Internet service and entrepreneurship.
RMB-denominated private equity (PE), the alternative to foreign PE, is significantly different in investment preferences: Foreign PE prefers Internet-and consumer-based TMT and service industries, while the RMB counterparts, maintaining a diffuse investment scheme, invest more in traditional industries. Foreign PE also usually invests into a firm in its early days, while RMB PE prefers later entries. Also, foreign PE looks for investment cycles of over 5 years, while RMB PE prefers 2-3 years.
But the anonymous VC source said that RMB PE are now looking for opportunities to invest in the Internet industries too. Mobile Internet and E-commerce are replacing real estate as the prime targets for RMB PE, who are now beginning to compete with his fund, the source said.
The most famous RMB PE is YunFeng Capital, co-founded by successful Chinese entrepreneurs including Jack Ma, Yu Feng (founder of JuZhong Media, now merged with Focus Media), Shi Yuzhu (founder of Giant Interactive Group) and Niu Gensheng (founder of Mengniu Dairy Group).
Gong Hongjia, President of Funinhand Technologies and an angel investor, made a bold prediction on his personal Weibo: “Should VIE regulations change, RMB VC/PE, government institutions and domestic stock market, will advance in the Internet industry.”
Perhaps this is not a coincidence. The aforementioned “internal report” pointed out that the fast development of China’s capital market, especially the development of RMB VCs, have created positive conditions for high-tech firms to issue stock shares in the domestic stock market. The report urged for policies encouraging leading Internet firms listed overseas to return to the A-shares market.
Many interviewees in the Internet and capital business believe that the consequences of the recent VIE debate will be preferable to maintaining the status quo of ambiguous VIE regulations that existed before. A compromise case would be the expansion of regulatory powers and rising costs of VIE operations.
Employees in the investment and capital business said they are not worried about a VIE disruption. They believe that the worst case would be a prohibition of US VC/PE from investing in China’s Internet industry. Then they will just find new jobs in RMB VC/PE.
Liu Xiangning, the Huaitai Securities analyst, suggests the state authorities should act decisively and eliminate further risk. According to Liu, the government should first acquiesce to the legality of existing VIEs, signaling its willingness to protect the interests of foreign capital in China. Second, restrictions on foreign capital should gradually be loosened to bring off-shore listed companies back to China without threatening economic security. Finally and most importantly, sanctions and the administrative processes should be renovated with a more tolerable mentality, allowing companies with novel technologies and new business models to be listed in the domestic stock market.
Read more posts on iChinaStock »
