In late 2012, the Supreme People's Court of the People's Republic of China (the "PRC") made the final judgment on the Chinachem case1, in which a series of entrusted investment agreements entered into between Chinachem Financial Services Limited ("Chinachem"), a Hong Kong company and China Small and Medium Investment Development Enterprise ("SME"), a domestic company registered in the PRC was held to be invalid for the reason of concealing illegal purposes with a lawful form and therefore Chinachem has no right to the shares of China Minsheng Banking Corporation Limited ("CMBC"). The Supreme People's Court upheld the findings of Beijing High Court and ruled that Chinachem evaded the previous mandatory provisions on investment in financial institutions (i.e. foreign investors shall not invest in Chinese financing institutions) by using a set of contracts to effectively obtain control over SME which in turn acted as a trustee of Chinachem to invest in CMBC and hold the shares in CMBC.

This judgment leads to concerns of reliance on the investment vehicle known as variable interest entity ("VIE") and a chill on foreign investment. In addition, Shanghai Commission of China International Economic and Trade Arbitration Commission ("CIETAC Shanghai") has granted two arbitral awards2 since 2011 to invalidate a set of foreign-control agreements entered into between a wholly foreign-owned enterprise ("WFOE") and a domestic online game company, in which CIETAC Shanghai applied the PRC Contract Law and relevant laws and regulations on foreign investment in domestic telecommunication sector to reach the same conclusion as that of the Supreme Court in the Chinachem case - the foreign-control agreements entered into for the purpose of indirect and de facto control of the domestic operation company by the WFOE were created to conceal illegal purposes with a lawful form and should be invalidated.

VIE structure has been widely used for years by foreign-invested PRC companies or PRC companies seeking overseas listing primarily to circumvent PRC laws and regulations that restrict or prohibit foreign investors from investing in certain industries or sectors. The essence of VIE structure is a series of contract agreements that create contractual arrangements between foreign investors and PRC companies and allow the foreign party to have de facto control over PRC companies operating in the industries or sectors subject to restriction on foreign investment. With various discussions on the similarities between VIE structure and the above Chinachem case and arbitration case, validity and legality of VIE structure becomes a practical concern.

For more than ten years VIE structure has been in legally grey area without any formal response as to the effectiveness or validity of the structure from the regulatory authorities nor any laws or regulations in respect of VIE structure in the PRC. Longtime general absence of official attitude towards this structure has been regarded as a sign of tacit approval by the PRC regulatory agencies. Furthermore, a large number and a wide range of transactions and companies have deployed such structure to attract foreign venture financing or seek offshore listings, for instance, it is estimated that about half of the more than 200 PRC companies listed on overseas stock exchanges use VIE structure. Total transaction amount involved in VIE structure accounts for a great proportion of GDP in the PRC. With the disputes or incidents in connection with VIE structure taking place in recent years, the structure has become more sophisticated and has been designed to be more mature.

However, the above two cases show the indication that contracts or agreements adopted in VIE structure to get around the PRC foreign investment restrictions or prohibitions might be invalidated by the court or the arbitration tribunal. Under the circumstances of uncertainties of legislation and official attitudes, focus should be put on the mechanism and approaches to improve VIE structure, and most importantly, to protect the investors, rather than on the validity or legality of the structure.

It is advised that the following mechanism and approaches can be used when establishing VIE structure. Firstly, foreign investors should have enough knowledge about the complexity and difficulty in dealing with deadlock in the PRC on the basis of Chinese culture and consider preventing demolishment of the VIE structure from the first place. Secondly, proper mechanism in line with judicial practice should be set up to avoid passive situations following disputes between foreign investors and domestic PRC companies, including but not limited to money management of the operation company and WFOE, appointment of the management, composition of the board of directors and establishment of the systems of company seal and legal representative under the PRC regulatory regime. Thirdly, foreign investors' control over domestic PRC companies should be strengthened through control of technology, employees and working capital by WFOE. Fourthly, withdraw mechanism from the VIE should be seriously considered and properly established in case of any fatal disputes arising from the structure. Lastly, when establishing VIE structure, investors should pay attention to the protective measures provided by the bilateral investment treaties entered into between the PRC and relevant countries, which may be effectively employed to safeguard investors' rights and interests when they are faced with unfair treatment of the government in the PRC.

Until greater clarification or clear provisions on the treatment of VIE structure are provided by the PRC regulatory authorities, all investors and market participants involved in VIE structure should be prudent and vigilant with regard to the inherent risks and uncertainties of the structure.


1Dacheng Law Offices represented Chinachem in this case until 2008 when Nina Wang Kung Yu-Sum passed away.

2 Dacheng Law Offices acted for the shareholders of the PRC domestic company in this case and advised on the overall plan in respect of the VIE structure, which resulted in the two awards of the arbitration of this case.

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