The Ministry of Commerce (MOFCOM) for the People's Republic of China (the "PRC" or "China"), which provides security reviews for inbound mergers and acquisitions, has implemented new review features that have the potential to alter the foreign investment landscape. Variable Interest Entities ("VIEs"), corporate structures utilized in certain mergers and acquisitions (M&A) to access industries normally restricted to foreign investment, may now fall under the scrutiny of MOFCOM. This would subject VIEs to tighter screening procedures and increase the likelihood that certain transactions will not be completed. Foreign companies making acquisitions in China will have to reconsider their approach to VIEs as these structures come under greater scrutiny.

Regulatory Background

On August 8, 2006, six PRC regulatory agencies promulgated the Regulation on Mergers and Acquisitions of Domestic Companies by Foreign Investors (the "2006 M&A Rules"), which became effective on September 8, 2006, and was subsequently amended in 2009. The 2006 M&A Rules established a general legal framework for foreign investors to acquire either equity or assets of a Chinese company in exchange for cash or stock of the foreign acquirer, requiring, among other things, approval by one or more PRC government authorities. The 2006 M&A Rules also require foreign investors to notify PRC authorities if a proposed M&A transaction results in foreign investors gaining control of a PRC company that involves or affects: a key domestic industry; national economic security; or well-known or traditional trademarks or brand names.

On August 30, 2007, the Standing Committee of the People's Republic of China ("China" or the "PRC") National People's Congress issued the Anti-Monopoly Law of the People's Republic of China (the "AML") and it took effect on August 1, 2008. Article 31 of the AML signaled that a national security review mechanism would soon be implemented in connection with M&A of domestic companies by foreign investors in China by stating that "where a foreign investor participates in the concentration of undertakings by merging or acquiring a domestic enterprise or by any other means..., and national security is involved, besides the examination on the concentration of undertakings in accordance with this Law, the examination on national security shall also be conducted according to the relevant provisions of the State."

On February 12, 2011, the PRC State Council promulgated a Notice on the Establishment of the National Security Review Mechanism for the M&A of Domestic Enterprises by Foreign Investors (the "NSR"), and on August 25, 2011, MOFCOM, which has primary authority over the NSR process, issued implementing regulations pertaining to the security review of inbound M&A transactions, which became effective on September 1, 2011. The NSR may impact the offshore structure of Chinese companies for the purpose of overseas listing as well the ability of companies with such structures to obtain private equity financing.

National Security Review and Implementing Regulations

The NSR and implementing regulations provide MOFCOM with the power to determine whether an acquisition of, or merger with, a domestic enterprise by a foreign enterprise should be subject to national security review by considering both the substance of the acquisition, as well as its actual impact on national defense, national economic stability, social stability, and on the research and development of key technologies related to national security.

Covered Transactions

The NSR covers: (i) the purchase by foreign investors of existing equity interest or shares or increased capital of PRC non-foreign-invested enterprises and conversion of such domestic PRC enterprises into foreign-invested enterprises (FIEs); (ii) the establishment by foreign investors of FIEs and the purchasing and operating of assets acquired from domestic PRC enterprises through such FIEs; (iii) the purchase of equity interests or shares of domestic PRC enterprises through FIEs; (iv) the purchase by foreign investors of assets owned by domestic PRC enterprises and the establishment of FIEs to operate such assets; and (v) the purchase by foreign investors of equity interests or shares owned by PRC parties in FIEs or the purchase by foreign investors of the increased capital of FIEs; with no minimum thresholds.

Covered Industries

National Security reviews are required for transactions involving PRC companies that are "Military and Related Enterprises," "Military Area Enterprises" and are otherwise deemed to be "Key Companies". Military Related Enterprises includes military enterprises, as well as enterprises that provide support to, or are otherwise connected to military enterprises. Military enterprises also include enterprises that are located near key and sensitive military facilities (the "Military Area"). Therefore, even if the a PRC target company is engaged in non-military business, if it is located in a Military Area, the transaction will also be subject to the security review. Although the NSR does not define what "key" means in this context, transactions involving PRC target companies involved with key agricultural products, key energy or natural resources, key infrastructure and transportation services, key technologies and key equipment manufacturing activities that raise national security concerns, so called Key Companies, are subject to national security review if the foreign investor may acquire actual control of such PRC target company.

For the purposes of the NSR, an acquisition of "actual control" refers to a situation where a foreign investor (including its parent or subsidiary), or several foreign investors: (i) acquire 50 percent or more of the PRC target's equity interests or voting rights; (ii) have a significant influence over the PRC target's shareholder meetings or its board of directors, or (iii) obtain actual control over the PRC target's business decisions, financial affairs, personnel and/or technology or other matters.

National Review Process

MOFCOM has the power to determine, whether a given M&A activity requires national security review. Upon its receipt of a notification or application from the transaction parties with respect to a covered transaction, MOFCOM has 5 business days to refer a transaction for national security to a ministerial-level review committee established under the State Council, led by MOFCOM and the National Development and Reform Commission (NDRC), and comprised of other authorities in charge of the industry to which the transaction is related (the "Committee"). If MOFCOM decides not to refer the transaction for review (a) other relevant departments or ministries under the PRC State Council, (b) national industrial organizations, (c) enterprises in the same industry as the PRC target; and (d) upstream and downstream enterprises of the PRC target company (together, the "Domestic Constituents"), have the right to request that MOFCOM refer a transaction to the Committee for national security review. MOFCOM is obligated to forward such Domestic Constituent requests to the Committee without discretion (although no specific timeframe is mandated in such cases).

The NSR stipulates a two-step review procedure: a preliminary review and a special review. The preliminary review commences with a written notice from the Committee to the Domestic Constituents within 5 business days after the Committee receives a request from MOFCOM. Domestic Constituents have 20 business days after receiving such written notice to provide comments, if any, to the Committee. If Domestic Constituent believes that the transaction will affect PRC national security, then the transaction must undergo a special review. The Committee will initiate the special review procedure within 5 business days after it receives notice from a Domestic Constituent that, in its view, the transaction will affect PRC national security. The Committee will then assess the transaction for impact on national security. If an absolute majority of the members of the Committee reach a conclusion regarding the transaction, the Committee will issue its decision. If the members of the Committee hold significantly different views on the transaction such that an absolute majority cannot be reached, or if the special review could not be completed within 60 business days after its initiation, then the transaction will be submitted to the PRC State Council for review.

After completion of its review, the Committee will issue a determination (through MOFCOM) as to whether the transaction will affect or will not affect national security. If the Committee concludes that the transaction has or will affect national security, it will issue a separate order or notice to MOFCOM, regarding what actions should be taken by the foreign investor and the PRC target. In such cases the Committee can require MOFCOM to either terminate the transaction, require the foreign investor to transfer its equity or assets, or take other measures for the purpose of eliminating the negative effect of the transaction on national security.

Prior to a formal submission to the review process, parties have the option of engaging in non-binding preliminary discussions with MOFCOM, subject to a confidentiality obligation imposed on the applicable commerce departments and personnel. In addition, the parties have the right modify or withdraw a transaction from review at any time during the review process.

Impact of Security Review on Variable Interest Entities

The implementing regulations of the NSR and other recent developments in China have raised some uncertainty relating to the long-term viability of the variable interest entity structure in China, as well as the ability of companies with such structures to obtain future financing. Although there is no express prohibition against the VIE structure, national security review of transactions with VIE structures will subject them to increased scrutiny and longer periods of time to complete. Article 9 of the implementing regulations expressly states that foreign investors may not for any reason evade the security review process, such as holding equity via trusts and exercising control through contractual arrangements, meaning that any foreign investment, including those with VIE structures, can be subject to security review.

A variable interest entity ("VIE") is a term used by the United States Financial Accounting Standards Board (FASB) to refer to an entity in which the investor holds a controlling interest that is not based on equity ownership or majority voting rights. Since the adoption of the 2006 M&A Rules, certain PRC companies without an offshore structure in place would establish a VIE structure in order to circumvent the requirement to obtain PRC governmental approval for covered merger or acquisition transactions. The typical VIE structure involves the establishment by the founder or nominee of a domestic operating company (Domestic Co) of an offshore company (Offshore Co), which in turn would establish a wholly foreign owned enterprise (WFOE) in China, that would, through a series of contractual agreements, gain most, if not all, of Domestic Co's profits, and control Domestic Co's management and operations. In such cases FASB Interpretation 46(R) permits consolidation of Domestic Co's financial data into the financial statements of the WOFE, regardless of ownership, as the WOFE controls the economic risks and rewards of the entity.

It is unclear what level of scrutiny of VIEs will be implemented by MOFCOM at the time of its national security review, but recent developments indicate that almost all VIEs may be subject to enhanced scrutiny. On July 4, 2011, the Communist Party School paper, Study Times, published an article criticizing the supposed influence of foreign capital within the country's sensitive IT sector, which has been largely accomplished through the VIE structure. In mid-September, 2011, Reuters reported on the existence of an unconfirmed internal China Securities Regulatory Commission (CSRC) report, dated August 17, 2011, describing VIEs as a major threat to China's national security and asking the PRC State Council to take action against VIEs in the following manner: (i) PRC companies under the VIE structure must receive approval from both MOFCOM and the CSRC to list overseas, but the old rules would still apply to companies that are already listed; (ii) the PRC government should encourage PRC internet companies to list on PRC domestic exchanges, and if such listings are not possible, then to list directly in foreign markets; (iii) the CSRC should collaborate with the SEC, and other foreign equivalents, regarding the enforcement of such rule.

There is also uncertainty as to whether the contracts that establish control in the VIE structure are enforceable under PRC law. The recent case of GigaMedia Ltd., a foreign private issuer with a PRC VIE relationship through T2CN Holding Limited, shows that the enforceability risk is real. Control of the VIE was usurped by its original PRC owner, Wang Ji, after the GigaMedia board voted to replace him as CEO of its PRC operations. GigaMedia reported that Wang had the seals, financial chops and business registration certificates necessary to run its online games business in the PRC, including, to declare dividends and approve service fee payments, conduct banking business and register the resolutions removing Wang from his position. The parent filed lawsuits against him in the PRC, Hong Kong, Singapore and the British Virgin Islands, but subsequently disclosed that it was highly unlikely that its VIE contracts would be enforced in court. GigaMedia based this conclusion on the fact that it had failed to register the equity pledge included in the VIE contracts, however, it is unclear whether they would be able to enforce VIE contracts with a restricted company in any event, especially in the current PRC regulatory environment. The company subsequently disclosed that it was considering writing off the entire investment in the entities held by the WFOE since they had lost control of the WFOE and were unable to gain access to any financial information regarding the entities.

In order to consolidate a VIE in the controlling company's financial statements, one has to show that the controlling company not only receives the economic benefits and takes the economic risks of the venture, but also that the VIE is in fact controlled by such company. In light of the foregoing, investors are increasingly concerned that control of VIEs in China may no longer be valid or justifiable for purposes of FASB Interpretation 45(R) now that the enforceability of VIE contracts is uncertain. If the contracts, which establish this control, are deemed invalid or unenforceable, consolidation may no longer justifiable under FASB Interpretation 46(R), then foreign investment in PRC companies with such VIE structures may be more difficult to secure.

What These Changes Mean to You

Potential PRC targets will need to be carefully considered and a coordinated strategy developed to address possible concerns, including, modification of the transaction scope or structure, especially in light of the rights provided to third parties to initiate the national security review process. Any existing VIE structure in the PRC target company should be examined to determine (i) whether the VIE structure is necessary due to operations in a restricted industry, i.e. was it established merely to circumvent PRC regulatory requirements; and (ii) if the VIE structure is necessary to participate in a restricted industry, whether the operating company is engaged in a military or related industry or located in a Military Area or engaged in one of the key industries identified in the NSR, and if the latter, whether the transaction is structured to provide a foreign person or entity actual control over the operating company. Foreign investors should also assess whether the VIE operates in the telecommunications sector, internet gaming sector, e-commerce/online payment services sector or steel sector, where PRC authorities have expressed disfavor to the use of VIE structures for foreign investment.

In 2006, the PRC Ministry of Information Industries (MII) issued its Notice Concerning Strengthening the Administration of Foreign-Invested Value-Added Telecommunications Business Operations, suggesting it would be taking a closer look at VIE structures used by internet companies. The use of the VIE structures continued in this sector, but practitioners viewed the notice as a warning and proceeded with additional cautions, including additional risk factors in disclosure documents like prospectuses. In September 2009, the PRC General Administration of Press and Publication (GAPP), the National Copyright Administration and the National Office of Combating Pornography and Illegal Publications jointly published the Notice Regarding the Consistent Implementation of the "Stipulations on 'Three Provisions'" of the State Council Internet Games, etc. This notice expressly prohibited the use of technology support or other agreements to give foreign investors control over internet game operations and services in China. This was significant in that it signaled PRC government awareness of the proliferation of VIE structures and its ability to regulate them.

In August 2010, the management of Alibaba Group Holding Limited, in which foreign entities, Yahoo Inc. and Softbank Corp, had "controlling" interests, transferred the assets of its VIE and largest e-commerce business, Alipay, to purely domestic ownership with no contractual arrangements made with the foreign entity, because, according to Jack Ma, Alibaba's founder and CEO, China's central bank refused to issue required payment business permits to online payment companies that have foreign ownership. It is unclear whether this case is signaling PRC government discontent with the level of foreign control over a PRC e-commerce and payment services business, or whether the spinoff was a strategic move by Ma to force the foreign investors, including Yahoo to sell their interests at a discount.

Buddha Steel, Inc. held its operations in a PRC company, Baosheng Steel, which was owned primarily by Buddha Steel's CEO and his family, but controlled pursuant to the usual VIE agreements and consolidated into Baosheng Steel's financial statements as a VIE. Buddha Steel was in the process of conducting a $38 million underwritten public offering in the U.S. when, in March 2011, the local government authorities in Hebei Province reportedly advised the PRC operating company that the VIE agreements "contravene current Chinese management policies related to foreign-invested enterprises and are against public policy." In response, Buddha Steel terminated its commercial agreements with its VIE and the VIE reverted to 100% control of the original PRC owners. This rendered Buddha Steel a shell company with no operations and resulted in a withdrawal of the public offering.

The foregoing represents examples in which PRC regulators have confirmed their awareness of the widespread use of the VIE structure, which in certain situations they believe may have been used to circumvent foreign investment restrictions in certain sectors, and the actions taken to discourage or prohibit such use.

Regulatory Outlook

The use of the VIE structure is prevalent among PRC listed companies. According to informal research conducted by China Finance blogger, Fredrik Öqvist1: (i) 42% of U.S. listed PRC companies use the VIE structure; (ii) more than half of NASDAQ listed companies (53%), 29% of NYSE listed companies and 6% of NYSE Amex companies use the structure; and (iii) the use of the VIE structure increased during 2010, with 47% of 2010 NYSE listings of PRC companies (9 out of 19) having used VIEs, and 65% of 2010 NASDAQ listings (10 out of 16) having used VIEs.

In his article "Cleaning up the VIE Section" in the China Accounting Blog2, Prof. Paul Gillis, visiting professor of accounting at Peking University's Guanghua School of Management, posits that the solution to the current uncertainty rests in the hands of the PRC regulators, and he makes the following suggestions for reform: (i) make it easier for PRC companies to directly list overseas without using an offshore entity; (ii) recognize the reality that there already is significant foreign investment in prohibited sectors, and find a way to regulate this investment; (iii) develop rules to make it possible to bring the offshore structures back onshore; (iv) develop a regulatory structure that works for these companies, and which coordinates effectively with the SEC and PCAOB; (v) create more opportunities for U.S. listed PRC operating companies to obtain a listing on PRC stock exchanges; and (vi) make it easy for firms to regularize their operations, and then strictly enforce existing PRC laws where such companies do not restructure.

While it is clear that MOFCOM wants to ensure that foreign investors do not avoid the NSR, including pursuant to a VIE structure, it does not necessarily mean that they will enforce existing rules in the future to the detriment of foreign investors. The consensus appears to be that while China could just get tough and force all of the companies using VIE structures to restructure into PRC owned entities, it is unlikely to do so as such conduct that would cause a great deal of harm to PRC companies with such structures, such as and Baidu, their shareholders and the PRC economy.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.