China: Developments In M&A Regulations In China And Impact On VIE Structures

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.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions