China’s economic growth has been compared to a locomotive charging down the tracks at top speed. But in October 2012 the Chinese Supreme Court issued a ruling that has the potential to slow the engine down. In a 16-page judgment, the court ruled that the Variable Interest Entity (VIE) – contractual agreements intended to circumvent restrictions on foreign investment – is now invalid.
What is a Variable Interest Entity?
China is no different from any other emerging market in that it wants to prevent its economy from being owned and controlled by foreign investors. The government considers industries such as finance, media, technology, the Internet, and education to be areas where foreign investment is prohibited. And, the VIE is a way of working around this.
Technically, a VIE allows an investor to have a controlling interest without having sufficient voting privilege to constitute a majority. This means that holding a substantial amount of equity in a company does not allow the VIE investor to make major decisions about operations, but it can enjoy the identical return on investment as any other investor. In other words: all the benefits without real corporate ownership.
This has allowed Chinese companies to attract foreign investment in key sectors of the economy that ordinarily would be considered off-limits. It has been quite successful as evidenced by Fredrik Öqvist, CEO of Chi-Eco Consulting, who reported that roughly half of the over 200 Chinese companies listed in the U.S. in 2011 made use of VIEs.
The Ruling’s Aftermath – Wal-Mart and Yihaodian
Chinese statutes stipulate that a contract written to avoid the requirements of Chinese law is void and not enforceable. Foreign companies with business relations that include VIEs most likely are quite nervous with good reason: There is a possibility that within an existing VIE agreement the Chinese partner can decide that it has already received the financing and access to intellectual property sufficient enough to create a clone. They can walk away from the earlier agreement, knowing that Chinese courts will not support any litigation against them.
It is possible the Chinese government may simply look the other way, not wishing to have existing VIEs dismantled and create economic havoc, but the government has already intervened in Wal-Mart Stores effort to bolster its presence in the e-commerce giant, Yihaodian.
It resulted in a major reorganization of Yihaodian and put limits on the business between the two. The ruling has in effect placed a Sword of Damocles over VIE-based contracts, and may result in non-Chinese companies hesitating to do more business in China until the dust has settled.
Alternative to VIEs?
Luckily, there is a workable alternative known as the Multi-Jurisdictional Captive Company (MJCC) structure. This mitigates some of the risks of a VIE by offering greater legal protection, and affording a sophisticated method of determining damages and enforcing judgments should an MJCC contract be breached. All parties to a VIE-based contract might wish to consider restructuring the agreement so that is more in line with an MJCC structure.
Whatever the future holds, any VIE business arrangement will have to be constructed or revised in light of the Supreme Court ruling. China itself may decide for the sake of the economy to open up protected industries to more foreign investment, making the VIE less important as a means of attracting foreign investment.
Major Lesson for Overseas Companies
A major lesson to be learned is that foreign companies wishing to enter into contract with businesses in China need to have legal counsel experienced in Chinese contractual law to avoid a situation where, accidentally, Chinese law is not strictly followed.