Exclusive: Popular China company structure under threat

By Stephen Aldred and Don Durfee

HONG KONG/BEIJING (Reuters) - China's securities regulator is asking the government to clamp down on the controversial corporate structure used by companies such as Sina <SINA.O> and Baidu <BIDU.O> to list overseas, and employed in thousands of other investments by foreigners into domestic Chinese companies, four legal sources told Reuters.

Lawyers at four different firms in China and Hong Kong said they have seen an internal report, dated August 17, said to come from the China Securities Regulatory Commission (CSRC) which asks China's State Council, or cabinet, to take action against the structures known as Variable Interest Entities (VIEs).

The CSRC did not respond to a Reuters request to confirm whether or not the report is genuine. But lawyers say they are taking it seriously and that if the government were to accept the CSRC's view it could jeopardize the way in which Chinese companies list overseas or receive foreign investment.

In particular, any change could hurt China's booming private equity market, with relies heavily on VIE structures.

"If this structure is prohibited, you're going to see a shrinkage on a massive scale in terms of the number of potential foreign investors in China. It will send shockwaves through the financial industries sector," said one lawyer at a foreign law firm in China who has seen the report but asked not to be identified given the sensitive nature of the document.

The lawyers say the CSRC is pushing for the Ministry of Commerce to take the lead in regulating the schemes, with all new variable interest entities requiring ministry approval before being set up. However, they are not expected to force existing VIEs to dismantle.

New rules from the Ministry of Commerce that took effect on September 1 bar foreign investors from using arcane investment structures to evade China's security review process, but didn't directly address VIEs. The CSRC report, if genuine, suggests the matter is more serious since regulators are indeed pushing to restrict the structure.


Variable interest entities have been used by non-Chinese investors to get financial control of companies in industries that limit foreign ownership, such as telecoms. These tend to involve a domestic Chinese company with licenses to operate in a restricted sector, which is then controlled through a series of service agreements, rather than shares, by foreign investors.

The likes of Internet giants Sina, Baidu and Netease <NTES.O> use these control agreements to give investors in holding companies listed offshore contractual rights to the domestic licenses, and the earnings from them.

They also have been used by some investors in some non-restricted sectors in order to avoid having to get regulatory approval from the Chinese authorities.

Their legality has always been questionable, but until recently lawyers had been working under the understanding that Chinese authorities would tolerate them. According to one foreign lawyer, the CSRC issued a letter stating that it had "no objection" to the structure when the first VIE deals were being crafted in the telecommunications sector in the late 1990s.

Over the past two decades, however, VIEs have proliferated and thousands are now being used for investments ranging from colleges to steel companies.

"If the PRC government did clamp down on the use of VIEs for overseas listings, it would leave few options for many of these companies to list outside of China, or even to take on foreign investment of any kind," said Alan Seem, a partner at Shearman & Sterling in Beijing who has not seen the internal document.

"I don't think U.S. investors would be that excited to be investing directly into a Chinese entity, and there is a question whether the CSRC would approve these companies for foreign listing even disregarding the VIE issue."


The move by the CSRC is apparently driven in response to the raft of fraud cases seen recently at Chinese companies listed in North America, many of which used the VIE structure. The CSRC has repeatedly stated that it often has no jurisdiction over these companies, which tend to be incorporated offshore, but the wider impact of the scandals on investor sentiment to China is putting them under pressure to act.

"The CSRC is not too happy about how the VIE structure has been abused or used incorrectly," said Rocky Lee, Asia managing partner at law firm Cadwalader, Wickersham & Taft in Hong Kong, who also has not seen the CSRC report.

"The CSRC arguably never even saw some of the Chinese companies which listed in the U.S. because they used a VIE structure, so the only way for the U.S. Securities and Exchange Commission to take issue with the CSRC is to say 'Well you should have been monitoring the VIEs'," he added.

Lawyers also say U.S. regulators are becoming more interested in the use of VIE structures by Chinese companies listing on American exchanges.

"You see a lot more questions from the SEC (Securities and Exchange Commission) about the VIE structure when you're listing a China-based company in the U.S," said Seem at Shearman & Sterling.

"They ask to see legal opinions from the PRC counsel and in some cases even question the legal basis for those opinions," he added.

(Writing and additional reporting by Rachel Armstrong in SINGAPORE, editing by Brian Rhoads in Hong Kong)