Foreign investors may use the variable interest entity (VIE) as a circumvention structure to invest in restricted or prohibited industries in China. In general, the basic structure is comprised of a Chinese domestic company, an offshore holding company and a wholly foreign-owned enterprise (WFOE). Usually,the holding company may owns the WFOE through many a level of holding. Critically, the WFOE  controls the domestic company by a system of  agreements, such as equity option, equity pledge, voting proxy and technical licence etc; so that the WFOE may consolidate the domestic company  its financial statements, which could be accepted by international capital markets.

When the Ministry of Commerce (MOC) issued the Provisions for the Implementation of the System for Security Review of Acquisition of Domestic Enterprises by Foreign Investors in August,2011, it caused much discussion among the venture capital and private equity communities. Many believe the Provisions have made it difficult for foreign investors to invest in the country’s restricted or prohibited categories through the VIE structure.

According to Guiding the Direction of Foreign Investment Provisions and the Guide, foreign investors cannot invest in or control any enterprises that fall under the prohibited or restricted categories of the Guide. Therefore, structured agreements under the VIE structure violate the spirit of the Provisions and the Catalogue.However,many Chinese companies under the restricted or prohibited categories have actually listed on international capital markets through the VIE structure. Sina pioneered to list on the NASDAQ in 2000. It appears Chinese  relevant government authorities actually support the listing mechanism. They have also made no objections to the VIE structure used by foreign investors for their investments into restricted or prohibited industries.

It is almost impossible for foreign investors to invest in enterprises related to national security. The VIE structure hinges on the domestic company held by the WFOE under a control agreement. Article 9 of the Security Review Provisions states that foreign investors cannot avoid security review during mergers and acquisitions. This includes holding equity in the agent’s name, trust, multilevel reinvestment, lease, loan, control agreement and overseas dealings. Therefore, when the holding company establishes the WFOE and it enters into the agreements with the domestic company, it is deemed as an acquisition by foreign investors. These agreements are then subject to security review.

This means that all control agreements between WFOEs and domestic companies are subject to security review. Article 1 of the Provisions states that if the agreements fall within the security review scope specified by the Circular on the Establishment of a System for Security Review of Acquisition of Domestic Enterprises by Foreign Investors, a security review application must be filed with MOC. The scope of the Circular’s security review includes if the domestic enterprise deals in armament or supports other companies relating to national defence security. In addition, if it has close ties to military or sensitive facilities or involves major agricultural products, major energy or resources, major infrastructure, major transportation services, key technologies or major equipment manufacturing, or it relates to national security.

A Notice from the General Administration for Press and Publication and the State Copyright Administration provides that no foreign investor may control and participate in the business operation of online gaming in any indirect way such as establishing a joint venture, signing relevant agreements or providing technical services. The actual and indirect participation by foreign investors in the domestic enterprise’s online game business operation under the VIE structure is incompliance with the Notice.

The China Securities Regulatory Commission (CSRC) has yet to announce its official position on the VIE structure. However, in September 2011, the CSRC’s Report Regarding Overseas Listing of Internet Enterprises such as Tudou.com has been widely circulated amongst professionals. The Report proposes to strengthen regulating VIEs by requiring the overseas listing of companies to be approved by MOC and with consent from the CSRC. Even though the CSRC has yet to issue any rules or policies, many see the Report as a starting point to restrict the VIE structure in the future.

After MOC issued the Security Review Provisions, the Hong Kong Stock Exchange (HKEX) imposed strict requirements on listing applicants using the VIE structure when it released its Listing Decision in November 2011. For example, if the domestic company does not engage in prohibited or restricted industries, the Listing Division of HKEX will refer the case to the Listing Committee of HKEX. In order to bypass the legal impediments of the Acquisition of Domestic Enterprises by Foreign Investors Provisions, some Chinese companies not engaged in prohibited or restricted categories also used the VIE structure to apply for a HKEX listing. However, there is a small possibility Chinese companies will be able to obtain approval from HKEX since the updated Listing Decision came into force.

Unlike the HKEX, the US Securities and Exchange Commission (SEC) has not issued new requirements regarding the VIE structure. Some Chinese internet companies, like LaShou.com, AdChina.com and Vipshop.com, have filed applications with the SEC to list on the NASDAQ or New Stock Exchange after MOC’s Security Review Provisions. Since the VIE structure violates Chinese laws, the listing applicant is required to disclose the risks, leaving investors to decide if they wish to add the company to its investment portfolio.

So far foreign investors can still use the VIE structure to invest in restricted or prohibited industries except for those engaged in national security of online gaming. However, it is said that Chinese government will possiblly impose greater restrictions on the VIE structure.