September 27, 2020

China’s draft Foreign Investment Law and VIEs: one more point


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BIO_2012_ClarkeBy Donald Clarke Share By Donald From Chinese Law Professor Blog

I want to add one more point about VIEs to my post from yesterday on the draft Foreign Investment Law (FIL) (it was late and I forgot to include it before hitting the “Publish” button).

Let’s not forget that as this law goes through the discussion and review process before its enactment in final form, there’s going to be a lot of politicking, which is another word for people trying to protect their financial interests. What kind of treatment for VIE structures best serves the interests of existing VIE structures? The answer is: grandfather in the existing ones and bar new ones. It’s easy to imagine that in some industries, companies with access to foreign financing can be in a competitively superior position to companies without such access. If foreign financing is forbidden in those industries, then companies that manage to access it despite the prohibition are clearly in better shape to dominate.

Take Alibaba or Baidu. In both cases, the offshore parent–a Cayman Islands company listed in the US–is controlled by Chinese citizens. This means that as the FIL is currently written, it is a Chinese company, not a foreign company. Poof! The illegal (or at least very dicey) foreign investment in a prohibited industry disappears; it’s now Chinese investment.

Of course, this result doesn’t protect Alibaba and Baidu from competition from other Chinese investors who raise money via controlled offshore companies, since the competition’s offshore vehicle would also count as Chinese. But it does protect them from competition from VIE structures that are not controlled by Chinese, since the government now seems more serious about not allowing such structures to exist. I wonder what’s going to happen to The last time I looked, its shareholding was widely dispersed and there was no controlling shareholder.

UPDATE JAN. 24: Check out Paul Gillis’s China Accounting Blog post on winners and losers. In fact, check out all his posts on this issue. Link:—winners-and.html

Comments on China’s draft Foreign Investment Law

By Donald From Chinese Law Professor Blog

On January 19th, China’s Ministry of Commerce (“MOFCOM”) released a draft of a new Foreign Investment Law (“Draft FIL”) for public comment. It also released an official explanation of the draft (“Explanation”). (Here is the MOFCOM press release with links to both.) The Draft FIL proposes very far-reaching changes in how China handles foreign investment. It also specifically addresses the issue of Variable Interest Entities. The latter point has attracted a great deal of commentary to date, but some of that commentary has overlooked important details, so please don’t forget to read Section V at the end.

I. Structure of foreign investment regulation

The Draft FIL fundamentally changes the way China handles foreign investment. First, it proposes a default norm of national treatment for foreign investment. Second, it abolishes the general requirement for MOFCOM approval and establishes a negative list principle. Third, it abolishes the special corporate vehicles for foreign investment.

A. National treatment for foreign investment

The Draft FIL proposes a default norm of national treatment (国民待遇) for foreign investment, stating, “When foreign investors invest in China they shall enjoy national treatment” (Art. 6). The Explanation states that this language manifests the principle of a “pre-establishment national treatment”, meaning that (except where otherwise specified in law), foreign investors may make investments on the same terms as Chinese investors, without being subject to additional approvals or sectoral restrictions.

Note that, at least as glossed by the Explanation, the Draft FIL’s promise of national treatment does not exclude post-establishment discrimination (for example, charging foreign investors or their Chinese enterprises more for utilities once the factory is set up). Compare the notion of “pre-establishment national treatment” with the language of Art. 3, Para. 1 of the 2012 US Model Bilateral Investment Treaty: “Each Party shall accord to investors of the other Party treatment no less favorable than that it accords, in like circumstances, to its own investors with respect to the establishment, acquisition, expansion, management, conduct, operation, and sale or other disposition of investments in its territory.” The Explanation’s understanding of national treatment is much narrower.

Whether the drafters really intended to leave open a space for post-establishment discrimination is hard to say. It’s worth noting that China has made what seems to be a promise of post-establishment national treatment in important areas in its WTO Protocol of Accession.[1] But I don’t see anything that would prevent China from, say, imposing different tax rates on foreign and foreign-invested enterprises.

B. Abolition of investment approvals; establishment of negative list

As part of its implementation of the national treatment principle, the Draft FIL abolishes the general requirement of government approval for all foreign investments. Instead, it establishes a default principle that foreigners may make any investment that domestic investors may make, and in the same way. Setting up a company will still require approval from the local Administration of Industry and Commerce, for example, but that’s true for domestic investors as well. What is gone is the general requirement of approval from MOFCOM and the National Development and Reform Commission. Nobody is going to be examining joint venture contracts or company articles of association any more. Instead of ex ante review, we have a system of ex post reporting.

Any deviation from this default principle must have a source in law (i.e., rules issued by the National People’s Congress or its Standing Committee), administrative regulations (i.e., rules issued by the State Council), or a State Council decision (Art. 22). The deviation must be listed in a special catalog of special regulatory measures (“Special Catalog”). The Special Catalog will, it seems, replace the current Guidance Catalog for Foreign Investment, which specifies the sectors in which investment is forbidden, restricted, or encouraged (all non-listed sectors being classified as “permitted”). An important difference between the Special Catalog and the Guidance Catalog is that the Guidance Catalog did not do away with the foreign investment approval process itself. It was instead more of an instruction to the approving entity on how to manage its business. By contrast, investments not covered by an exception in the Special Catalog are (at least presumptively) not subject to foreign investment approval at all (Art. 26).

The Special Catalog will list prohibited investments and restricted investments. Restricted investments are of two types: (1) those that exceed investment limits set by the State Council, and (2) those that are in certain sectors. Investors in restricted investments must apply for foreign investment approval (Art. 27), submitting a variety of materials set forth in Article 30. The Draft FIL sets out a variety of rules regarding the approval process, including the nice touch that where the approval authority does not notify the applicant of any deficiencies in the application within five working days, the application is deemed accepted for review and the clock starts ticking on that process (Art. 31). This may not be very meaningful, since the approval process remains discretionary, and so it remains necessary for the applicant to please the reviewing authority regardless of what formal deadlines may have passed.

The fact that non-restricted investments are not subject to the above foreign investment approval process seems to create some problems with other parts of the Draft FIL. Article 34, for example, deals with the interaction between foreign investment approval and national security review. Where the reviewing authority discovers a potential national security issues, it should refer the project over to the relevant body for national security review. But if the project never comes before the approval authority, how does the state ever become aware of a potential issue? I discuss this further below in the section on national security review.

C. Abolition of special corporate vehicles for foreign investment

When China first opened up to foreign investment in the post-Mao era, there was no general company law and the government was not ready for such a law, so China had to invent special corporate forms for foreign investment: the equity joint venture (“EJV”), the contractual joint venture (“CJV”), and the wholly foreign-owned enterprise (“WFOE”, and collectively, the “Three FIEs”). With the promulgation of the Company Law in the early 1990s, it became theoretically possible for foreigners to invest in regular companies, and eventually it became actually possible as well (subject to various restrictions and approval requirements).

Adding to the complexity of the system was the problem of the degree to which Company Law requirements should apply to the Three FIEs if they were not specifically contradicted by applicable law. (For example, the WFOE Law says nothing about a Board of Supervisors for WFOEs; the Company Law requires one. Should the WFOE Law’s silence on the issue be considered a gap that can be filled by the Company Law, or is it an affirmative silence representing a legislative intention that WFOEs not be required to have any corporate governance institution not called for by the WFOE Law?)

The Draft FIE Law gets rid of this problem entirely by simply abolishing the Three FIEs. All foreign investment must use one of the general statutory vehicles for business associations. In practice, this will likely mean a company under the Company Law (that is, a company limited by shares or a limited liability company or a partnership under the Partnership Law.

As a policy matter, this seems to me a sensible approach that should be applauded. There is a minor procedural fly in this legislative ointment that deserves some attention. Anyone reading Article 170 might think that the organizational laws for the Three FIEs will disappear when the Foreign Investment Law comes into effect. Not quite. Existing EJVs, CJVs, and WFOEs have three years to convert to a new corporate form, but before they do so they still need some kind of governing law, so they will still be governed by the applicable statutes (that is, the Equity Joint Venture Law, the Cooperative Joint Venture Law, and the Wholly Foreign-Owned Enterprise Law respectively) (Art. 157) and presumably the various regulations promulgated by innumerable government bodies that put flesh on the bones of those statutes. What is a bit odd is that the legal regime for the Three FIEs will have to remain frozen for up to three years, since the laws under which any regulations are promulgated will have disappeared.

II. National security review

The Draft FIL makes all foreign investments potentially subject to a national security review. This review can be triggered by a foreign investment approval authority when it spots a potential issue. But as we have seen, the whole point of the Draft FIL is to put large swaths of foreign investment outside of the review process. How, then, are non-restricted investments with national security implications to come to the attention of the authorities?

One route is self-reporting (Art. 50). This is the approach taken by the United States for CFIUS review: “Despite the voluntary nature of the notification, firms largely comply with the provision, because the regulations stipulate that foreign acquisitions that are governed by the Exon-Florio review process that do not notify the Committee remain subject indefinitely to divestment or other appropriate actions by the President.” Very possibly firms investing in China would take the same approach.

The relevant review body can also initiate an investigation sua sponte (as can CFIUS). In fact, just about anyone can suggest that a national security review is needed, although curiously the suggestion is supposed to be made to the foreign investment review authority, which is completely uninvolved in a non-restricted transaction (Art. 55).

III. Ex ante review replaced by ex post reporting

Chapter 5 of the Draft FIL, starting at Article 75, deals with the reporting system. As noted above, the ambition of the Draft FIL is to generally replace a system of before-the-fact approval with a system of after-the-fact reporting. This places much less of a strain on administrative resources—authorities can concentrate their attention on regulated parties who actually violate the rules (or are suspected of doing so) and not have to spend time on every potential violator of the rules, i.e., every single regulated party. It is the sign of a more confident administration, and is more consistent with a system of predictable rules: after-the-fact reporting works best when those reporting who wish to be compliant with law can self-assess their compliance as they go along.

The one problem here is that the reporting requirement seems to go too far, again possibly as a result of careless drafting. Article 93 sets forth a reporting requirement for all foreign investors—this includes individuals—who own less than 10% of a listed company. The report needs to be submitted only once a year, but nevertheless is going to be exceptionally onerous for any individual investor who is just taking a flutter on the Chinese stock market. Do the drafters really desire or expect that all investors who buy stock in Shanghai-listed companies through the Shanghai-Hong Kong Stock Connect program will file annual reports with all the required information for each stock they own?

IV. The control rule

The Draft FIL contains an important control rule. First of all, foreign entities controlled by Chinese investors can, at least in some circumstances, be considered Chinese domestic investors (Art. 45). Second, Chinese entities controlled by foreigners are considered foreign investors (Art. 11). Both these rules deserve some discussion.

The first rule, which converts Chinese-controlled foreign investors into Chinese investors, will be discussed much more extensively below in the section on VIEs. Here I just want to point out a nice consequence possibly unintended by the drafters. Think about why Chinese money likes to go overseas to form a corporate entity, only to have that money come back to China to fund an investment. This round-tripping used to be explained by all the special benefits—tax breaks and the like—that foreign investors got in China. But those special benefits have pretty much disappeared. What explains it now? I think the answer is that Chinese investors are seeking foreign corporate law. Chinese corporate law has traditionally been quite rigid. It’s improving—China recently got rid of its silly minimum capital requirements—but it still has quite a way to go before it can accommodate the complex and sophisticated financing structures that are possible under the corporate law of other countries.

The problem with organizing abroad now is that doing so has significant costs, one of which is that you are counted as a foreign company and subject to restrictions on foreign investment. In counting foreign companies controlled by Chinese as Chinese companies, the Draft FIL considerably lowers the barriers to Chinese investors taking advantage of foreign organizational law to engage in investments right back in China.

The second rule converts foreign-controlled Chinese entities into foreign investors. This seems symmetrical with the first rule, but in fact does not seem to have been thought through and may be a drafting error. It would make more sense to say that a Chinese entity subject to foreign control is a foreign-invested Chinese entity, not an actual foreign investor. Article 15, for example, defines control through contracts as a type of foreign investment. If a foreign company controls a Chinese company through contracts, then according to Article 15 it has invested in the Chinese company. Why not then simply consider the Chinese company to be a foreign-invested company?

The state makes certain decisions about how it wants to regulate entities with foreign investment—and very possibly subject to complete foreign control—that are organized under Chinese law (for example, WFOEs). It’s hard to see any reason for treating a Chinese company differently simply because the foreign control is exercised through contracts instead of through direct investment. Indeed, the whole point of the actual control test is to say that these are essentially the same and should be regulated the same way. If the contractually-controlled Chinese company is treated as a truly foreign investor, that has all sorts of bizarre consequences. Perhaps it cannot hire employees directly and must instead do so through a labor service company. Perhaps it cannot even engage in business in China—foreign companies engaging in production must set up a Chinese subsidiary.

There is also a possible problem with the definition of “control”. It’s defined in Article 18. But whenever Article 18 talks about proportionate ownership or control of anything, instead of talking about “more than half” or “a majority”, it consistently uses a concept of “half or more”. Chinese speakers all know about the ambiguity of the term yishang (以上); the Draft FIL specifically states that it includes the number preceding it, so every time Article 18 speaks of “50% yishang” or “half yishang”, it must, by the terms of the Draft FIL itself, be interpreted as “50% or more” and “half or more”. This means that under the Draft FIL, two opposed parties could both be deemed in control of an enterprise.


Although neither the Draft FIL nor the Explanation specifically use the term “Variable Interest Entity”, it is absolutely clear that the Draft FIL intends to address the issue. (The Explanation states, “The issue of foreign investors obtaining control rights over domestic enterprises through a series of contracts has received widespread attention.”) What will happen to existing VIEs? What about VIEs in the future?

Let’s recall the basic problem of VIEs: they are an attempt to get around restrictions on foreign investment in particular industries, most notably telecommunications and the internet. They do this by setting up a series of contracts between a wholly domestic Chinese entity (“DCE”), which holds the operating license, and a foreign-invested/foreign-controlled Chinese entity (“FCE”). These contracts mimic the effects of ownership, assigning control and risk to FCE. Money is supposed to flow from DCE to FCE, and thence offshore to FCE’s foreign parent company (“Parent”), and thence to shareholders of Parent.

Chinese contract law is quite clear: contracts to achieve an unlawful purpose are invalid. We even have a recent Supreme People’s Court case right on point telling us so. The disclosures in the “Risk Factors” section of the Alibaba prospectus—by no means unique—do not exactly exude confidence in the robustness of their fundamental corporate structure: “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, . . . we could be subject to penalties or be forced to relinquish our interests in those operations.”

Despite their obvious illegality, VIE structures have been permitted to openly raise funds abroad and operate in China. It is impossible to believe that somehow the Chinese government did not know that Alibaba, or before it, was raising funds abroad, or how it was doing it. Like so many technically unlawful practices before it, the VIE structure works—until it doesn’t.

Have we now reached an “until it doesn’t” moment? It’s not entirely clear.

Let’s leave existing VIEs aside for the moment and start with future VIEs. We can imagine three kinds of VIE structures: (1) those in which Parent is actually controlled by Chinese individuals (“Chinese-controlled parent” or “CCP”), (2) those in which Parent is actually controlled by foreign individuals (“foreign-controlled parent” or “FCP”), and (3) those in which the issue of control is not clear. I include category (3) for the sake of completeness and shall discuss it no further. Finally, assume existing law remains unchanged, and that foreign investment in industry X is restricted or prohibited.

For CCP VIE structures, there may be no problem. This is because the control rule, discussed above, may make the VIE structure unnecessary where you have a CCP: even though the CCP is a foreign company, it can be treated as a wholly Chinese entity and lawfully invest directly (without having to use fancy contractual structures) even in sectors where foreign investment is restricted. According to Article 45, if a foreign investor is actually controlled by Chinese investors, it can, when applying for foreign investment approval, at the same time apply to be treated as a Chinese investor.

Note, however, that the actual-control test does not help you if you are trying to invest in a prohibited sector—or at least that’s what Article 45 implies by its mentioning only restricted investments. This may be an unintended drafting oversight; I can’t think of a strong policy reason for using an actual-control test when considering investments in restricted areas, but not when considering investments in prohibited areas. Part 3.3 of the Explanation, in discussing the actual-control test for status as a Chinese investor, does not seem to consider the distinction important; it notes that one suggested path for existing VIE structures in restricted or prohibited sectors would be for them (assuming Parent is controlled by Chinese investors) to seek treatment as a Chinese investor. In any case, the point is that in some cases Chinese-controlled offshore entities can count as Chinese investors and therefore can invest directly in industry X, instead of indirectly through a set of contracts that try to mimic the effects of direct investment.

For FCP VIE structures, it looks like bad news. (Remember, I’m still talking about entities that might be created in the future, not existing entities.) Article 11 lists who counts as a foreign investor, and adds that any domestic Chinese entity controlled by any entity on that list also counts as a foreign investor. Moreover, Article 15 defines control through contracts as a type of foreign investment covered by the law. Thus, there could be no onshore Chinese entity—no DCE—that could hold an operating license in an industry in which foreign investment were prohibited; by virtue of the control exercised over it, the DCE would cease to be a DCE and would become not just a FCE, but an actual foreign investor.

What about existing VIE structures? The consensus of commentators such as Practical Law and the Jun He law firm—and even Dan Harris of the China Law Blog, who thinks the Draft FIL is a death sentence for VIEs—is that somehow the system will let existing VIE structures continue, if only because shutting down the likes of and Alibaba is unthinkable.

The Draft FIL actually leaves the relevant article (Article 158) blank and refers to the reader to the Explanation. Part 3.3 of the Explanation offers three proposals for dealing with existing VIE structures and asks for public input, making it clear that nothing is set in stone (or at least, that’s what they want you to think). Here are the alternatives:

1. “Foreign investor enterprises [note: not “foreign-invested enterprises”] exercising control through agreements [i.e., involved in a VIE structure] who report to the State Council’s department in charge of foreign investment that they are subject to the actual control of Chinese investors may retain their structure of control through agreements, and the relevant entity may continue to undertake business activities.” Note that this option involves reporting, not applying.
2. “Foreign investor enterprises exercising control through agreements should apply to the State Council’s department in charge of foreign investment for confirmation that they are subject to the actual control of Chinese investors; after confirmation by the State Council’s department in charge of foreign investment that they are subject to the actual control of Chinese investors, they may retain their structure of control through agreements, and the relevant entity may continue to undertake business activities.”) Note that here an application and approval is required, not simply a self-report.
3. “Foreign investor enterprises exercising control through agreements should apply to the State Council’s department in charge of foreign investment for access; this is the term used throughout the Draft FIL to mean, in effect, permission to invest]; the State Council’s department in charge of foreign investment shall, in consultation with relevant departments, make a decision based on an overall consideration of the actual controller of the foreign investor enterprise and other elements.”
Let’s consider existing VIE structures with a foreign-controlled offshore parent. By definition, they are dead in the water under the first or second alternatives. Their only hope is the infinitely flexible third alternative, which gives total discretion to government authorities over whether to grandfather them in. The authorities can (if they wish) consider matters other than actual ownership.

Now let’s consider existing VIE structures that have a Chinese-controlled offshore parent. First, we can apply the same analysis (with the same caveats) we applied to future VIE structures with a Chinese-controlled parent: perhaps they don’t even need a VIE structure any more. If for some reason they want to keep a VIE structure, clearly alternative 1 is the best for them. Alternative 2 is more troublesome, but if they are truly Chinese-controlled, things should come out all right in the end. Alternative 3 is the most worrisome for them; they have in effect to re-apply for permission to be doing what they’re doing, and permission isn’t guaranteed; Chinese control is only one element for the authorities to consider.

(Incidentally, on the question of whether corporate organizations that don’t need a VIE structure have the option of keeping it, it’s worth remembering that many VIE agreements provide that if there is a change in law such that the VIE structure is no longer necessary and a conversion to direct ownership is possible, the various parties are obliged to do whatever is necessary to effect that conversion. I’m not holding my breath on that one.)

Finally, a thought about all the energy we are spending on looking at the law. It seems a bit odd to be worrying about what the Draft FIL says about the legality of VIE structures or to say that it somehow makes them illegal. As I argued at the beginning of this discussion, they are already illegal. Hardly anyone denies this. And yet the authorities have permitted them to exist, and indeed to flourish, right under their noses. Back in the 1990s we saw the same thing with the CCF structure: a prohibition on foreign investment that was openly violated through a too-clever-by-half contractual arrangement. That arrangement worked just fine until it didn’t. Then it was resurrected in the form of the VIE structure, which we are now told is being made illegal, or—given that it’s already illegal—at least is not fine any more. Is there any reason to think that the pressures that produced the CCF and VIE structures, despite their being clearly prohibited, won’t survive this new purported prohibition and give us yet another transparent workaround?

* * * * *

[1] “Except as otherwise provided for in this Protocol, foreign individuals and enterprises and foreign-funded enterprises shall be accorded treatment no less favourable than that accorded to other individuals and enterprises in respect of:

(a) the procurement of inputs and goods and services necessary for production and the conditions under which their goods are produced, marketed or sold, in the domestic market and for export; and

(b) the prices and availability of goods and services supplied by national and sub-national authorities and public or state enterprises, in areas including transportation, energy, basic telecommunications, other utilities and factors of production.”


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