A Chance to Solve the "VIE Dilemma"！
Preamble
On July 16, 2020, China’s State Administration for Market Regulation ("SAMR") cleared the merger filing in relation to the Establishment of a Joint Venture between Shanghai Mingcha Zhegang Management Consulting Co., Ltd. and Huansheng Information Technology (Shanghai) Co., Ltd. ("SMZ Case"). While the SMZ Case was accepted as a simplified case on April 20, SAMR took 88 days in total from the date of formal acceptance to complete the review and grant the unconditional clearance in the Phase II review period (rather than in the Phase I review period, like for most of other simplified cases), which substantially exceeded the average review period for simplified cases in the first quarter of 2020[1]. It was reported that the extended review period may have been due to the high market share in certain segmented area(s) of the relevant market of Shanghai Mingcha Zhegang Management Consulting Co., Ltd. (“SMZ”)[2].
In fact, this SMZ Case has attracted widespread attention since SMAR’s formal acceptance of the filing on April 20. SAMR’s publicly disclosed information specifically mentions that SMZ, one of the parties to the joint venture, is ultimately controlled by Leading Smart Holdings Limited through contractual arrangements. This is the first time that Chinese merger control authority(ies) have publicly accepted and unconditionally approved a case involving a VIE structure. Previously, according to the public record, the Chinese authority has never accepted and approved filing transactions involving VIE factors (even though they have met the merger filing thresholds).
This article reviews the origins and dilemmas of merger filings involving the VIE structure in China, discusses possible changes of SAMR’s attitudes towards the VIE issue, and sets out some issues yet to be clarified.
Companies are recommended to re-assess carefully their future merger filing strategies in China when facing VIE structure issues, and the impact of such changes on their transactions.
1 Questing for the Roots: Compliance Issues of the VIE Structure
The VIE structure, i.e. the Variable Interest Entities structure, also called “contractual control” structure, refers to a method of control whereby a wholly-owned foreign enterprise (“WFOE”),invested by an offshore entity, is able to exercise control over a Chinese domestic operating entity through a series of contractual arrangements. In this way, the WFOE is able to exercise control over the domestic operating entity’s business operation decision-making, human resource matters, distribution of profit, issuance of securities, equity incentive plan and other key factors (without directly holding the equity thereof). This also enables the foreign shareholder to collect all the economic interest generated from the operation of the domestic entity, and consolidate the profit generated thereby into the offshore entity. A typical VIE structure is set out as follows:
In practice, the application of VIE structure not only helps Chinese domestic companies to obtain overseas financing, but also allows foreign investors to go around China’s foreign investment restrictions. Since the successful listing of SINA at NASDAQ in 2000 by using the VIE structure, such structure has been widely applied in the fields of Internet, education, media, broadcast and other fields that are subject to foreign investment restrictions in China. On the other hand, with the implementation the Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign Investors in 2006, which requires any Chinese companies or persons to obtain an approval from MOFCOM for their acquisitions of domestic affiliated companies via overseas entities controlled by them ("Approval of Affiliated M&A "), the application of the VIE structure has been extended to the fields without foreign investment restrictions, and become an effective way to assist Chinese private companies in building up a “red-chip structure” and avoid having to receive the Approval of Affiliated M&A for going public on overseas stock markets.
Nevertheless, the compliance issues of the VIE structure, especially under the foreign investment restriction policies, have always been in a “grey area”. The Foreign Investment Law (draft for comment) issued by MOFCOM on 19 January 2015 even defined the VIE structure for the first time, which tried to incorporate it into the scope of foreign investment regulation, and attempted to distinguish the VIE structure controlled by Chinese investors from foreigners. However, provisions concerning the VIE structure were set aside in the officially released version of the Foreign Investment Law in 2019. Thus the compliance issue of the VIE structure still needs to be clarified.
2 Reviewing the Current Status: "VIE Dilemma" in Merger Filings
For a long time, in practice, transactions involving a VIE structure (including where one or more concentrating parties have a VIE structure, the target has a VIE structure, or the parties are acquiring the control rights over another company via the VIE structure) have encountered difficulties in getting merger filings accepted in China, possibly due to concerns with the compliance issues of VIE structures especially under foreign investment policies. On the other hand, the existence of the VIE structure is not a statutory exemption for a transaction which has met the notification threshold from the merger filing obligations. Therefore, companies are usually faced with this dilemma for transactions involving a VIE structure.
In the notification form, the concentrating parties are required to make an undertaking on the legitimacy and compliance of their business in China and the same for the notified transaction. However, due to the ambiguity of the VIE structure’s compliance status, in practice, the merger control authority may be concerned that the acceptance of a filing involving the VIE structure may be interpreted as an “acquiescence” and “endorsement” of the VIE structure. According to the public record, prior to the SMZ Case, there has been no merger filings involving VIE structure accepted and unconditionally approved by the Chinese merger control authority. It has further led to the situation that for many years, almost none of those transactions involving VIE structure have been notified to the Chinese authority, regardless of whether they have met the notification thresholds. For example, the CEO of a large Chinese internet company has stated publicly that in the fields of domestic M&A, transactions which should be submitted for merger filing review “could not be accepted like other cases when the VIE issue is involved”[3].
However, under the Anti-Monopoly Law and current merger control regime in China, there is no basis for exempting transactions where any of the concentrating parties or the target company or assets involve a VIE structure from merger filing obligations. In fact, SAMR has never publicly recognized that the transaction involving a VIE structure does not need to be notified for or could be exempted from merger filings. Conversely, the Chinese authority has initiated antitrust investigations on transaction involving the VIE structure.[4] Therefore, there still remain compliance risks for transactions involving the VIE structure which are not notified.
3 Emerging Hope: A Chance to Solve the "VIE Dilemma"
The SMZ Case
In the SMZ Case, SMZ and Huansheng Information Technology (Shanghai) Co., Ltd. (“Huansheng”) proposed to set up a joint venture to engage in the development of information technology in the catering industry and internet technology, data processing, artificial intelligence application software/hardware development, and to provide technical solutions for the catering industry.
The SMZ group is mainly engaged in providing enterprise customers with the full-point consumer measurement and optimization, intelligent analysis and decision-making, business and data-centric intelligent closed-loop marketing solution, as well as new-generation human-machine collaborative solutions in smart dining and other scenarios, and providing artificial intelligent solutions for government departments or public utilities. Huansheng is mainly engaged in western fast food, Chinese fast food, hot pot catering, casual catering, etc.
In particular, SMZ is ultimately controlled by a Cayman company, Leading Smart Holdings Limited, through a series of agreement arrangements (i.e., VIE structure), rather than through a shareholding relationship. It is worth noting that pursuant to the information disclosed in the National Enterprise Credit Information Publicity System, it seems that so far the business scope of SMZ or its direct and/or indirect shareholder does not include any business that is subject to any foreign investment restrictions.
SAMR's changed approach towards VIE issue and other issues to be clarified
The SMZ Case is the first transaction with concentrating parties having a VIE structure that SAMR has publicly accepted and unconditionally cleared.
Based on public information, from a merger control review perspective, the SMZ Case has the following characteristics worth noting:
The target company in the SMZ Case does not involve a VIE structure. The transaction is an establishment of joint venture between the parties and the proposed joint venture itself does not involve a VIE factor;
While one party to the transaction has a VIE structure, the VIE structure in this case does not appear to involve any circumvention of foreign investment restrictions.
While SAMR has not yet made further explanation and clarification on the VIE structure issues specifically reflected in this transaction, it opens the possibility that for future similar transactions involving a VIE structure, there could be a change in SAMR’s approach towards the VIE issue, to the extent that such types of transactions will be able to be accepted and cleared. However, given the limited information disclosed publicly in the SMZ Case, it remains to be seen whether the acceptance and clearance of this case by SAMR implies that all transactions involving a VIE structure will be treated normally going forward. In particular:
Where either the parties to the transaction or the target company adopts a VIE structure to circumvent foreign investment restrictions
As mentioned above, according to public information, at present, the SMZ group is likely not engaged in any business that is subject to foreign investment restrictions, and the proposed joint venture does not have a VIE structure. It is to be further clarified whether SAMR may adopt a different position in circumstances where any of transaction parties or the target company uses the VIE structure to circumvent foreign investment restrictions, or if foreign investors are acquiring control over Chinese entities via VIE agreements for this reason as well.
Where NEITHER the parties to the transaction NOR the target company involves any circumvention of foreign investment restrictions through VIE structure
The SMZ Case only involves the establishment of a joint venture between the parties, and the target company itself does not involve a VIE factor. However, it still needs to be closely monitored and confirmed with SAMR whether notifications for all similar transactions (in particular where the target company involves a VIE structure) which do not involve circumvention of foreign investment restrictions can generally be accepted and approved.
>> With respect to a transaction where a foreign investor is the buyer and the target company involves a VIE structure, such as in another earlier case[5], MOFCOM, as one of the conditions for clearing the transaction, specifically required that the foreign buyer shall not engage in the value-added telecommunication business via a VIE structure which was then restricted from foreign investment and then lifted this condition in 2016 with the removal of the relevant foreign investment restriction. For similar transactions in the future, if the target company does not involve any circumvention of foreign investment restriction policies via a VIE structure, SAMR should not have the same concern of MOFCOM as in this earlier case in 2012.
>> With respect to a transaction where a foreign investor acquires control over domestic entities via VIE agreements, there is no precedent where SAMR has accepted and cleared notifications for such transactions. Technically, if the target company is not involved in any business subject to foreign investment restrictions, the acquisition of control through contractual arrangements does fall into the scope of a notifiable transaction.
With respect to the above questions, we noticed that some reports have claimed that SAMR is prepared to accept and review the merger filings for the transactions involving a VIE structure[6]. We will continue to keep a close eye on the development of SAMR’s practices going forward.
In addition, it remains to be seen whether SAMR will also sweep through past transactions involving a VIE structure which were notifiable but not notified. However, we expect that, given the clearance of the SMZ Case, in the future, if a notifiable transaction involving a VIE structure is not notified, the possibility that SAMR will give “special consideration” to the existence of a VIE structure as the reason for not notifying may decrease when deciding whether to initiate a failure-to-notify investigation.
4 Taking Cautious Approach: Re-assessing Filing Strategies for VIE Issues and the Impact to Transactions
Given the fact that VIE structures have been widely adopted in various industries, it is expected that eventually SAMR will need to accept and review a notification for a transaction involving the VIE structure in the same way that it would do so for any other filing which meets the filing requirements. The SMZ Case is an indication that SAMR is considering solving the “VIE Dilemma” and has taken a first step forward.
Considering that SAMR may be changing its approach towards the VIE issue, there is an increasing risk of being caught and penalized for failure to notify transactions involving a VIE structure which meet the notification thresholds. In the meantime, given that SAMR still needs to continue to clarify its position regarding transactions involving VIE structures, it is important to closely follow any developments in SAMR’s position on VIE-related transactions.
With respect to transactions involving VIE structures, we recommend that companies assess them on a case-by-case basis, and re-consider their strategies in dealing with merger filings for VIE-related transactions.
In particular:
For the assessment of whether a transaction constitutes a “concentration of undertakings” and the risk of being caught for failure to notify, the existence of a VIE structure in such analysis may be a substantially less important factor, or even no longer a factor to be considered;
For transactions similar to the SMZ Case, where the notification threshold has been met and does not involve any business subject to foreign investment restrictions, it seems more likely now that SAMR may accept and review the transaction for notification as it normally would;
For transactions still subject to foreign investment restrictions or other compliance issues, where the target company involves a VIE structure or the acquisition of control is done through VIE agreements, companies will need to make a more detailed and cautious assessment of the transaction structure and their notification strategy, or may consider clarifying with SAMR through the consultation process, when necessary;
From the perspective of the overall timeline and planning for a transaction which has met the notification threshold but involves a VIE structure, the transaction schedule and timeline for closing should appropriately take into account that the transaction may need to be notified and cleared before closing. In particular, given that SAMR’s approach towards the VIE issue is likely to be changing (although further clarification is still needed), companies should consider allocating adequate time as needed to properly complete any necessary assessment and clarification with SAMR for specific issues in relation to the merger filings for their transactions.
Foot note:
[1] In the first quarter of 2020, the SAMR took an average of 12.79 days to approve deals placed under its simplified merger review procedure.
[2] See Yonnex Li, Yum China’s VIE-linked deal faces formal challenge against fast-track process, Mlex, May 19, 2020.
[3] See: http://it.people.com.cn/BIG5/n/2013/0304/c1009-20664270.html
[4] See: http://www.eeo.com.cn/2018/1129/342209.shtml
[5] See: http://it.people.com.cn/BIG5/n/2013/0304/c1009-20664270.html
[6] See: http://www.eeo.com.cn/2018/1129/342209.shtml
—— Authors ——
Cheng Liu
Partner
Corporate & Commercial Group
liucheng@cn.kwm.com
Mr. Liu Cheng is a partner in the corporate department of KWM. His main areas of practice include antitrust and competition law, corporate investment and M&A. Mr. Liu has extensive experience in antitrust and competition law since 2005. He regularly advises clients on Chinese antitrust and competition matters and has represented numerous multinational companies and Chinese companies in their merger filings at Chinese authority, including a number of high profile transactions. He provides advice on antitrust compliance for the clients’ business model, and delivers antitrust trainings. He also advises clients in dealing with antitrust investigations by the authorities. Mr Liu has been recognized by many global media as one of the leading competition lawyers in China.
Yun Bi
Senior Assosiate
Corporate & Commercial Group
Jeff Liu
Senior Foreign Legal Counsel
Corporate & Commercial Group