Shanghai CIETAC’s finding on VIE case raises plenty of questions

By Kenneth Kong and Shelly Sui, Martin Hu & Partners
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The widely adopted variable interest entity (VIE) mode, also known as “protocol control mode”, has long remained in ambiguous territory when it comes to the law. The Alipay dispute and Tudou.com report, incidents that have arisen since the end of 2011, have drawn even greater attention to it.

Kenneth Kong Partner Martin Hu & Partners
Kenneth Kong
Partner
Martin Hu & Partners

VIE legislation is still in the works, but disputes between investors represented by foreign private equity or venture capital (PE/VC) funds and the founders or controllers of domestic enterprises, under VIE frameworks, have been increasing. These disputes have mainly revolved around the right to control and manage the enterprise, the conveyance and distribution of profits, the core legal issues in a VIE framework.

Between 2010 and 2011, we successfully acted as counsel in two related arbitrations arising from a VIE dispute. In the two arbitrations, the tribunals of the Shanghai Sub-commission of the China International Economic and Trade Arbitration Commission (Shanghai CIETAC), composed of different arbitrators, both rendered awards invalidating the VIE agreement and the entire arrangement on similar grounds. These cases are the first ones in which Shanghai CIETAC has rendered a direct award on the validity of VIEs, and are worth our attention.

VIE framework

In the course of a China enterprise’s securing of foreign investment and listing overseas, it is impossible for foreign funds to directly enter in the form of an equity investment into a China enterprise that operates in an industry in which foreign investment is restricted or prohibited, or one in which it is impossible for a wholly foreign-owned enterprise (WFOE) to secure a special permit. Where a foreign investor is not allowed to directly secure control of a China enterprise’s equity as an equity investor, in order to circumvent such restrictions and enable a foreign investor to control a China enterprise’s equity and satisfy the requirements for a future foreign listing, such as consolidated statements, foreign investors need to erect a “non-equity control method” VIE framework and control the China enterprise’s equity by way of an agreement.

Shelly Sui Associate Martin Hu & Partners
Shelly Sui
Associate
Martin Hu & Partners

Under a typical VIE framework, the foreign investor first needs to establish a WFOE, following which it executes a shareholder vote proxy agreement, exclusive equity transfer option agreement, equity pledge agreement and other authorisation documents (collectively known as control agreements) with the shareholders of the China enterprise through the WFOE, thereby securing the right to comprehensively control the equity, operation and management of the China enterprise.

Additionally, in order to realise the entry of foreign funds into the China enterprise through the WFOE and their use in its operations, and profits of the China enterprise to be transferred abroad through the WFOE in future so that the investor can realise its returns, the foreign investor needs to reach agreements on technical services, management consulting, information services and equipment leasing, among other things (collectively known as profit conveyance agreements).

The arbitration case

T Company is a wholly Chinese-owned company engaged in the online game operation business and has the internetb content provider licence and other permits (a licence and permits that cannot be secured by foreign-invested enterprises) required to engage in its business. The foreign investor established a WFOE in China through a British Virgin Islands company. The WFOE executed a series of profit conveyance agreements with T Company and a series of control agreements with the founding shareholder of T Company.

In the course of their co-operation, a conflict arose between the founder and investor over control of T Company. The founder wished to regain control of T Company through a denial of the validity of the VIE agreement, whereas the investor wished to have the VIE agreement performed so as to achieve actual control of T Company. The core focus of the case, then, was whether the VIE agreement and arrangements were valid.

The finding

The Shanghai CIETAC tribunal found as follows in its final award: the core objective and result of the arrangement (which consisted of securing control over the decision-making and returns of T Company through the WFOE executing the profit conveyance agreements and control agreements with T Company and the founder) was “to enable the WFOE, which did not have online game operation qualifications, to participate in the operation of online games in the PRC and to obtain the attendant returns”. This arrangement violates express provisions of current laws that prohibit foreign investors from actually controlling and participating in the online game operation business of domestic enterprises through such indirect means as executing relevant agreements or the provision of technical support, as well as the Contract Law and other such regulations.

Accordingly, the tribunal, based on the Contract Law, rendered an award invalidating the VIE agreement in the case on the grounds that the lawful form of the VIE agreement (including both the control agreement and profit conveyance agreement parts) covered up illegal objectives and the agreement violated mandatory provisions of administrative regulations of the state.

Remaining questions

This case leaves many question marks. For example, the loan contract between the WFOE and T Company was not a part of the arbitration and the borrower had repaid the loan in full before the arbitration commenced. However, if the borrower had been unable to repay the loan, or if the loan contract had also become a part of the arbitration, what would be the outcome?

In this case, the online game operation sector is prohibited from foreign participation by all means. However, in other industries where VIE arrangements are not expressly prohibited, how should the validity of such VIE arrangements be judged? Should each of the agreements that form part of a VIE arrangement be taken as a “whole” for the purposes of review and rendering of an award, or can they be arbitrated separately? These questions require further consideration by litigators and corroboration in future VIE trial practice.

Kenneth Kong is a partner and Shelly Sui is an associate at Martin Hu & Partners (MHP Law Firm)

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胡光 Martin Hu

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孔焕志 Kenneth Kong

电子信箱 E-mail: kenneth.kong@mhplawyer.com

隋雪芹Shelly Sui

电子信箱 E-mail: shelly.sui@mhplawyer.com

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