By Paul Gillis From Seeking Alpha
Earlier I wrote about the proposed new foreign investment law for China. The new law appears to change the way China will look at variable interest entities, focusing on who actually controls the entity vs. who is the owner of record. That could create problems for many VIE structures that would be found to have prohibited foreign investment.

There is another way to look at this proposal, which is well explained in this article just released by Chinese law firm Haiwen (in Chinese). The proposal introduces a concept of actual control. That concept could be applied to the VIE, and the actual control of the VIE would be found to be with the foreign, typically Cayman Islands incorporated, public company. That would cause a problem if foreign investment continues to be banned in internet companies.

The other way the concept could be applied is to look at the listed, typically Cayman Islands company. If this company is controlled by Chinese, perhaps that means that the VIE is actually controlled, indirectly, by Chinese, and can continue to operate legally. What it means is that China will look to ultimate control, rather than legal ownership to apply its foreign investment restrictions, and if Chinese are ultimately in control, then no restrictions will apply.

Treating the Cayman Islands company as Chinese controlled would allow it to continue to use a VIE, but shareholders should not accept that solution. If the foreign investment restrictions can be circumvented in this manner, then the Cayman Islands company should be allowed to acquire the VIE and operate it as a wholly foreign owned enterprise (WFOE). That would give the public entity actual ownership in the VIE, even though it remains under Chinese control. We have not had the government shutting down VIEs for illegal foreign investment, but we have seen VIE owners stealing the VIE from the public shareholders. Making the VIE a WFOE helps to fix that problem.

Some companies will not be able to take advantage of this approach, since they do not have the Chinese in control of the public company. Many Chinese companies have followed the example of Facebook (NASDAQ:FB) and have used control structures to keep voting power in the hands of the founders even as they sell off a majority of their shares. So in some companies founders may own less than 20% of the company but still control a majority of the voting rights. Others have not done this and will be unable to make the argument that the Cayman Islands company should be treated as Chinese controlled. These companies would have to obtain permission to have foreign investment, possibly by moving to the Shanghai free trade zone.

Alibaba (NYSE:BABA) abandoned plans to list in Hong Kong when Hong Kong regulators would not permit it to use a control structure that allowed Jack Ma to remain in control despite have a minority of shares. Hong Kong listed Tencent (OTCPK:TCEHY), with founder Pony Ma controlling only 10% of the shares, may be unable to take advantage of this approach.

This is going to be a complicated change, but a necessary one for the development of China’s capital markets. Haiwen is the first law firm to analyze the issue; I expect all of the major law firms to deal with it in the next few weeks.

Disclosure: None

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