VIE in the Spotlight: A Recent Court Case in Education

April 5, 2017

For more than a decade, variable interest entities (VIEs) have been used as a vehicle to facilitate foreign participation in Chinese industries subject to restrictions on foreign investment. The structure has become commonplace and is used by many of China’s best-known offshore-listed companies. The enforceability of VIE arrangements, however, has been a sensitive subject, and there has been an aversion to testing the structure in court. Not the least, the VIE structure raises a potential public policy issue: if the VIE facilitates foreign participation in an industry that is explicitly restricted to foreign investors under the Industry Guideline Catalogue for Foreign Investment (the “Catalogue”) issued by the Ministry of Commerce (MOFCOM), should the contracts governing the structure be deemed void? The defendant in a recent case Yaxing v. Ambow was a VIE in the education industry. Although the Supreme People’s Court skirted the question of the ultimate enforceability of VIE arrangements, some interesting and thought-provoking arguments emerged from the Court rulings. 

I.  The Case: Yaxing v. Ambow

Changsha Yaxing Property Development Company Limited (“Changsha Yaxing” or “plaintiff”) sued Beijing Shida Ambow Education Technology Co., Ltd. (Beijing Ambow) to unwind its sale of two elementary and middle schools to Beijing Ambow consummated in 2009 (the “Transaction”), claiming that the underlying framework agreement should be invalidated because, immediately after consummation of the sale transaction, the two schools were controlled by Ambow Education Holding Ltd. (Ambow Education), a foreign company, through a VIE in violation of the Catalogue[1].

The case was brought before the Hunan Higher People’s Court, which ruled in favor of the defendant Ambow, and was appealed to the Supreme People’s Court, which upheld the original judgment.

II.  Key Takeaways

Whether a VIE constitutes a foreign invested enterprise (FIE).

Both Courts determined that, under the current legislative regime, whether an entity is a foreign invested entity is to be determined by the identity of its shareholders registered with the State Administration for Industry and Commerce. The fact that the shareholders in a domestic entity may have granted voting proxies and transferred economic interest in such domestic entity to a foreign invested entity should not result in such entity being characterized as an FIE regardless of being associated with foreign investment. In effect, the Courts ruled that a VIE should be treated as a domestic entity notwithstanding foreign control. 

Whether violation of the Catalogue and the National Security Rules[2] can be the basis for invalidation of an otherwise binding contract.

Concerns around VIEs largely derive from their use to ostensibly circumvent the Catalogue and the National Security Rules. The Supreme People’s Court ruled that violation of the Catalogue and the National Security Rules cannot be the sole basis to invalidate an otherwise binding contract because neither of them rise to the status of a law or administrative regulation[3]. A further argument could be logically drawn from this reasoning, although the Supreme People’s Court did not explicitly reach such conclusion: the standard suite of VIE contracts should not be subject to invalidation solely for violation of the Catalogue or the National Security Rules.

Whether Ambow’s VIE arrangement endangers national security in the education industry.

The Hunan Higher People’s Court found lack of evidence to support the plaintiff’s argument that Ambow’s VIE arrangement rose to the level of endangering national security. Grant of voting proxies and the transfer of economic interests of the two schools were not deemed to be sufficient evidence that foreign parties had any control over the curriculum of the schools.

The Supreme People’s Court, however, dodged this question by asserting that this specific issue was outside of the scope of the case and deferred to the judgment of the Ministry of Education. From the outset, since both schools held valid administrative permits issued by the Ministry of Education for their operations and there was no evidence indicating either the Ministry of Education or MOFCOM considered the Transaction in violation of the relevant administrative rules, the Supreme People’s Court could not find sufficient grounds to declare the Transaction in violation of national security norms.

Whether Ambow’s VIE arrangement violates Sino-foreign Cooperative School Regulations[4].

The Sino-foreign Cooperative School Regulations prohibit Sino-foreign cooperative schools from offering elementary and middle school compulsory education. The Supreme People’s Court deferred to the position of the Ministry of Education, which replied to the Court that the two underlying schools should constitute domestic schools, not Sino-foreign cooperative schools, because their owners of record were PRC citizens, and therefore, concluded that the Sino-foreign Cooperative School Regulations simply did not apply to this case in the first place, let alone any potential violation of such regulations. Given that relevant administrative rules regulating the education industry—and for most industries generally—do not specifically address schools with VIE arrangements, this implies that none of these rules explicitly prohibit foreign involvement through VIE arrangements in such industries.

III. Further Implications in Terms of  VIE Structures

Enforceability of VIE structure continues to remain uncertain.

The Supreme People’s Court explicitly did not review the enforceability of the VIE arrangements between Beijing Ambow and Ambow Education in this case and refrained from giving any opinion on the enforceability of such arrangements. The court’s deferral to the Ministry of Education may signal its position that the legitimacy of VIE structures in specific industries should be determined by the relevant government authorities in charge of such industries (the “Industry Authorities”). This seems consistent with current market practice where red-chip companies with VIE structures typically hold informal sessions with relevant Industry Authorities to discuss their views before an offshore listing.

Continuing questions around VIE structures.

Over the years, certain Industry Authorities and other governmental authorities have indicated their negative views about the VIE structure.

  • Anti-trust. From an anti-trust perspective, MOFCOM has deemed “exerting a decisive influence on other business operators by contract” to be one of the various forms of concentration, equivalent to acquisition of controlling stake, and therefore subject to anti-trust review if relevant thresholds are met. At the same time, MOFCOM has refused to accept anti-trust filings involving VIE companies, apparently on the premise that this would be a de facto approval of the VIE structure.
  • Online Games. The General Administration of Press and Publication specifically prohibits foreign parties from controlling any online game business in China through contractual arrangements.[5] 
  • Telecoms. The Ministry of Information Industries strives to eliminate ”disguised” foreign participation in the operation of telecommunications businesses.[6] 
  • Steel. The offshore listing of a cold-rolled steel business in Hebei through Buddha Steel, Inc. was called off as a result of local Hebei government advising that such VIE arrangements were against public policy. The Buddha Steel case, however, was arguably one of a kind, and its implications are largely considered to be limited to the steel industry.

The “control” element in the Draft Foreign Direct Investment Law, if adopted, may supersede this case.

The draft Foreign Direct Investment Law, circulated in January 2015 for comment, indicated that domestic enterprises “controlled” by foreign investors should be regarded as foreign-invested enterprises subject to foreign investment restrictions. It further defined “control” to include holding rights and interests in a domestic enterprise by contract, trust, or other means. This “control” concept was clearly intended to sweep up VIE arrangements, and if adopted, will mean that Beijing Ambow should be treated as an FIE (which would also bring it under the Catalogue). The impact of the proposed direction of the draft Foreign Investment Law would be substantial and it would render elements of the Ambow case moot. Inasmuch, it has been the subject of much debate.

* O’Melveny recognizes legal consultant Qianru Hong for her valuable contribution in researching and drafting this article.

1. Operation of elementary and middle school compulsory education falls under the foreign investment prohibited categories in the Catalogue.

2. Provisions of the Ministry of Commerce on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (《商务部实施外国投资者并购境内企业安全审查制度的规定》)

3. The Catalogue and the National Security Rules were department rules issued by the Ministry of Commerce and National Development and Reform Commission, while laws shall be adopted by the People’s Congress and administrate regulations shall be adopted by the State Council.

4. Regulations on Establishment and Operation of Sino-foreign Cooperative Educational Institutions (中外合作办学条例)

5. Notice on Implementing the Provisions of the State Council on “Three Determinations” and the Relevant Explanations of the State Commission Office for Public Sector Reform and Further Strengthening the Administration of the Pre-approval of Online Games and Examination and Approval of Imported Online Games (关于贯彻落实国务院《“三定”规定》和中央编办有关解释,进一步加强网络游戏前置审批和进口网络游戏审批管理的通知)

6. Notice Concerning Strengthening the Administration of Foreign Invested Value-Added Telecommunications Business Operations from the Ministry of Information Industries (信息产业部关于加强外商投资经营增值电信业务管理的通知

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