Yes, another esoteric VIE post. The good news is that this is less about VIEs than it is about certain topics of jurisprudence. Then again, that might be worse. Have some strong coffee before reading this.
It is somewhat amusing to note that we’ve had a spike in Net chatter about the VIE corporate structure this week despite the complete absence of news. Neither China nor the U.S. has made any relevant moves, and there haven’t been any new scandals or disputes involving well-known companies that have adopted the VIE corporate structure in China.
But hell, we all love a good argument. Or, if all else fails, at least an argument. There’s been some great back-and-forth between China Law Blog, DigiCha, China Finance Blog, China Accounting Blog, with some excellent straight news reporting from iChinaStock. Most of it has been focused on whether VIEs are now illegal or are likely to be in the future.
Some of the best discussion has come from the comment section of China Law Blog. As I mentioned in my earlier post on the subject, we’ve got people with different perspectives making pronouncements on the subject, letting us know what they believe is really important. (Of course, that all depends on whether the person is a lawyer, an accountant, an investor, and so on. Some folks tend to focus exclusively on VIEs used by U.S.-listed Chinese companies, for example, which misses out on a LOT of other VIEs out there. Remember that this whole thing originated with foreign investment restrictions, not with the stock market or accounting rules.)
Among other points, the one that I found most interesting concerns the illegality of VIEs and the invalidity of related contracts. For some reason, folks often get these two terms “illegal” and “invalid” mixed up. They shouldn’t. They don’t mean the same thing.
Invalidity refers to something that is weak or, in contract terms, unenforceable. The source of that invalidity could very well be that some, or all, of that agreement runs counter to law (i.e. is illegal). However, there are also many grounds of invalidity in addition to illegality.
Simple example: a contract that was never signed may be invalid. It is not, however, illegal. With respect to what “illegal” means, take a look at an earlier post I wrote about legal realism.
The tie-in here to the VIE discussion relates to the validity of contracts between VIEs and (usually) onshore subsidiaries of foreign companies (i.e. WFOEs). As I mentioned in my last post, I believe that the more significant risk of using a VIE structure is the question of validity of those contracts, as opposed to the illegality of the structure itself as declared by MOFCOM or other part of the government. There have always been questions about how VIE agreements could be enforced that do not directly concern the legality of the underlying relationship. For example, if a court ruled in favor of a foreign company in a VIE dispute involving a Pledge Agreement, how would the foreign company hold the VIE equity, given foreign investment restrictions?
At the risk of getting into some tall weeds, I’d like to specifically address one of the comments posted on the China Law Blog post, which responds to statements made by Dan Harris and Steve Dickinson. The commenter’s handle is “twofish” (I’m not trying to single out anyone. This comment just raises the issues I wish to discuss):
Harris: One, the government has come out with regulations making very clear that such structures are illegal.
No they haven’t. MOFCOM has issued a regulation which restricts the creation of new VIE’s. It’s far from clear that it makes these structures illegal.
Okay, I have some problems with this. The MOFCOM rules are about the security review process for cross-border M&As. MOFCOM is worried that VIEs will be used to avoid the review process, so it stated specifically in the rules that companies are still required to submit to the review even if they are using VIE/VIE-ish structures.
While the practical effect of the MOFCOM rules might mean that it is now more difficult to enforce VIE contracts in court (Dan pointed that out in a later post), it does not follow that the new rules make VIEs per se illegal. Small, but important, distinction. Twofish got this part right.
However, the second part of that quote is a real head scratcher. Unless we’re talking about different rules, MOFCOM has definitely not restricted the creation of new VIEs. Again, this is all about a reporting requirement for the national security review, and it only applies to certain M&A transactions. I’m not sure how we go from that narrow issue to restricting the creation of new VIEs. Perhaps I’m missing something.
Here’s the second half of that comment:
Dickinson: Even if the Chinese regulators do not take this drastic step, it is now clear that the contractual arrangements on which the various VIEs are based are in clear violation of Chinese law. This renders the contracts unenforceable and makes existing VIE structures essentially meaningless.
Absolutely not true.
Stopping there, I’d agree that there are some problems with Steve Dickinson’s language. I actually agree with his general conclusions about unenforceability, but saying that it is now “clear” is probably overstating things a bit. Again, as Dan Harris clarified in a later post, the MOFCOM rules might make it more difficult to enforce VIE contracts in court. But that’s not the same thing as an affirmative declaration that the structure is illegal.
Does that then make VIEs meaningless? Again, I think Steve’s language is too strong. I think VIEs are weak crap, but I wouldn’t call them meaningless. Lots of companies operate with unenforceable contracts. The agreements are bad, but to the extent that they are relied upon by both sides of a commercial arrangement, they certainly are not meaningless. Are MOUs meaningless?
To be fair to Steve though, it is certainly understandable from a corporate attorney’s point of view to say that an agreement that is unenforceable is meaningless. In our world, that’s not a crazy thing to say at all, but to laymen, it probably sounds odd.
Here is the commenter’s response:
MOFCOM doesn’t have the authority to invalidate contracts that are already written. In order to invalidate the contracts, you’d need a a series of ruling from the courts. It’s possible that the courts will agree with MOFCOM, and invalidate the contracts. On the other hand courts are often more sympathetic to local governments than MOFCOM, so it’s quite possible that they won’t. Even if they do, it will take about a year or two before you have a series of decisions that invalidate contracts, and it’s not likely to be a sudden thing.
I don’t get this. Of course MOFCOM has the ability to invalidate contracts. The legal principle is invalidity by operation of law. Now, it’s probably true that parties to an agreement that is rendered invalid by operation of law might end up in court, and that judge could rule on the validity of that specific contract, but that’s an interpretation issue.
Example. Let’s say that the Trademark Office issues a rule concerning trademark license agreements, in effect saying that unless certain information is included in the contract, portions will be deemed invalid. Because a court in many cases will eventually rule on that question of invalidity according to that rule, would we therefore say that the Trademark Office does not have authority over the content of trademark license agreements? Of course not.
Okay, this is all academic though. There is no MOFCOM rule that declares anything illegal or restricts new VIEs. That’s all speculation.
One last issue about legality from a later comment made by the same person about whether VIEs have been deemed illegal by the government:
They are inconsistent with the MOFCOM guidelines on permitted foreign investment. On the other hand, MII and local governments have issued business licenses for them, and courts not shut them down or generally invalidated any contracts.
One thing about China is that you have a ton of officials and a ton of laws and regulations, and so when you have a situation when one set of officials and regulations are acting counter to another set of laws and officials, you end up with a mess.
Wait a second here. On its face, this comment sounds like the old legal realist position. The government position is hopelessly muddled, so we can’t say whether VIEs are actually illegal. I addressed that in another post.
However, if you’re going to try and make a legal realist argument, you’d best get it right. MII (now called MIIT) has never issued a business license to anyone. Only the AIC can do that. MIIT does issue specific permits (e.g. VATS licenses) to companies, but it would have no way of knowing whether that company is a VIE based on the documents normally disclosed during the application process. From the “outside,” VIEs appear to be perfectly normal-looking domestic companies. So that really doesn’t tell us anything.
And why would courts shut down VIEs? These are companies in good standing (i.e. with valid business licenses). As to validity of contracts, of course courts have not invalidated them — no one brings such a VIE dispute into a Chinese court. If they do, I haven’t heard about it, and I’m not the only one.
To sum up here, the reason I slogged through all that was to make the distinction between VIE as illegal structure and invalidity of VIE contracts. I’ve been telling a lot of people recently that the latter is much more important than the former in terms of risk management, and the discussions of the past couple of days has given me a nice framework for conveying the distinction.