Proposed new rules HONG KONG-China foreign investment will help the government to re-exert control over the flow of Chinese money and interests at the Internet industry booming foreign country.
It's probably a blessing for Alibaba Group Holding Ltd. and Chinese Internet companies like him, investors, executives and lawyers say. But for foreign shareholders of these companies, as well as Western Internet companies trying to operate in China, the rules can be a double-edged sword, they say.
"The goal, as with everything the Chinese government does is maintain control," said lawyer Antonio Dapiran, Hong Kong partner at Davis Polk & Wardwell LLP has advised the types of Chinese companies would affected by the new rules.
The Commerce Ministry did not immediately respond to a request for more information on the purpose and implementation of the draft regulation.
The draft standards, published by the Ministry of Commerce of China last week, covering everything from policies to encourage foreign investment to the relaxation of restrictions on foreign investors in non-sensitive sectors. Fundamentally, they are also directed to a complex corporate structure designed to circumvent Chinese restrictions on foreign investment in politically sensitive industries such as Internet, telecommunications and education. The structure, known as a variable interest entity, or VIE, allows investors to take stakes in portfolio companies offshore contracts based on control, but no Chinese entities own businesses actually operate.
VIEs are used by everyone from Chinese Internet companies seeking US venture capital for the biggest players in technology companies such as e-commerce giant Alibaba, search company Baidu Inc. and online games and social networking firm Tencent Holdings Ltd.
So far, the Chinese government became largely blind eye to VIEs. But for more than a decade, their extralegal state has caused many anxious that their interests can not be protected if Beijing cracked down on the structure, or Chinese authorities decided not enforce contracts that bind to foreign investors offshore holdings .
Under the proposed new rules, foreign investment through variable interest entities would be permitted, provided that the companies could demonstrate that Chinese individuals or entities exercise "effective control" over the business. That might be comforting certainty for foreign investors.
"I think many Chinese companies listed on the New York trading at a discount whenever some kind of freaked about VIE comes," said Hans Tung, managing partner of GGV Capital, a venture capital firm that was a Alibaba early supporter. "If the VIE structure is recognized by Chinese law as a legitimate way for foreigners to make foreign investments, which will make it much easier to investors."
Executives and investors say the big question is how Chinese officials defined control.
The Chinese founder of a startup based in Beijing which uses a VIE, who requested anonymity because of the sensitivity of the issue, said he is clearly in control now still owns most of the company. But he is worried about what would happen if the level of foreign investment in your sign ups.
"What if we go through two more rounds of funding and if my game falls below the participation of foreign investors?" I asked. "The company considered under foreign control?"
One solution might be the type of management structure used by Alibaba, which keeps the Chinese control, giving the power to appoint a majority of its directors to a small group of Chinese managers.
During a press Ministry of Commerce representatives last week foreign companies, Huang Feng, deputy director of the administration's foreign investment ministry, quoted Alibaba as an example of a company that would benefit from the new rules VIE, according someone who attended the briefing. Mr. Huang did not elaborate.
Such an interpretation of control could encourage the founders and managers of Chinese Internet companies to build more power over their companies using dual structures on shares or other arrangements that give them more voting power, lawyers say. It could also disappoint foreign shareholders hoping to exert more influence on Chinese operations.
"With these new proposed rules I hope to see China's Internet and mobile companies who want to maintain control with a special installation supervoting" said Rocky Lee, Asia managing partner at Cadwalader, Wickersham & Taft LLP, expert working VIE structures with many Chinese technology companies.
Those who could find themselves in the delicate position are foreign companies using VIE structure so that they can become players in the Internet industry in China, experts say.
For example, in its annual report 2013 US e-commerce giant Amazon Inc. Amazon.cn described its business in China as being operated by Chinese companies directly owned by Chinese citizens, a structure that said made "only risks" due to uncertainty about its legality. Amazon did not respond to a request for comment on how the draft rules could affect its operations in China, and it is unclear what impact they may have.
The VIE proposed rules make clear that Chinese households of such foreign companies would like. That means you probably have to seek government approval for permits and licenses to provide Internet content such as videos, for example-you may find it difficult to obtain.
The proposed rules are in line with China's unhappiness with foreign companies trying to use the VIE structure to operate in the industries, the government has tried to keep them off, said Marcia Ellis, a lawyer based in Hong Kong with experience advising business VIE. She described Beijing's attitude as "We're fine with true native Chinese companies, local grown, but we are not happy with you big multinational Internet companies trying to enter and use this structure."