In April 2020, and for the first time, the Chinese competition law authority (the State Administration for Market Regulation, or SAMR) accepted a merger control case involving a party incorporated under an “variable interest entity” (LIFE) structure.

While this case was not announced with fanfare by SAMR (indeed, it was only revealed through the standard public disclosure process applicable to all filings made under the simplified notification procedure), it is supposed to signify a significant change in the position of SAMR vis-à-vis the VIE structure.

For foreign investors who hold stakes in Chinese companies through VIE structures, or who seek to invest, this is an important development. In this e-newsletter, we explore what this means for funds and other foreign investors.

What is a VIE structure?

VIE structures and merger control in China

VIE structures now able (and expected?) To deposit

Increase in maximum penalties in consultation

What is a VIE structure?

VIE is a concept commonly used by foreign-invested companies operating in industries where China has restricted foreign ownership. The VIE structure can be used to circumvent certain restrictions via: (1) an offshore holding company creating a wholly owned subsidiary (under a wholly foreign-owned company, or WFOE structure) in China; and (2) the WFOE would control and then receive all of the profits of the RPC business through a series of contractual arrangements. The shareholders of the Chinese company would remain Chinese nationals (according to regulations), while the offshore holding company would recognize the income and record the operations of the WFOE in its financial statements.

The VIE structure allows domestic Chinese companies in narrow sectors to seek foreign venture capital funding, as well as register in offshore jurisdictions. Many tech giants listed on China’s stock exchanges have adopted this structure, including Alibaba, Baidu and Tudou.

VIE structures and merger control in China

Although VIE structures have been widely used for some time, until recently they were not formally recognized by the Chinese government. In particular, it is common practice for SAMR (and its predecessor, the Ministry of Commerce) not to formally accept merger review cases involving companies operating under a VIE structure.

This has led to significant uncertainty as to the risk of non-compliance for EDV structures. Despite widespread practice, there is no clear legal basis for SAMR not to accept deposits involving VIE structures, nor an explicit exemption under anti-monopoly law (AMLA) on which companies adopting such structures could rely not to notify triggering transactions.

However, this has now changed following the recent acceptance by SAMR of a filing involving a VIE structure. On April 20, 2020, SAMR officially accepted a dossier submitted by Huansheng Information Technology (Shanghai) Co., Ltd. (“Huansheng“) and Shanghai Mingcha Zhegang Management Consulting Co., Ltd. (“Mingcha“). Huansheng is said to be a subsidiary of Yum China, the operator of restaurant chains such as KFC, Pizza Hut and Taco Bell in China.

According to the public disclosure form of this file, Mingcha is controlled by a Caymanian company “via related entities on the basis of a series of contractual arrangements”, which shows that this company is incorporated via a VIE structure. According to recent reports, consideration of this transaction has been hampered due to competition law complaints raised by third parties, which appear to be unrelated to the fact that Mingcha is organized under a VIE structure.

VIE structures now able (and expected?) To deposit

Following this case, it is clear that SAMR will accept deposits regarding transactions involving VIE structures. More importantly, this likely means that SAMR will now expect such deposits, and the involvement of a VIE structure will no longer serve as a reason not to file.

In turn, SAMR may begin to sue VIEs for failing to file transactions. While we cannot rule out the possibility that SAMR will pursue historical transactions involving VIE structures that were not filed due to the previous policy position, attention should certainly be turned to future transactions. In particular, for funds and other investors in Chinese companies organized under a VIE structure, and who have previously ignored the need to make merger review filings in China due to SAMR’s approach, this may mean that a fundamental shift towards merger control strategy is needed in relation to future transactions. Going forward, it will be essential to consider Chinese merger control even when the transaction involves a VIE entity.

Increase in maximum penalties in consultation

In addition to SAMR’s change of approach to VIE structures, the potential risk of non-reporting is also likely to increase in the near future. Currently, the maximum fines that can be imposed by SAMR are capped at RMB 500,000. However, SAMR is currently consulting on various AML changes, including a substantial change to its fine powers.

According to the SAMR’s AML amendment proposals (published for public consultation in January 2020), it is proposed to significantly increase the maximum fines for failure to notify a transaction in violation of merger control rules, passing from RMB 500,000 to 10% of total enterprise revenue in the previous fiscal year.

This increased cap also applies to other breaches of merger control rules, including the completion of transactions notified before authorization (i.e. the jump of weapon) or the completion of a transaction prohibited by SAMR. The proposed increase in fine powers aligns the PRC regime with that of other key merger control jurisdictions, such as the EU. However, it should be noted that merger review requests are triggered more frequently under the PRC for a variety of reasons, including significantly lower turnover thresholds and the lack of “full functionality” criteria in the PRC. valuation of joint ventures that exist in the EU regime.

These changes are likely to put merger control compliance in the PRC even further into the spotlight, especially as jump-arms has long been an enforcement priority of SAMR (and its predecessor, MOFCOM). .

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