MOFCOM declaring the use of VIE (variable interest entity) structure in the internet sector illegal?

On 13 August 2012, MOFCOM approved Walmart’s acquisition of a controlling interest in an online supermarket business in China subject to conditions. What is worth noting about the decision is not that the acquisition is approved but the express reference made by MOFCOM to the use of VIE structure in the approval. Michelle Chan, Karen Ip and Clarice Yue provide an analyse of the decision.

The merger control approval

On 13 August 2012, Walmart received a conditional approval from the Ministry of Commerce (MOFCOM) to acquire, amongst others, part of the online retail business of Yihaodian, one of the biggest online supermarkets in China.

MOFCOM is of the view that the leading positions of Walmart and Yihaodian in the supermarket business will lead to a negative impact on competition in the online retail business. Since Yihaodian also allows third parties to sell their products through its online platform, which is regarded as a value-added telecom business (VATB) under PRC law, MOFCOM has also considered the anti-competitive effect of the proposed transaction in the VATB market.

The MOFCOM approval is subject to three conditions. In short, the conditions provide that the PRC domestic entity controlled by Walmart is only permitted to acquire the part of Yihaodian’s online business which is for the sale of its own products and services. The PRC domestic entity is prohibited from allowing third parties to sell their products on its online platform unless it has obtained the applicable VATB telecom licence from the telecom authority. Intriguingly, MOFCOM explicitly prohibits Walmart from putting in place a VIE structure to operate the part of the online retail business regarded as VATB which the PRC domestic entity has not been permitted to acquire. The imposition of these conditions appears to be primarily driven by MOFCOM’s concern over the potential use of the VIE structure by Walmart to operate essentially a VATB business without obtaining the requisite foreign investment approval.

Some observations

Prior to the issuance by MOFCOM of the notice in 2010 concerning the sale of products through internet and vending machines by foreign investors as discussed in our previous e-bulletin, no distinction was drawn between the sale of a company’s own products and services using its own online platform and the provision of an online platform allowing third parties to set up online shops to sell their respective products and services: both activities require a telecom licence. Following the issuance of the notice, telecom licences are no longer required for the former, even if conducted by an FIE. A registration with the telecom authority suffices. This thus explains MOFCOM’s decision to allow the part of the operation concerning the sale of Yihaodian’s own products and services to be acquired indirectly by Walmart.

The difficulty of obtaining a formal foreign investment approval to invest in the telecom sector in China and the desire of Chinese internet companies to list offshore have resulted in the widespread adoption of the VIE structure, i.e. a structure pursuant to which the management control of the domestic Chinese telecom licensee is achieved through a series of contractual arrangements.

The inherent risk of such investment structure is well recognised: the foreign investor may not be able to enforce the contracts in China in the event that “something goes wrong”. Until the issuance of this decision, the relevant PRC authorities have never made any express reference, formal statement or opinion on the legality of using the VIE structure in the internet/telecom sector. This remained the case even when the well-publicised controversy between Alibaba and Yahoo! was raging on last year. The VIE structure was briefly referred to in an online game notice issued by the General Administration of Press and Publication in 2009, i.e. foreign investors are prohibited from engaging in the online game business through “contractual arrangements” (e.g. providing technical support) to indirectly control an online game operator in China. But even so there was no express reference to the VIE structure as such.

The MOFCOM approval therefore is the first time that the VIE structure has been expressly mentioned by a PRC authority. It should be noted that the approval itself does not expressly say the use of such structure is illegal. Accordingly, it remains to be seen whether MOFCOM will take any further action in this regard.

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Filed under China, Competition law, Hong Kong, Technology Media and Telecommunications (TMT)

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