The role of an investment vehicle commonly used by mainland companies, the variable interest entity (VIE), is gaining attention for all the wrong reasons. The announcement in July last year of a US Securities and Exchange Commission (SEC) investigation into New Oriental Education & Technology has reignited discussion over VIEs. While the SEC has indicated it will not object to New Oriental's use of a VIE structure, the well-publicised scrutiny has shaken general market confidence in the structure. Investors and potential business partners also need to fully understand the litigation risks associated with this investment strategy. What is a VIE structure? Under a VIE structure, effective ownership (and foreign investor control) of a mainland company is obtained through legal agreements rather than direct share ownership. A Chinese citizen may form a domestic company - the actual VIE - and retain sole shareholder control. Separately, the shareholders and their foreign partners establish a wholly foreign-owned enterprise (WFOE) in China. The WFOE and the VIE are bound through contractual arrangements. To access the US capital markets, for example, the WFOE is wholly owned by a firm incorporated offshore, which then obtains a listing on a US exchange. The WFOE has operational control over the VIE and receives economic benefits from the VIE's operations. The flow of funds from the VIE to shareholders is accomplished mainly through service agreements, under which the VIE agrees to pay the WFOE for services provided. Why is the structure used? Under Chinese law, certain industries - such as energy, technology and telecommunications - are considered sensitive, and companies are prevented from issuing stock to foreign investors. Some mainland companies operating in these sectors have adopted the VIE structure to gain access to foreign capital. How popular is the structure? Fredrik Öqvist, an independent analyst, estimates that 42 per cent of mainland firms listed on US exchanges use a VIE structure. They include Baidu, Sina and Tudou. How have VIEs historically been viewed? Since foreign investors do not directly own the domestic assets of the VIE, they must be assured that the contracts and agreements tying the WFOE and VIE together will be enforceable by law. Some believe the contracts have tacit government approval, but enforceability has never been tested. The absence of a track record in enforcing these agreements is a risk for foreign investors. What has changed recently in China? Article 9 of the recently enacted regulation on the national security review system for mergers and acquisitions of domestic enterprises by foreign investors specifically prohibits the use of "contractual controls" to circumvent the restrictions on foreign investment in sensitive sectors. Essentially, the new law creates a risk that Chinese courts will not enforce the contractual arrangements that make the VIE a viable option for raising foreign capital. It remains unclear to which industries the regulation applies. What are the implications of the SEC's investigation? New Oriental said in September it was informed by SEC staff that "based on the company's representations made in response to the SEC's inquiries, the staff has no objection to the company's consolidation of its variable interest entity … into the company's consolidated financial statements". The VIE, in this case, has maintained a significant degree of control over the company's large network of mainland education centres. If, in other circumstances, the SEC determines that the WFOE in a VIE structure is not responsible for or in control of the company's primary operations in China, the consolidation of the VIE could be construed as improper. Looking beyond the New Oriental example, the SEC and other agencies could potentially probe issues broader than accounting treatment of the consolidated entity, such as China's change in attitude towards VIEs, the uncertainty of the contractual framework, seemingly opaque accounting methods, and possible inadequate disclosures. Send your legal questions to firstname.lastname@example.org .