SEC probe raises uncertainty over VIE structures

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.

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.