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Ambow: China’s Latest Word on the Viability of VIEs in Prohibited Industries
date:2017-4-7   Views:302

The Supreme People’s Court’s recent Ambow decision goes out of its way to avoid ruling on the legal viability of a variable interest entity (VIE) structure operating in China. On balance, the position of foreign companies who use these entities to invest in China’s prohibited industries remains much as it was before this decision. However, the court does appear to implicitly acknowledge that VIEs, like all investments, are still subject to some amount of political risk.

Facts

The plaintiff, Yaxing Company, was the founder of the Tongshenghu Shiyan school and the Tongshenghu kindergarten in Changsha, Hunan Province (Targeted Schools).

The defendant, Ambow Education and Science and Technology Ltd (Ambow Company), is a domestic company owned by two Chinese citizens. Ambow Education Holding Ltd. (Ambow Education) is a Cayman Islands company that was listed on the New York Stock Exchange (NYSE) beginning in 2010. Ambow Online Software Ltd. (Ambow Online), a wholly foreign owned entity, was formed by Ambow Education in China.

In 2009, Yaxing signed a Cooperation Framework Agreement with Ambow Company. In exchange for a substantial sum of money, Yaxing transferred to Ambow Company 70% of its rights in the Targeted Schools as well as other properties. To manage the investment (and presumably to finance it as well), Ambow Company became a party to contracts that are typically found in a VIE structure i.e. the Exclusive Cooperation Agreement, the Purchasing Options Agreement and the Entrustment Contract (VIE Contracts).

In this case, Ambow Company, the Chinese company, and its two shareholders contracted with Ambow Online, the wholly foreign owned entity, to develop and manage educational programs in China.

In 2014, Ambow Education’s share prices fell and it was suspended from trading on the NYSE. Yaxing then filed suit against Ambow Company to invalidate the Cooperation Framework Agreement in order to get back the rights to the Targeted Schools.

Parties’ Arguments

Yaxing claimed that by employing the VIE Contracts, Ambow Company and Ambow Online Company “maliciously circumvented the laws and industrial policies forbidding foreign investment in compulsory education” through the “lawful conduct of a domestic enterprise purchasing the targeted schools”and therefore the Cooperation Framework Agreement was an invalid contract as it "conceals an illegal intention within a lawful form".

The laws and industrial policies Yaxing was referring to are Article 6 of the Regulations of the People's Republic of China on Sino-foreign Cooperative Education (Regulations) and the Catalogue for the Guidance of Foreign Investment Industries (Catalogue). Basically, each says that foreigners are not allowed to invest in providers of compulsory education. There was no disagreement that the Targeted Schools were providing compulsory education.

For those reasons, Yaxing asked for the return of its rights to the Targeted Schools.

Ambow Company had three arguments in response.

First, the Cooperation Framework Agreement was a valid contract, and Ambow Company had performed its duties according to the Agreement and had not violated any laws in operating the schools.  

Second, the Cooperation Framework Agreement was between Yaxing and Ambow Company, two domestic companies. Both shareholders of Ambow Company were natural persons and Chinese citizens so there was no foreign investment in Ambow Company.

Finally, there was no evidence that Ambow Company was effectively controlled by Ambow Online.

The Court’s Decision and Reasoning

The Supreme People’s Court ruled in its final judgment that the Cooperation Framework Agreement was the true intent of the parties and concerned legitimate subjects, and it did not violate the mandatory provisions of the laws and administrative regulations. With that, the case was dismissed.

The Court’s reasoning was as follows:

1.    The Cooperation Framework Agreement is a valid Contract.

The Court found that Ambow Company’s shareholders were domestic natural persons, and there were no foreign shareholders in the company. Although Ambow Online was entrusted to exercise the rights of the Ambow Company shareholders by contract, it was not a shareholder of Ambow Company. Thus, Ambow Company is a domestic company, not a foreign-owned company.

The Court further found that Yaxing Company signed the Cooperation Framework Agreement with Ambow Company in order to transfer its holding rights in the Targeted Schools for a price. And the agreement was not concluded by means of fraud or coercion. Thus, the Cooperation Framework Agreement was the true manifestation of intent of the two parties.

2.    The Cooperation Framework Agreement violated no laws.

Yaxing asserted that foreigners are not allowed to invest in a compulsory education institution according to the Catalogue; in response, the Court ruled that the Catalogue is a departmental regulation, not a law or administrative regulation.

Yaxing Company also claimed that the Cooperation Framework Agreement was invalid because it violated the Regulations that prohibit foreign investment in any institution responsible for delivering compulsory education.

In response, the Supreme People’s Court made a distinction. Although Ambow Online, a foreign company, was involved with the schools by means of contracts with a domestic company, it did not directly participate in delivering education or in the management of the schools. Therefore, the contractual arrangement did not fall within the scope of the Regulations.

Furthermore, the Court found that the validity of the VIE Contracts between Ambow Company and Ambow Online were not within the scope of the hearing.

3.    Ambow Company had a clean administrative record.      

At the end of its ruling, the Court added its findings regarding Ambow Company’s administrative record. After the Cooperation Framework Agreement was signed, the District Department of Education removed Yaxing as the holder of the Targeted Schools and listed Ambow Company in its place. This action was approved by the relevant administrative supervisor. Furthermore, administrative supervisors presented no evidence that Ambow Company and the targeted schools were illegally delivering education or conducting activities that harmed the security of education or the public interest.

Comments

In our opinion, there are three main takeaways from this case:

1.    For foreign investors concerned about the continuing viability of VIE structures in China’s prohibited industries, this decision does not add any certainty. However, it may be reasonable to conclude that the Court is uninterested in allowing private litigants to use the mere involvement of a VIE structure as a means to reverse an otherwise legal transaction. After all, China’s most recent Five Year Plan calls for more foreign investment—not less—as the nation’s economy slows down.

2.    As a matter of Chinese contract law, the Court made an important distinction between the Catalogue, a departmental regulation, and duly promulgated laws and administrative regulations. How far this distinction could be pushed in the VIE context requires further consideration. (We suggest readers interested in the contract law issues in this case to watch Professor Clarke’s Chinese Law Prof’s blog for his forthcoming thoughts on this topic.)

3.    Like all business transactions everywhere in the world, VIE structures in China are subject to political risk. It is therefore perhaps worthwhile to consider the Court’s final point. In this case, Ambow Company’s administrative record contained no evidence that the public interest or administrative regulations were violated by its contractual arrangements or operations. However, one could imagine—if Lotte Mart’s current fire code problems are any guide—that the public interest and administrative regulations might be low hurdles to clear for a private litigant if a VIE invested business found itself involved in politically sensitive matters.

 

The Authors:

说明: 7Sam

Samuel Speed 山姆·斯毕德

American Lawyer

Senior Consultant of Foreign Affairs

Email: samuelspeed@yingkelawyer.com

Pei Lin 林佩

Overseas Counsel

Email: liangxinran@yingkelawyer.com

 

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