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Thursday, July 7, 2011

Who owns the Chinese internet?

An article recently published in Xuexi Shibao (Study Times), an organ of the Central Party School, has drawn a lot of attention (see here and here). The authors, Jing Linbo and Wang Xuefeng from the Chinese Academy of Social Sciences, assert (a) that foreigners (“foreign capital”) in the article’s terminology) have come to control the Chinese internet, and (b) that this is a bad thing. I’m not going to address the second point here; among other things, if the first point is false, then the second point is irrelevant. It’s important to get the facts straight on this matter, because apparently it has become sensitive. The authors made the same argument in an academic journal in 2009,[1] but it didn’t seem to attract any attention. Now we are seeing it in the pages of a Central Party School publication. Does this mean something?

I’m going to argue here that the article is fundamentally wrong in its understanding of who controls China’s internet companies. First, it is wrong in thinking that the contracts subjecting Chinese internet operators to the control of foreign companies are robust and enforceable in China. Second, even if the contracts were robust and enforceable, the “foreign” companies exercising the control may in fact be controlled by Chinese individuals – sometimes the same Chinese that are on the other side of the contracts.

Actually, the article represents a curious phenomenon that periodically crops up in China’s relations with other countries: Chinese start worrying about a foreign bogeyman at exactly the same time the foreigners are worrying about a Chinese bogeyman. Each side fears that the other has the upper hand – and in the same matter. They can’t both be right.

Chinese internet businesses with foreign interests – and there are a lot of them – are typically structured through what’s called a Variable Interest Entity (explained in detail here and here.) Because foreigners can’t own internet operations directly, an offshore entity is set up (the Baidu that’s listed on the New York Stock Exchange, for example, is a Cayman Islands company). Typically, the offshore company (“Offco”) is the sole owner of a Chinese subsidiary (“Chisub”). Chinese individuals (“Chiparties”) – typically, the entrepreneurs associated with the business – also set up a Chinese company (“Chico”). Because Chico is owned by Chinese, it is able to hold the licenses and operating permits needed to run an internet business. Offco raises money through a listing abroad, and either directly or through Chisub lends the money interest-free to Chiparties. Chiparties then use the money to capitalize Chico. Both Chiparties and Chico sign a series of contracts with Offco and/or Chisub pursuant to which Offco, directly or through Chisub, controls the operations of Chico, reaps the benefits, and suffers the losses. Since control and risk-bearing pretty much define what ownership is about, this structure mimics – or at least attempts to mimic – precisely what is prohibited under Chinese law. These contractual control rights alarm the authors of the article.

At the same time, however, since last March serious concerns have been raised in the foreign business community about whether this contract-based structure is solid. (Here’s a sample blog post.) The contracts exist in order to mimic the features of direct ownership while evading the prohibition, and contracts for the purpose of achieving a prohibited purpose are void in China. Article 52 of the Contract Law spells this out:

In any of the following circumstances, a contract is void: . . . (3) a lawful form is used to conceal an unlawful purpose; . . . (5) there is a violation of mandatory provisions of laws or administrative regulations.[2]

Moreover, the governmental authorities that now allow these structures to go forward could at any time decide to stop allowing them. That is exactly what happened in 1999, when foreign investors in telecommunications ventures using the CCF (“Chinese-Chinese-foreign”) structure were forced to unwind their holdings, sometimes at a loss.[3]

There is evidence that the worries are well founded:

  • GigaMedia had a VIE structure for its China operations. But its Chinese manager – the type of person who is described in the article as a passive puppet-like agent sought out by foreign capital to do its bidding – recently decided to cut the strings, and GigaMedia essentially lost all its China business (about 20% of its consolidated revenues) as a result. (See here and here.) It has apparently not been able to enforce the contracts that purported to give it control.
  • Buddha Steel’s planned IPO in the United States was cancelled last March. It used a VIE structure to exercise control over a Hebei cold-rolled steel company. Apparently the Hebei provincial authorities advised the onshore operating company that the VIE agreements “contravene current Chinese management policies related to foreign-invested enterprises and are against public policy.”[4] (See also here and here.)
  • Finally, it is puzzling that the authors also use the Alipay dispute as an example in support of their point, since in fact it undermines it. Jack Ma has apparently in no way been constrained by any contractual obligations he or the onshore company may have to Alibaba, the offshore listed company. If he is supposed to be an obedient puppet of foreign capital, I think somebody forgot to inform him.

But let’s suppose the contracts are all valid and readily enforceable, so that the offshore entities really can exercise control. That still leaves open the question of who controls the offshore entities. Is it “foreign capital”? Not always. These entities aren’t necessarily the product of foreign capital looking for a Chinese puppet. They can be the product of Chinese individuals and companies looking for foreign capital.

  • Take Baidu (the Cayman Islands company listed on the NYSE), for example. 52% of the voting power is owned by Robin Li, either directly or through a BVI company he owns and controls. Another 16% is owned by his wife. Except for a Scottish partnership that holds 2.49%, the rest of the voting power appears to be widely held. In other words, foreign capital is helping out Robin Li, but exercises no control. Robin Li, to the best of my knowledge a patriotic citizen of China, controls the offshore company and the money.
  • Dangdang presents another model of control. In this case, the Chinese entrepreneurs – Li Guoqing and Peggy Yu – don’t have absolute, majority control. They do, however, control more than 45% of the company’s voting power and occupy the top management and board positions. This doesn’t look very much like control by foreign capital.
  • presents a third model. The president and CEO, Charles Chao, is of PRC origin. (I don’t know if he is still a citizen.) He appears to be the largest single shareholder, controlling over 8.66% of voting rights. Only one other shareholder holds more than 5% of the voting rights. In other words, the shareholding is largely dispersed and there is no controlling shareholder. Since Jing and Wang admit in their 2009 article that has no controlling shareholder, how then can they claim at the same time (as they do) that the company is “controlled by international capital”? They state that ownership of more than 50% of the shares constitutes absolute control, but this means that some unified will – a single person or a unified group – has to control all those shares. In grammatical terms, the subject of the verb “to own” has to be an entity capable of thinking and expressing a will. “International capital” is not a person with a unified will. The authors appear to believe that in a 10,000,000-share company, if 5,000,001 foreigners each own one share, that is “foreign control” just as much as if one foreigner holds 5,000,001 shares. It is not. One can always identify a group of random and unconnected shareholders in any company whose holdings add up to more than 50%; that does that mean that they control the company. When a company has no controlling shareholder, who does control it? The answer is: management. And in the case of, management appears to be predominantly in the hands of Chinese nationals.

Of course, there may be Chinese internet businesses using the VIE structure in which the offshore company really is controlled by foreigners. I have not researched each one; I have just looked at random some prominent examples, including one discussed by the authors themselves, and discovered that the so-called foreign control is an illusion. Moreover, as argued in the first part of this essay, even if the offshore company is genuinely under foreign control, it is still far from clear that its contractual relations with the onshore company and the onshore company’s Chinese investors are solid and enforceable under Chinese law. In short, the Chinese government still retains its power over the Chinese internet and has yielded little or nothing of importance to foreign interests.[5]



[1] 荆鳞波,王雪峰,《外资对我国互联网业市场影响的研究》,财贸经济,2009年,第5期,97-103.

[2] “有下列情形之一的,合同无效:. . .(三)以合法形式掩盖非法目的;. . .(五)违反法律、行政法规的强制性规定。”

[3] This history is set forth in a succinct corporate disclosure from China Unicom here.

[4] Thomas Shoesmith, “PRC Challenge to Variable Interest Entity Structures?,” Pillsbury Client Alert, March 31, 2011, available at

[5] If anyone doubts this, consider the list of banned search terms on’s microblog platform that appeared within 24 hours of rumors of Jiang Zemin’s death – i.e., search terms for which the web site returned the result, “According to the relevant laws, regulations and policies, the results of this search cannot be displayed.” There are too many to list here, but they included any references to rivers (the character used in Jiang’s surname), “former leader,” “affairs of state,” “important news,” and even “Song Zuying” and “mother of the state”, both references to Jiang’s alleged mistress. The state’s hand, and’s ready cooperation, is obvious. See 新浪微博敏感词最新更新:江泽民(2011年07月07日), China Digital Times, July 7, 2011, available at; Josh Chin, “Following Jiang Death Rumors, China’s Rivers Go Missing,” China RealTime Report, Wall Street Journal, July 6, 2011, available at

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you write ... "Actually, the article represents a curious phenomenon that periodically crops up in China’s relations with other countries: Chinese start worrying about a foreign bogeyman at exactly the same time the foreigners are worrying about a Chinese bogeyman. Each side fears that the other has the upper hand – and in the same matter. They can’t both be right."

yes, they CAN both be right ... excuse the in-built cliche, but the china mind understands this ... after all, they invented the yin/yang concept ... you will find examples in china where forces are neutralized not by polarities (which strengthen each other) but by the same force returned.

Posted by: gregorylent | Jul 7, 2011 3:40:27 AM

Thank you for the great post!

I completely agree with you in finding the choice of Alipay as an example very strange, but I think it was done simply because the topic is hot in China, so it was likely to attract interest to the piece.

I think another important distinction they miss is that they look at stock ownership directly with no regards to the voting power of the stock.

I think the really interesting bit is going to be how the debate takes shape in China. Who will answer them on the article and how.

Posted by: Fredrik | Jul 7, 2011 3:47:31 AM

Great post. Reality does not justify the paranoia behind that report. VIE structures are fundamentally weak and round-tripping is endemic in the industry.

To throw out one idea as to where the paranoia comes from, though, perhaps the worry is that as long as the Net company is (supposedly) held or partially controlled by an offshore entity, it is possible that the shares of that SPV will someday be sold to foreigners. For example, if Robin Li sold off a big chunk of stock and retired.

Posted by: Stan | Jul 7, 2011 4:55:18 AM

It never ceases to amaze how many companies are willing to enter into joint ventures that do not make legal sense in order to tap the potential of China's marketplace.
When a country such as China routinely violates the human rights of its own citizens, there's little chance the government is going to respect and enforce contracts that are against its interests.
As you described, the game is rigged against an Internet business that operates as a Variable Interest Entity. And to the extent that a VIE somehow operates contrary to the Chinese government's interests, steps will be taken, legal or otherwise, to remedy the situation to the detriment of the foreign investors.

Posted by: Mike Young, Esq. | Sep 11, 2011 6:34:56 PM

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