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In China, Concern of a Chill on Foreign Investments

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China was booming, and Nina Wang, a Hong Kong billionaire, wanted a piece of the action.

It was 1995, and a group of investors was setting up the first nationwide joint-stock bank of the Communist era to be primarily owned by nongovernment companies.

But Ms. Wang, considered to be the richest woman in Asia and a flamboyant figure who wore her hair in pigtails well into her 60s, faced an obstacle: Foreigners were barred from holding stakes in Chinese financial institutions.

To this day, it remains a hurdle in China, where swaths of the economy can be off limits to foreign investment, including areas like education, finance, media and technology.

To get around the problem, Ms. Wang became a pioneer in the use of regulatory loopholes to control restricted assets in China. The practice has since been refined by Chinese companies that have raised billions of dollars on stock markets in the United States and Hong Kong and also by some multinational corporations with onshore business in China.

Ms. Wang's Hong Kong company, Chinachem Financial Services, used a series of contracts to effectively gain economic control over a mainland Chinese firm, which in turn acted as a proxy to buy and hold the stake in the new bank, the China Minsheng Banking Corporation.

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Chinachem soon had a falling out with the Chinese holding company over the ownership and dividends from the bank shares. The dispute ended up in mainland courts for 12 years — until a little-noticed ruling by the Supreme People's Court, the top judicial body in China.

In what appears to be the first time that high-ranking Chinese authorities have weighed in on the issue of foreign control agreements, the court ruled that the contracts Ms. Wang had signed were invalid. The court said the shares in the bank — by then worth about $700 million, compared with Ms. Wang's original investment of $11 million — belonged to the Chinese holding company.

Moreover, the court, in a 16-page judgment, ruled the contractual agreements between the Hong Kong and mainland companies had clearly been intended to circumvent China's restrictions on foreign investment, and amounted to "concealing illegal intentions with a lawful form."

The ruling was the latest indication that Beijing's long-assumed tolerance of overseas capital finding its way into the economy's restricted sectors might be waning, a development that could have far-reaching implications for investors and the companies they support.

"This case shows that contracts used to get around China's foreign investment restrictions can be struck down by the courts,'' said Paul W. Boltz Jr., a partner at the law firm Ropes & Gray in Hong Kong. Until then, many observers had come to regard the general absence of an official response as a sign of tacit approval — an acknowledgment that such investment could help build corporate champions and create jobs.

"'While this situation is fundamentally different" than how such contracts are now drafted and put in place, Mr. Boltz said, the ruling "'does raise the possibility that a Chinese court could take a similar position on other contracts."

The loopholes used by foreign investors in China, and by Chinese companies seeking to list on overseas stock markets, have become more sophisticated since Ms. Wang made her play for the stake in Minsheng bank.

Beginning in 2000, when Nasdaq listed the Internet company Sina.com, most Chinese companies in restricted sectors have relied on complex investment vehicles known as variable interest entities, or V.I.E., as a way to sell shares to foreigners and get around China's laws on outside investment.

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About half of the more than 200 Chinese companies listed on the New York and Nasdaq stock exchanges rely on the investment vehicles to control onshore assets in China, according to research by Paul Gillis, an accounting professor at Peking University's Guanghua School of Management, and Fredrik Öqvist, an independent financial analyst.

The structure has also been used in Hong Kong listings, like that of Tencent Holdings, China's biggest publicly traded Internet company, with a market value of more than $70 billion.

While variable interest entities in such cases are technically owned by the Chinese, foreign-owned corporations maintain de facto control through a series of contracts that can involve equity pledges, profit assignments, purchase options and service or consulting agreements.

The complexity of the agreements, and the fact that they have not often been tested in court, has created some prominent challenges for foreign investors.

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In 2011, Yahoo shareholders were caught by surprise when the Chinese Internet giant Alibaba, in which Yahoo held a 40 percent stake, announced that it had transferred the assets of its online payment unit, Alipay, to a variable interest entity controlled by Jack Ma, Alibaba's chief executive.

A large online video company, Tudou Holdings, delayed its initial public offering on Nasdaq in 2010 after the former wife of the company's founder filed a lawsuit in a Shanghai court seeking control of the investment vehicle that held Tudou's operating licenses, claiming it was common property from her marriage.

The matter was settled by the court in June 2011, and Tudou successfully listed two months later. (Tudou merged with a rival Internet video company, Youku, last year.)

In the Chinachem case, Ms. Wang signed several lending and trust contracts in 1995 with the mainland Chinese firm that was to hold the bank stake, China Small and Medium Enterprise Investment Development, or China S.M.E.

Chinachem then transferred $11 million to a mainland bank account owned by China S.M.E., which in turn acquired a board seat and a 6.5 percent stake in Minsheng bank. China S.M.E. was to use its board seat to vote in accord with Chinachem's wishes, and to transfer dividends to the Hong Kong company.

Problems became apparent in 1997, when the mainland firm did not respond to Chinachem's requests for information about the bank's finances. The next year, Chinachem sought to enforce its contracts and lay claim to the bank shares. China S.M.E. responded that it was the shares' rightful owner.

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Chinachem eventually sued in Beijing, seeking ownership of the Minsheng shares. The court ruled against the Hong Kong firm in 2001, but ordered China S.M.E. to pay Chinachem about $15 million in compensation.

Chinachem appealed the case to the high court in 2002, and Ms. Wang died in Hong Kong five years later, before the court ruled.

It is unclear why it took a decade to issue the ruling, which confirmed a lower court's decision that Chinachem had no right to the bank stake. It did, however, increase the compensation payable by the mainland firm to more than $300 million.

Today, Minsheng bank is traded in both Shanghai and Hong Kong and has a market value of around $45 billion. China S.M.E. retains a stake worth $1.26 billion based on the stock's current valuation.

China's courts are not independent, and rulings do not have the same precedent-setting effect that they do in the United States.

Still, other foreign-control contracts have come under official scrutiny in recent years. In August, China's Ministry of Commerce attached a notable condition in allowing Wal-Mart Stores to bolster its stake in one of China's biggest e-commerce companies, Yihaodian.

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The ministry, which enforces China's antimonopoly legislation, said Wal-Mart could lift its shareholding in the online retailer to a controlling stake. But it expressly forbid the American company from using a variable interest entity to operate an Internet trading platform that Yihaodian had hosted for other online retailers and consumers.

Since 2010, Shanghai's arbitration board has invalidated two variable interest entities that had been used by foreign companies to control onshore businesses. In one case involving an online game company, the panel applied China's contract law to reach the same conclusion as the supreme court in the Chinachem case — saying that the variable-interest entities were "concealing illegal intentions with a lawful form."

"I think what you are looking at here is that China is attacking these V.I.E. structures and the other ways that people have used legal form to get around the substance of what Chinese law says you can't do," said Mr. Gillis, of Peking University, who also serves as a member of the standing advisory group of the Public Company Accounting Oversight Board in the United States.

"Of course," he said, "people have been doing that as long as there has been foreign investment in China."

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