WHY WON’T YOU BE WATCHING NETFLIX IN CHINA ANYTIME SOON?

CHRIS PENG

September 2nd, 2020 

Recently, there has been immense discussion surrounding the treatment of the social media platform TikTok within the United States. One of the most recent developments in this rapidly evolving issue has seen President Donald Trump give the Beijing headquartered parent company ByteDance Inc until September 15[1] to either sell the app or to risk it being banned by the Committee on Foreign Investment in the U.S.[2] 

Although TikTok’s treatment is currently a highly prominent and topical development, it should come as little surprise. In an increasingly frosty investment war with China, the U.S has consistently intervened to quash prospective purchases, or to force divestments, of Chinese tech companies in the U.S. For example, due to US national security concerns, Beijing Kunlun was forced to sell the popular gay dating app, Grindr,[3] and, most recently, the Chinese acquisition of a hotel booking app was blocked by executive order.[4]

The answer to my titular question seems simple, then. The trade war is the reason I can’t re-watch episodes of Community when I’m visiting my relatives in Guangzhou. But that wouldn’t be strictly true. 

Despite the trade tensions and an increasingly hostile environment for Chinese investors in the U.S, American firms have continued to pile money into China, with China’s Ministry of Commerce (MOFCOM) reporting a 6% increase in the amount of Foreign Direct Investment (FDI) from U.S firms.[5]

With 904 million internet users and an ever-growing demand for digital content, China’s digital media industry is definitely a worthy investment for growth.[6] As of today, China’s two largest streaming services, iQiyi and Tencent Video, both boast around 100 million subscribers, trailing only Netflix in subscriber count. However, penetration of foreign streaming services into China remain negligible.  

The barrier to entry for U.S streaming services has existed long before Trump came to office, and to understand why it’s so hard to break into the Chinese market, we must first look at the Chinese FDI regime as a whole. We’ll use the hypothetical scenario of a US streaming powerhouse like Netflix entering the Chinese market as a nice lens to review China’s attitude to foreign investment.

For the purposes of this article, we will assume that industry players like Netflix will generally seek to invest in the Peoples Republic of China (PRC) through an equity investment vehicle, as opposed to simply licensing assets (such as their shows) to Chinese streaming incumbents.

 

An Overview of Foreign Direct Investment into China

The chief concern when any foreign entity is looking to investing in China is whether the industry they want to invest in is a prohibited industry or not. This is determined through the ‘negative list’ published by MOFCOM. In the most recent Negative Lists, which were published in June, the number of prohibited industries was reduced to 33 industries.[7] But unfortunately for companies like Netflix, TV Production and Web-series remain prohibited.

An interesting caveat to this is that there is a separate Negative List for Free Trade Zones (FTZ) with slightly less restrictions. A summary of differences can be seen below from the English translations of both Negative Lists:

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Through the Negative Lists, the PRC government has undertaken to limit FDI in these ‘sensitive areas’. On its face, then, it should be impossible for foreign companies to invest in streaming in China.

But that isn’t the end of the story. In the late 1990s, a group of clever financial advisors devised a way for Chinese companies to circumvent laws prohibiting or restricting foreign investment in specific sectors[8]. This was termed the Variable Interest Entity (VIE) structure.

 

What is VIE?

As mentioned above, VIE is a way to circumvent the Negative Lists. Since the Negative Lists prohibit equity investment into prohibited industries, the VIE structure utilizes contractual arrangements between the parties through interposed corporate entities as a proxy for actual share ownership.

Although the practicalities around establishing and implementing a VIE structure are incredibly complex, I’ll try my best to summaries.

To effect foreign control and investment, the VIE structure involves setting up a wholly owned offshore holding company, usually in an advantageous tax jurisdiction. This is owned by foreign owner / investors like Netflix, in partnership with the Chinese partners of the VIE.

The offshore holding company then establishes a wholly foreign owned entity (WFOE) in the PRC to operate the parts of the business which are not prohibited. The areas of the business which are prohibited are held in an Operating Company (OPCO) which are 100% owned by PRC residents. This is also the eponymous variable interest entity. 

All licenses, government approvals and operating rights required to conduct the prohibited business will be held in the OPCO. Contracts are subsequently signed with the OPCO to transfer rights to vote, rights to dividends and right to make decisions from the OPCO to the WFOE. To transfer the revenue from the OPCO to the WFOE, contracts are signed which stipulate that the WFOE will provide management or consulting services to the VIE in exchange for a fee, often equal to the net income of the company. In effect, the outcome of these arrangements is to imitate a shareholding relationship.

 

The problem with VIE’s

VIE’s are essentially a grey area of law. Although a large number of high-profile PRC corporations have utilized VIE structures to gain access to foreign capital, VIEs are a risky investment vehicle for foreign investors.

Firstly, VIE structures do not provide control that is as effective and certain as direct ownership, and the strength of the arrangement lies solely in the contractual relationships. Where the PRC partners breach their contractual obligations there is little foreign investors can do to gain recourse.

This is especially the case given that VIE contracts have limited enforceability. Enforceability of VIE contracts in a dispute heard in PRC Courts is uncertain, as Chinese case law regarding VIEs is an undeveloped area. Moreover, there is no specific law that explicitly validates VIEs’ contracts in China. 

Finally, there is a real risk that VIE structures may be deemed illegal. Under PRC Contract Law (Art 52(3)), and PRC General Principles of the Civil Law (Art 58(7)), contracts which ‘conceal an illegitimate purpose under the guise of legitimate acts’ shall be void. Since VIEs are a contractual vehicle to circumvent FDI Law, if there is political motivation to stop such arrangements, the PRC Standing Committee may issue an interpretation that rule all VIEs’ as void.

This risk is further compounded by uncertainty surrounding the PRC government’s attitude towards VIEs. The 2015 Draft Foreign Investment Law (FIL) attempted to prohibit the use of VIEs by proposing a new concept of ‘control’, and contemplated that a PRC domestic enterprise ‘controlled’ by foreign investors via a VIE would be deemed to constitute foreign entity, making it prohibited under the Negative List. However, such content was not included in the final version of FIL, and the 2019 FIL is silent on this issue.

 

Regulatory Considerations for operating a streaming service in the PRC

Even assuming that Netflix was comfortable with the legal and regulatory risk that is inherent in a VIE approach and that they had established a content streaming service in the PRC, media and communications in China are among the most heavily regulated in the world. 

In terms of content that is allowed to be broadcast in the PRC, the National Radio and Television Administration (NRTA) strictly regulates shows that can be aired. In general, illegal or immoral content, such as that which threatens national honor and sensibilities, is prohibited.

From a Western perspective, the content allowed and disallowed may seem bizarre and potentially arbitrary. For example, Game of Thrones was banned until all nudity and ‘dead creatures’ were removed. Popular children’s show Peppa Pig was banned outright ‘for promoting a slacker lifestyle’. Even Chinese hit dramas like ‘Story of Yanxi Palace’ have been axed for ‘pursuing the glamorous lifestyles of China’s past monarchs and promoting pleasure and luxury’ above the ‘virtues of frugality and hard work’.[9]

Ultimately, the PRC regulatory environment for foreign investment and participation in streaming is so severe that it’s hard to foresee a future where Netflix is available in China.