Is China pushing VCs out of third-party payment?Jack Ma is every bite the internet pioneer. In Alibaba.com, he created Chinas leading business-to-business trading platform; Taobao swept aside eBay to become the number-one auction website; and the launch of Alipay, a third-party payment service, plugged a hole in the e-commerce market.Last year, Ma added a less savory line to his resume: he became the first Chinese CEO to break a variable interest entity (VIE) contract, the structure through which foreigners invest in certain kinds of Chinese companies.Mas actions, which only became public in June, were intended to offset regulatory concerns about foreign involvement in Chinas third-party payment industry. He did this by transferring ownership of Alipay from Alibaba Group to a domestic firm of which he is the majority shareholder, thereby removing the subsidiarys exposure to the VIE that secures Yahoo and Softbanks financial interest in the parent company. The foreign firms opposed the move at board level, saying it rode roughshod over their investment agreements.This apparent violation of shareholder rights and fiduciary responsibility sets a worrying precedent for venture capital firms that have backed third-party payment providers and also for those that invest through VIEs in general.“GPs tell LPs that there is a potential total loss scenario, which creates a wave of panic,” says Rocky Lee, managing partner for Asia at Cadwalader. “This is what gets me on the phone at 2 a.m. talking to LPs and funds in California. These guys may have 50 other portfolio companies with VIEs.”Market leaderAlipay is without question the dominant force in Chinas third-party payment market, having been introduced in 2005 to support Taobao users. It accounted for just over 50% of the $156 billion in transactions processed by all service providers last year, according to iResearch. Tenpay, owned by internet platform Tencent, is second on 20%, while no other competitor has a double-digit market share. By 2014, the market is expected to be worth $636 billion.This rapid growth in transactions, which is taking place outside the formal banking sector, caught the attention of the Peoples Bank of China (PBoC). Last year it announced that all participants would have to apply for licenses, and that those with foreign investors would be subject to separate review. The first round of licenses was issued in May, with 27 companies making the shortlist, including some that have in the past received foreign capital. Up to 30 more approvals are expected before the implementation deadline on September 1.The PBoC has also indicated that foreign control over these companies will not be tolerated, either directly or indirectly through VIEs. “I believe the reason they are focusing on third-party payment is because it relates to the banking system,” says David Wang, a partner at Paul Hastings in Shanghai. “They are not ready for foreign investors to be controlling that aspect of the financial services sector in China.”The approach is not altogether surprising. Given that PayPal falls under the remit of Americas banking regulators, it is understandable that China might want to extend its cap on foreign ownership of financial institutions to third-party payment providers.According to people familiar with the situation, companies are broadly following one of three strategies: working with their foreign investors to find an alternative solution to the VIE; terminating the VIE contract and offering to compensate their backers at a later date; or telling investors that the contract is null and void and therefore no money is owed.Apparently negotiations between Alibaba, Yahoo and Softbank are ongoing. It has separately been reported that Lakala has bought back shares owned by Morningside Ventures and other overseas investors. And sources tell AVCJ that local renminbi funds are buying into companies, trying to cherry pick those that are likely to receive licenses.DFJ DragonFund China has invested over $5 million in YeePay, which claims to be the largest independent third-party payment provider, since 2004, accounting for roughly one-fifth of total funds raised by the company. Tony Luh, managing director at DFJ, says the situation has been discussed but there are as yet no plans to sever ties. “The whole thing started with the Alibaba situation and their structure is a lot more complicated than ours and they have well known stakeholders in Yahoo and Softbank,” Luh tells AVCJ. “To us, it is business as usual its like you hear an air raid siren on once in a while and then everyone senses things are normal.”The bigger pictureSuch issues are likely to be resolved in due course, but it remains unclear what scars they will leave on the VIE structure in general. Wang of Paul Hastings insists that the restrictions are specific to third-party payment, but Lee of Cadwalader is more circumspect. He notes that permission to cr