Handling Investment Activities Based on Sham Transactions: Challenges and Implications

(First appeared in Vietnamese in The Saigon Times on 20 November 2020.)

According to Article 48.2 of the 2020 Investment Law, investment registration authorities can terminate or partially terminate investment project activities if “the investor carries out investment activities based on a sham civil transaction as stipulated by civil law.” This law is rather vague, making enforcement difficult.

There are two main factors for this law to be applied: the existence of a sham transaction and the investor carrying out investment activities based on that sham transaction. For example, a foreign company and a Vietnamese employee establish a company T in Vietnam. The foreign company holds 49% of the charter capital, while the Vietnamese employee holds 51%. Both parties agree that the Vietnamese employee’s 51% ownership is merely to enable company T to benefit from local investor conditions and procedures, while the foreign investor actually provides all the capital. To fund company T, the foreign investor signs a loan agreement with this company, which then buys shares in a listed company B on the Vietnamese stock exchange. So, can the agreement between the foreign investor and Vietnamese employee be considered a fraudulent transaction and based on that the foreign investor carries out investment activities in Vietnam?

Clear Authority but Difficult to Implement

The authority to terminate investment projects lies with the investment registration agency (Article 3.2). The problem is that to be able to penalize the project, this agency must first prove the existence of a sham civil transaction. However, the authority to declare a sham transaction invalid rests with the court (Article 132 of the Civil Code), and even judicial officials admit that “determining a sham contract is very difficult both theoretically and practically” (1).

The issue is whether officials from the investment registration agency are competent enough to assess and determine whether a civil transaction is sham. This raises concerns about the potential for abuse of power. If officials lack the necessary competence but still exercise their authority, it constitutes an abuse of power. This further raises issues of responsibility, not only for individuals but also for state agencies. The Prime Minister recently noted that international investment disputes are increasing, with each case “lasting about two years, costing millions of US dollars, not to mention the time and effort of state officials involved. Particularly, when we lose, the Government and state agencies must compensate large sums of money” (2). The Prime Minister also assessed that “the capability of state investment management officials at the local level does not meet practical requirements.” So, does the Government have enough confidence in delegating this authority to local levels?

The next clause of the Investment Law 2020 (Article 48.3) stipulates that for investment projects subject to investment policy approval, the investment registration agency shall terminate the project activities after obtaining the opinion of the investment policy approval authority.

The problem is identifying the projects that fall under the category of requiring investment policy approval. Is it an ongoing project based on a sham transaction, or a project that exists due to a sham transaction but does not fall under the investment policy approval category? The law’s drafters seem to intend that the former falls under the investment registration agency’s authority, making their power even greater. Another point is that this law not only grants power but also seems to mandate the termination of such projects by the investment registration agency, as indicated by the wording “the investment registration agency shall terminate or partially terminate…”. Thus, if the investment registration agency fails to terminate these types of investments within their jurisdiction when aware, they could be seen as neglecting their duties.

Scope

Termination can apply to the entire or part of the investment project activities. Here, the law’s drafters did not (or could not) provide criteria for when to terminate entirely and when to terminate partially. This can lead to both abuse of power and lack of detailed guidance for law enforcement.

Target

The target for termination is the investment project activities. In some cases, identifying the specific investment project to terminate is not easy. Returning to the example at the beginning, if the agreement between the foreign investor and the Vietnamese employee is considered to be hidden by one or more other transactions (such as a loan agreement), then which investment activity should be terminated? The “hidden” 51% investment of the foreign investor or the share purchase activity of company T in company B? Perhaps the target for termination should be the 51% hidden investment, as it is the core investment activity based on arrangements and secret agreements.

Sham transactions are often hard to detect. It is usually only when the nominal holder is no longer interested in the relationship with the hidden investor that the sham nature is exposed. Unfortunately, the new law lacks mechanisms to detect and reveal these types of investment activities.

Investor

An investor is defined as an organization or individual conducting business investment activities, including domestic investors, foreign investors, and foreign-invested economic organizations (Article 3.18). Briefly, a foreign-invested economic organization is one with foreign investors as members or shareholders (Article 3.22). Thus, this law (Article 48) is not only aimed at foreign investors but also at domestic investors and foreign-invested companies. Returning to the previous example, the investor whose investment activity is terminated would likely be the foreign investor, as they are the ones needing to conceal their 51% stake.

But between the foreign investor and the Vietnamese employee, who is the investor with the terminated investment activity? It could be the foreign investor, as they are the ones with the hidden 51% investment, concealed by the Vietnamese employee’s investment activities. Another aspect is that this law could apply to situations where certain individuals are not allowed to establish and manage businesses in Vietnam (e.g., officials, civil servants, public employees according to the Law on Officials and Public Employees). Thus, this law could be used to combat the situation of officials establishing and running “backyard” businesses.

Behavior

The behavior targeted by this law is the act of conducting investment activities. The phrase “investment activities” is not defined, but the Investment Law has a separate chapter (Chapter IV), which lists the types of investments as follows: (i) establishing economic organizations, (ii) contributing capital, buying shares, or purchasing capital contributions; (iii) executing investment projects, (iv) investing under PPP contracts; (v) other forms of investment and new types of economic organizations as stipulated by the Government.

Thus, “conducting investment activities” can be understood as an investor engaging in any of these investment activities. Textually, there is an inconsistency between the act (conducting investment activities) and the object of termination (investment project activities). However, reading this together with the definition of “investment project” in Article 3.4, it can be understood that the behavior to be terminated is the investor’s investment activity.

The law does not specify whether it applies to investment activities that have been or are being conducted. For example, in the scenario where the authority discovers the foreign investor’s actions after they have already legalized their 51% hidden investment, can this law be applied retroactively to terminate the hidden investment activity? The answer is likely no, as the authority would then be unable to “terminate” an already legalized investment activity. From a legislative perspective, this is a significant loophole that could render the law ineffective in practice.

Fiction

As mentioned earlier, the authority must prove the existence of a sham transaction. A sham civil transaction is defined in Article 124 of the 2015 Civil Code as follows: “When the parties establish a civil transaction in a sham manner to conceal another civil transaction, the sham transaction is void, while the concealed transaction remains valid, unless it is also invalid under the provisions of this Code or other relevant laws.” Thus, there must be at least two transactions, one established to conceal one or more other transactions. Any of these transactions may not necessarily involve the hidden or nominal investor; for instance, the loan agreement between the foreign investor and company T does not necessarily involve the Vietnamese employee.

Purpose

Why would an investor conduct investment activities based on transactions established to conceal other transactions? According to the author’s limited understanding, there are a few reasons. First, the investor may not have the right to establish and manage businesses, necessitating sham transactions. Second, the foreign investor may want to benefit from market access conditions and investment procedures applicable to domestic investors. Third, the foreign investor may want to indirectly own real estate in Vietnam as a Vietnamese person. Fourth, the investor may wish to conceal their identity and nationality, even though they could openly conduct related investment activities. From these reasons, it is clear that hidden investments primarily (i) aim to evade legal regulations and (ii) are carried out through investment activities such as establishing economic organizations and purchasing shares or capital contributions in Vietnamese companies. This helps assess how the new law addresses such investment activities.

Penalty

This law stipulates that investors must liquidate investment projects according to regulations on asset liquidation when investment projects are terminated (3). This means the State recognizes the investor’s legal ownership of these assets, even if they were used to carry out or formed from investment projects based on sham transactions to evade the law. Thus, from the investor’s perspective, the legal risk of engaging in such investment activities is acceptable because, even in the worst-case scenario, they can still recover their investment capital and benefit from illegal investment activities. The assets they receive can then be reinvested in other investment activities based on sham transactions. This implies that the law lacks deterrence. These investment projects are also handled uniformly, meaning any investment activity based on a sham transaction can be terminated, regardless of the investor’s purpose. Ideally, projects with different purposes should be handled differently. For instance, investment activities conducted to benefit from domestic investor conditions and procedures should be addressed differently due to the varying nature and severity of their impact on the economy.

By Ngu Truong

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(1) Dr. Dang Thi Thom, “Purchasing Assets to Conceal Loan Transactions,” People’s Court Journal (May 2, 2018), at https://tapchitoaan.vn/bai-viet/phap-luat/giao-dich-mua-ban-tai-san-nham-che-giau-giao-dich-vay-tai-san (last accessed July 23, 2019).

(2) Directive 27/CT-TTg dated July 10, 2020, of the Prime Minister on strengthening state management of investment and preventing the emergence of international investment disputes.

(3) The handling of land use rights and assets attached to land when terminating investment project activities shall comply with land law and other relevant laws (Article 48.5). However, according to the author, land law and other relevant laws currently lack effective provisions to address this issue.