For years, Beijing has quietly chafed as its most valuable companies sought to list in New York over domestic markets like Hong Kong and Shanghai. Now, after rug-pulling Didi's listing while delivering the dreaded shoulder-tap to ByteDance - the TikTok owner has reportedly already scrapped its plans to list in New York in favor of Hong Kong - China's Securities Regulatory Commission is reportedly changing rules that have allowed foreign IPOs.
According to Bloomberg, the CSRC is planning to reverse rules governing overseas listings that have been in place since 1994 (long before China finally joined the WTO).
Specifically, the new rules would explicitly require Chinese firms using the Variable Interest Entity model - or VIE - to seek and receive approval from Chinese regulators before they can go public in Hong Kong and the US.
American analysts and investors have long been wary of the VIE structure, which received a lot of skeptical press coverage in the US back in 2014 ahead of Alibaba's historic public offering.
As Globescan explains, almost every listed Chinese company trading outside of China is listed through a VIE structure. The structure ensures that investors - many of whom don't realize what's going on - don’t actually own any part of the underlying Chinese company.
You will find more infographics at Statista
While that might sound ridiculous, sadly its true. Investors who buy shares in Chinese stocks such as JD.com, Alibaba, Tencent, etc., do not technically have any ownership of the underlying business whatsoever.
For years we've been talking about VIE and its unsustainability and yet we see hundreds of thousands of Chinese companies listed in the US with the structure. Is it end time now? https://t.co/qY0fZrfp8p— Ningning Xie (@NingningXie1) July 7, 2021
The reason is that under Chinese law, foreign ownership in certain (most) Chinese industries is prohibited. As a result, it is illegal for Chinese companies like JD.com and Alibaba to have any non-Chinese shareholders. Back in the early 2000s, as the China growth engine was really beginning, Chinese companies growing quickly looked longingly at the huge amounts of capital available in the US and wanted to access it. At the same time, US investors and Wall Street firms looked longingly at the huge growth rates in China and wanted to access that. But Chinese law prevented them both from doing so.
So, a structure was developed to circumvent Chinese law: the VIE (Variable Interest Entity). This is a structure that has been around for decades, first popularized here in the US by Enron to obfuscate assets and liabilities on its balance sheet (there is the first alarm bell…).
The VIE structure achieves the dual purpose of giving Chinese companies access to Western capital, whilst simultaneously allowing Western investors access to Chinese stocks. It does so by effectively saying two different things to each side: the VIE says to the Chinese regulator that the company in question is wholly owned by Chinese nationals, while the same VIE simultaneously tells the Western shareholders that they legitimately own that Chinese company.
To explain exactly how the VIE structure works, Globescan offered Tencent as an example:
We will use Tencent as an example to explain the basic structure of a VIE. Tencent operates in a sector on the ‘restricted list’ issued by the government. This list outlines which sectors are prohibited from having any foreign ownership. It is a very broad list, with general wording such that in reality the majority of Chinese companies are barred from any outside ownership.
So as a result, Tencent cannot sell its shares to any non-Chinese investors. But it can circumvent this law using that VIE structure. Without getting into complex legalities, the VIE works as follows; Tencent creates a Cayman Islands listed shell company (no real business, no office, no employees), which it also calls Tencent. (For simplicity from here onwards we will refer to the actual Tencent as ‘Real Tencent’, and the Caymans shell company as ‘Fake Tencent’) Once Fake Tencent has been setup, Real Tencent then creates a complex web of legal agreements that serve to give Fake Tencent a claim on the profits and control of the assets that belong to Real Tencent.
(Note that there is no recognition of any actual ownership, just a claim on the profits and indication of an element of control)
Fake Tencent now owns as its only asset these contracts and agreements. Fake Tencent then lists itself as a company on the NYSE, selling shares to investors under the name ‘Tencent’. Wall Street banks take in millions of dollars in fees to list Fake Tencent, and hundreds of investment firms and investors invest billions of dollars into buying shares of Fake Tencent. Bear in mind, the whole time the Western investors are buying stock in a company called ‘Tencent’ that appears to simply be the Chinese company. Fake Tencent appears to have control over the assets and a right to the profits of the real Tencent in China, even though in reality it is just a shell company with no real assets or business.
Since Chinese first discovered the loophole, it has been technically illegal in China. But a loophole embraced by regulators allowed firms to continue to list in the US using the structure. Now, Beijing is looking to close that loophole after Chinese firms raised $76 billion via new offerings in the US over the last decade.
Already, anti-monopoly regulations released in November following the abrupt suspension of Ant's offering adopted language to give it approval power over mergers and acquisitions conducted by VIEs. The condition has since been used to fine tech companies for past deals and hangs over future transactions.
Now, BBG's sources say regulators are quietly warning firms and their advisers that they should abandon any plans to pursue new foreign deals using the structure.
The CSRC didn’t immediately respond to a fax seeking comment. Foreign Ministry Spokesman Wang Wenbin directed questions on VIE firms to the relevant authorities during a press briefing in Beijing. Bloomberg News reported on the potential rule tightening in May.
Pioneered by Sina Corp. and its investment bankers during a 2000 initial public offering, the VIE framework has never been formally endorsed by Beijing. It has nevertheless enabled Chinese companies to sidestep restrictions on foreign investment in sensitive sectors including the Internet industry.
The structure allows a Chinese firm to transfer profits to an offshore entity -- registered in places like the Cayman Islands or the British Virgin Islands -- with shares that foreign investors can then own.
Aside from ByteDance, which has already reportedly decided to move its offering to Hong Kong, HK-based logistics and delivery firm Lalamove, known as Huolala in China, has already reportedly filed (confidentially, of course) for a US IPO.
As we pointed out yesterday, Beijing needs domestic companies to list in Hong Kong and Beijing because if they don't, who will?