China Spells Out Rules for Overseas IPOs of Domestic Companies, VIEs

China has released new rules for domestic companies listing IPOs overseas, including companies that use variable interest entity or VIE structures. This puts an end to months of speculation over Beijing’s stance on these issues. China’s top securities regulator has also previously denied that the country will end the VIE structure, in a sign that it is avoiding financial decoupling with the US. Nevertheless, Chinese companies going the overseas IPO route should expect greater scrutiny. The introduction of fleshed-out rules underlines Beijing’s growing concerns over its national security amid a volatile external political environment.

On December 24, 2021, China Securities Regulatory Commission (CSRC), the country’s top securities regulator, released two draft rules for domestic companies eyeing overseas listings, open for public consultation until January 23, 2022:

• The Provisions of the State Council on the Administration of Overseas Securities Offering and Listing by Domestic Companies (Exposure Draft) (hereafter “Provisions”); and
• The Administrative Measures for the Filing of Overseas Securities Offering and Listing by Domestic Companies (Exposure Draft) (hereafter “Administrative Measures”).

Shortly after that, on December 27, 2021, the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM) rolled out the updated Special Administrative Measures for Foreign Investment Access (2021 Edition) (hereafter the “FI Negative Lists”), which added a provision regarding overseas listings of Chinese companies engaged in businesses restricted from receiving foreign investment.

Why the regulatory update matters to foreign investors

Ever since the Chinese government’s regulatory blow to the US IPO of Didi Chuxing, a ride-hailing giant, in late June this year, there has been much speculation about Beijing’s attitude towards its firms’ offshore listings.

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In early December, a Bloomberg scoop reported that China was going to ban tech firms from using the variable interest entity (VIE) to go public on foreign stock markets – VIE structures are often adopted by foreign investors to engage in sectors that are restricted or prohibited to foreign investment in China, such as education, media, and internet industries.

Now, the rules and remarks of the CSRC suggest that Beijing will not close the VIE loophole, in a sign that China doesn’t want to close channels for foreign investment into China and is trying to avoid financial decoupling from the US.

However, the CSRC’s rules has imposed new filing requirements for Chinese companies seeking to sell share directly or indirectly overseas, which reflects China’s growing concerns over its national security, especially in areas covering foreign investment, cybersecurity, and data security.

We discuss key aspects of the new rules and analyze their impact on overseas listing of Chinese domestic firms.

China’s position on overseas IPO listing by domestic companies

The CSRC’s rules are aimed at reforming China’s lax regulatory system for overseas listings of domestic companies. The move was likely prompted by the abrupt US IPO of Didi, which raised Beijing’s concerns over data security, and the earlier offshore fraud scandal of Luckin Coffee.

According to the Provisions, the securities watchdog plans to establish a filing-based regulatory system to cover both direct and indirect overseas listings of Chinese companies. That means all Chinese companies pursuing overseas IPOs, directly or indirectly, will be required to file with the CSRC.

Certain companies will also need to undergo relevant security reviews before filing with the CSRC – to comply with legal provisions regulating foreign investment, cybersecurity, and data security.

Under what circumstances will domestic enterprises be prohibited from listing abroad?

Domestic enterprises are clearly prohibited from listing overseas under any of the five circumstances: (1) it violates national laws and regulations; (2) it may constitute a threat or endanger national security; (3) there are major ownership disputes over equity, assets, and core technology; (4) in the last three years, the domestic company or its major shareholders have been investigated or convicted for corruption, bribery, embezzlement, and misappropriation of property; and (5) in the last three years, the domestic company’s senior management has been subject to administrative punishments or are under judicial investigation for major violations.

Under the above situations, the CSRC and relevant government departments under the State Council can ask the companies to postpone or terminate their foreign IPOs.

The CSRC will also work out a mechanism to coordinate with other regulatory bodies, boost cross-departmental flow of filing information, and improve the cross-border cooperation in securities regulation.

What’s more, the rules have stipulated the legal liability of enterprises for failure in performing filing procedures or falsification of filing materials.

China clarifies its stance on IPOs by variable interest entities

The CSRC’s draft rules and public remarks have eased concerns that China would ban the variable interest entity / VIE outright.

Previously, on December 24, in a published set of remarks by a spokesman for the CSRC, it was stated: “Under the premise of complying with Chinese laws and regulations, companies with VIE structures can go public overseas after filing with regulators.”

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This brought immediate relief to some foreign investors, as well as the companies currently listed in the US or Hong Kong using VIE structures as they faced the possibility of needing to adjust their ownership structures. Since the rules follow the principle of non-retroactivity, companies already listed overseas may not need to make any changes.

Nevertheless, it must be noted that based on the definition of “indirect overseas offerings and listings” in the draft provisions – indirect overseas listings, including through the VIE structure and the so-called “red chip” structure, will soon be subject to new rules. A red-chip structure generally involves a string of offshore holding vehicles holding full ownership of an onshore Chinese companies.

Another concern relates to China’s broader cybersecurity focus; back when Bloomberg reported that Didi was facing pressure from the Cyberspace Affairs of China (CAC) to delist from the New York Stock Exchange (NYSE), business analysts worried whether the CAC, as a government body focused on cybersecurity and data security, was well-equipped to consider the broader economic impact of its decisions.

Now, by introducing a filing-based regulatory system, domestic companies and securities institutions will be brought under the unified supervision of the CSRC. This should streamline regulatory scrutiny and enable the government to better measure the political and economic fallout of its decisions via a cross-departmental coordination mechanism.

Newly added provision regarding overseas listings in China’s FI negative lists

What does the provision say?

The latest 2021 edition of the FI negative lists, which enumerates the industries where foreign investment is prohibited or restricted, has added a provision regarding offshore listings of Chinese companies.

Chinese companies in sectors that are off limits to foreign investment must now get clearance from regulators before selling shares overseas.

Foreign investors are not permitted to participate in the operation and management of these companies, and their shareholding ratio must be governed in accordance with the relevant regulations on the management of foreign investment in domestic securities. Existing regulations require that total foreign ownership in such a company is capped at 30 percent, with no single investor holding more than 10 percent.

Why is it important?

The new FI Negative Lists allow companies in restricted sectors to receive foreign investment to go public overseas – after they get permission from relevant regulators. Moreover, foreign investors will be able to buy these companies’ foreign-traded shares. Some analysts think this arrangement will slash the advantages of VIE companies. Traditionally, companies listing overseas via VIE structures have been able to circumvent the bulk of the regulatory review processes, a fact that authorities likely do not appreciate.

What’s next for VIEs?

The rules issued by China’s authorities will improve regulatory certainty, which is a positive sign.

However, looking forward, the future of VIEs may still be highly uncertain.

The Chinese government’s attitude towards VIE structures has been ambiguous. There is no clarification in the Foreign Investment Law (FIL) whether it is legitimate and whether it falls within the scope of “foreign investment”. In a legislative draft released in 2020 regarding pre-school education, VIE structure is explicitly prohibited in the sector. Some cases show that the State Administration of Market Regulation (SAMR) is strengthening the anti-monopoly review for M&As with a VIE structure. In addition, the amended Anti-Monopoly law for the first time covered the VIE structure.

While not banned outright, VIE structures could face tougher scrutiny under the new rules, which will make the compliance process more difficult and expensive. Companies looking to secure overseas IPOs through VIEs structures are advised to weigh the compliance risks carefully, in addition to the breach risks of contractual arrangements.

Besides, it can be predicted that Hong Kong IPOs are likely to be more favored by domestic firms as those seeking US IPOs may find themselves in a quandary – more filing requirements and security review processes at home and risks of being delisted by US regulators.

Internet and information services companies planning to list abroad must especially be more cautious when choosing their listing destinations. Although mainland companies seeking to list in Hong Kong will be subject to a cybersecurity check if “national security” issues are flagged, listing in Hong Kong is still subject to less scrutiny than listing abroad.

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