For two decades, IPOs by most Chinese companies on U.S. stock markets have existed in a regulatory no man's land. Technically, investment in the sectors most enticing to overseas investors — including internet, media, telecom, and education — was off-limits to foreign ownership. But beginning with the listing of Sina Corporation in 2000, Western lawyers and investment bankers were able to successfully skirt these rules using a variable interest entity, or VIE, structure. Foreign investors could not own the assets of or exert direct control over the Chinese operating company but theoretically had a claim on the profits and cash flows and the right to acquire ownership should Chinese law change to make that permissible in the future.
This rickety structure enabled China's private technology companies to tap massive amounts of foreign capital and dominate China's digital consumer economy. Alibaba, Tencent, JD.com, and many lesser-known companies used the VIE to go public much earlier and at much higher valuations than would have been possible on China's tightly managed domestic stock exchanges. The digital goliaths also became adept at investing in and then spinning out subsidiaries to extend the reach of their network and obtain fresh injections of capital. China's domestic securities regulator, the China Securities Regulatory Commission (CSRC), maintained a policy of benign neglect towards foreign IPOs, on the basis that offshore offerings were outside of its jurisdiction. Thus, while it was never clear that the VIE workaround was legal or enforceable under Chinese law, local law firms could affirm that it was not clear that it was explicitly illegal either.
This system was upended when Chinese authorities banned downloads of the app of China’s rideshare leader Didi Chuxing within days of its $4.4 billion IPO on June 30, 2021. The Cyberspace Administration of China (CAC) launched an investigation of potential violations of national security and data privacy rules, and Didi’s stock plummeted. Subsequently, Chinese authorities informed Didi that it could not continue to operate in China as a U.S.-listed company. In early December, the company announced that it would “immediately” start delisting from the New York Stock Exchange and prepare to list in Hong Kong.
U.S. IPOs by PRC-based companies ground to a halt after the Didi debacle. The SEC announced that it was pausing the review of all registration statements by companies relying on the VIE structure. And Chinese authorities indicated that stricter regulation of offshore listings would be coming. The era of benign neglect and the “disorderly expansion of capital” was over.
New Year, New Regime
Over the past month, Chinese regulators have announced a series of new rules for overseas listings that may finally provide some helpful clarity to the sizable roster of mainland PRC companies seeking to list overseas.
Starting February 15, the Cyberspace Administration of China (CAC) will require that all internet companies that maintain data on more than one million users apply for a security review before listing abroad. Foreign IPOs that CAC does not deem a risk to national security would be cleared to move forward, which should ameliorate investor concerns about a repeat of the shock delisting of Didi.
Under the new rules, CAC will respond within ten days if a cybersecurity review is warranted and then determine whether the IPO may proceed within 45 days in most cases. The wording of the new regulation suggests that Hong Kong IPOs may be exempt from cybersecurity review, which might provide the Hong Kong Stock Exchange an edge in attracting very large internet companies that maintain data the government deems sensitive.
On December 24 of 2021, the CSRC published draft regulations requiring all companies seeking to launch IPOs or selling additional shares abroad now need to register in advance. Offerings deemed to be a threat to national security will be prohibited. The rules came as a relief to some market participants, given that earlier press reports had suggested that China would ban the use of the VIE structure outright.
That said, the process will add considerable uncertainty to any overseas listing. Issuers will be required to submit their filing application and prospectus within three days of applying to list overseas, meaning that candidates undertake the considerable expense of preparing for an IPO before knowing if they will be approved. The draft rules state that securities companies that organize these overseas IPOs by domestic Chinese companies are also subject to supervision by the CSRC, a significant compliance burden for western investment banks.
Companies will be prohibited from listing overseas: 1) If the investment is prohibited by national laws and regulations, 2) If it could constitute a threat to national security, 3) If there are material disputes over the ownership of major assets or core technology, 4) If the company or controlling shareholders have committed or are under investigation for corruption, embezzlement, bribery, or other criminal offenses.
The regulations state that companies that list overseas must take steps to "fulfill confidentiality obligations, protecting state secrets from unwarranted disclosure and safeguarding national security and public interest from harms." Given that China takes an expansive view in defining state secrets and national security, it may be difficult for companies to comply with information requests from overseas regulators. All such requests for documents must be reviewed and approved by the CSRC before companies comply.
On December 27, 2021, China’s top economic regulators, the National Development and Reform Commission (NDRC) and Ministry of Commerce (MofCOM), updated existing regulations on foreign investment access. The new rules explicitly require companies operating in restricted industries to obtain government approval before listing overseas. Ownership by foreigners in such companies is limited to 30%, with no single foreign shareholder permitted to own more than 10% of the shares. And foreigners are not allowed to participate in the management of these companies.
Future of Cross-Border IPOs
Taken together, these new rules establish a comprehensive system of review and approval, where four central Chinese authorities effectively have veto power over any foreign IPO.
On the one hand, the framework may provide overseas investors and regulators greater confidence that the government will not capriciously cancel future offerings post facto. However, speed to market and certainty of execution has always been central to the attraction of a U.S. listing. America’s disclosure-based securities regime enabled high-growth private companies to raise capital when market conditions are optimal, rather than joining the queue of over 700 private companies aspiring to list on China’s domestic markets.
How will this new regime influence the decisions made by the management of China’s 300 unicorn companies and their private equity backers?
Competition for capital among China’s entrepreneurs is so fierce that any possibility of a fast-track to public status will always be attractive. U.S. markets continue to offer unmatched liquidity and flexibility in capital raising.
Market participants will be watching closely to see how efficiently Chinese regulators render decisions and what parameters they establish for companies greenlighted to list in the U.S. Balancing openness and transparency with regulators’ desire for increased control will be essential to attracting the influx of talent and risk capital that has fueled China’s innovation economy in the past two decades.
