China is toughening its rules for companies that seek to list overseas, with new regulations requiring all entities to file for approval with the stock watchdog. A separate set of instructions stipulates that companies in restricted industries must seek special permission to go public abroad.
The net effect is to close the loophole that Chinese tech companies in particular have exploited so they can sell shares outside China's walled-off stock markets. While these changes remove the loophole, they also clarify that it is not totally illegal for companies in the tech sector or sensitive industries to go public abroad.
China therefore paints the changes as an opening up and liberalization of its securities regulations. But it makes it harder for Chinese companies to sell shares internationally at a time they also face regulatory pressure from U.S. authorities. The U.S. Securities and Exchange Commission is imposing new rules requiring overseas listings to file accounts that the SEC's accounting arm can inspect, or be kicked off U.S. exchanges after three years. Chinese accounting firms, even the local arms of the Big Four, are blocked by law from doing just that.
What are the rules in China?
China has just published on Monday a new version of its "Negative List," which will go into effect on January 1. The list itemizes which industries are off-limits or require special permissions for investment.
The regulator that compiles that list, the National Development and Reform Commission, has also issued new guidance to "improve the accuracy" of how the list applies to overseas investors. What's new is that foreign investors are not allowed to participate in the management of Negative List companies, and they can own at most 30% of such companies, with no single investor owning more than a 10% stake.
Optimists note that this makes it clear foreign investors can own stakes in sensitive sectors, legally. But the extent of that ownership is now clearly described.
Separately, China's stock regulator, the China Securities Regulatory Commission (CSRC), on Friday proposed new rules for the overseas issuance of securities by domestic companies. Noting that many of the rules for overseas listings were set back in 1994, the commission said it will now impose "unified filing management" standards on all Chinese companies and subsidiaries selling shares abroad, including indirect listings.
To date, Chinese companies in the tech sector and other areas where overseas investment is not allowed have gone public using that favorite legal sleight of hand, the "gray area." Using a structure known as a Variable Interest Entity, or VIE, they have created a separate paper shell company, normally based in the British Virgin Islands or the Cayman Islands. This entity sells shares on a foreign market such as Nasdaq or the New York Stock Exchange. In turn it signs a legal agreement giving it the "economic proceeds" of the Chinese parent company. Hey presto, the foreign investors aren't owning a Chinese company at all!
Chinese securities regulators tolerated these legal shenanigans while the country was opening up and desperate for foreign capital. But no more. Quite honestly, I don't blame them, since the BVI or Caymans structure was an obvious dodge to skirt securities regulations.
China has stopped short of banning VIEs altogether, something investors feared. The CSRC explicitly states that VIEs will be allowed if companies meet compliance requirements. But any company planning such a structure must get it approved first. I doubt that filing process will be easy. The Chinese authorities have a history of technically allowing things while never approving them in practice.
The new rules also state that the Chinese government can order a company to dispose of its assets or businesses, if the offshore listing threatens what it deems national security.
On the plus side, it's possible at least theoretically that companies in any industry, including those on the restricted list, could sell shares directly overseas. This would be better for, say, U.S. investors buying up to 30% in a Chinese dot.com, who could own shares in the company itself rather than a VIE structure that could fall apart if the Chinese company runs into financial trouble. Lawyers say it is not clear whether VIE holders could enforce an ownership claim over a Chinese company in which they technically have no ownership, just a contractual business arrangement.
The new rules should prevent a repeat of the fiasco surrounding the listing of DiDi Global (DIDI) . The market leader in ride hailing in China went public on June 30 to much fanfare. Days later, its shares tanked when the Chinese authorities barred it from soliciting new customers and stripped its apps from app stores. DiDi said at the start of December that it will delist in New York and sell shares in Hong Kong instead, as I explained on December 3. DiDi shares fell another 5.4% on Monday, taking their loss to 62.5% since the listing, after the Financial Times reported that the company is blocking existing and former employees from selling shares before they delist.
Even more importantly, the CSRC said the new rules would not be retroactive, meaning they do not apply to many of China's largest tech companies, including the two largest, Alibaba Group Holding (9988.HK) and (BABA) and Tencent Holdings (HK:0700) and (TCTZF) . Tencent shares have fallen 3.9% since the start of trade Friday in Hong Kong, where trading resumed Tuesday, while Alibaba shares are essentially flat, down 0.3%. Like most Chinese tech companies, their U.S. shares take the form of VIEs.
On the Negative List, China has gradually opened up access for companies in industries such as finance and automobile production, making it no longer essential for foreign companies to form a joint venture with a Chinese company. Foreign companies in those industries can now own their Chinese subsidiaries outright if they are approved for the licensing. In the new list, overseas car companies are now also allowed to operate two or more subsidiaries making different cars in China.
China attracted US$149.3 billion in overseas direct investment in 2020, according to official figures. That ranks it behind only the United States.
In explaining the new provisions, a spokesperson noted that, while China has successfully cut the number of Negative List industries from around 100 to just 31, "unilateralism and protectionism are on the rise, and economic globalization is encountering a countercurrent."