What China’s overhaul of overseas IPO rules is all about

The turmoil that followed Didi Global’s $4.4 billion listing on the New York Stock Exchange last year was not only unprecedented, but may also prove to be the final straw for listings of Chinese mainland companies in U.S. equity markets.

Within days of its June 30 debut, the Chinese ride-hailing giant faced a devastating backlash from China‘s internet watchdogs. The company, which had pushed through its New York initial public offering in spite of misgivings and potential risks flagged by domestic regulators, was forced to undergo a cybersecurity review, remove its apps from domestic app stores and suspend new user registrations.

The fallout from the debacle led several other Chinese internet companies – including audio content platform Ximalaya and shared bike operator Hello – to shelve their U.S. IPO plans and await clarification about overseas listings, sources previously told Caixin.

The government had been flagging impending changes for months, not only to rules on overseas IPOs but also to the overall supervision of overseas-listed Chinese companies over their compliance with a raft of new domestic laws and regulations including the Data Security Law and the Personal Information Protection Law.

The latest regulatory deluge began on Dec. 24 with the China Securities Regulatory Commission (CSRC). The watchdog proposed an overhaul of the Special Provisions of the State Council Concerning the Overseas Securities Offering and Listing by Limited Stock Companies, the main policy document promulgated in 1994 that regulates overseas listings.

The draft document put forward a new framework to supervise overseas share sales by Chinese companies. Once finalized, the rules will, for the first time, establish a unified supervision system for all overseas listings, regardless of the location of the IPO and the ownership structure of the company, and provide a clear filing, vetting and approval process. The rules are open for public feedback until Jan. 23.

The CSRC’s announcement was followed three days later by the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM). They jointly issued the annual update of the national negative list for foreign investment which details all sectors that are off-limits to non-domestic equity shareholdings. This new version, which took effect on Jan. 1, 2022, not only scrapped restrictions on several sectors, including the foreign ownership cap on passenger vehicle joint ventures, but also, for the first time, contained specific provisions related to overseas share sales by domestic companies in sectors on the negative list.

Then on Jan. 4, the Cyberspace Administration of China (CAC), backed by 12 other government agencies, weighed in, unveiling final rules on cybersecurity reviews that companies holding personal information on 1 million users or more will need to undergo before they can proceed with a foreign listing. The rules will go into effect on Feb. 15. The review will involve identifying and assessing national security risks that may arise from data processing activities carried out by domestic companies, especially internet platform operators. The CAC will have the power to prevent a company from proceeding with a foreign listing if the review determines its activities do have an impact on national security.

In official documents and media interviews, officials have emphasized that the regulatory overhaul is aimed at providing a unified mechanism for mainland companies to raise capital overseas by setting out clear rules and compliance processes. They deny that it represents a tightening of rules and say the new framework still allows companies to choose where they want to list – either onshore or offshore – provided they meet the requirements set out in Chinese laws and regulations.

In terms of how these government entities will work together, the supervision of overseas share sales will be led by the CSRC, the NDRC said in a Q&A on the negative list.

“After a domestic company submits materials to the CSRC for an overseas listing, if the company is a business on the negative list, the CRSC will seek opinions from regulatory authorities governing the corresponding industry and move forward with relevant regulations,” the NDRC said.

Problems with existing rules

Pressure for a comprehensive overhaul of the country’s antiquated rules on overseas IPOs had been building for several years. In notes on the draft rules posted on its website, the CSRC acknowledged “deficiencies and shortcomings” in the current system, which it said had failed to keep up with the changes in the market. The new rules are aimed at “addressing the existing weaknesses of the system and meeting the demand of market development,” it said.

The need for change gained added urgency following a string of scandals including the accounting fraud at then-Nasdaq-listed Luckin Coffee, the deepening of a long-standing dispute with American regulators over access to the audit papers of U.S.-listed Chinese companies, the increasing use of the controversial variable interest entity (VIE) structure by tech companies to skirt restrictions on foreign investment in certain sectors, and the government’s growing concern that the troves of data controlled by many overseas listed tech companies could pose risks to national security.

The government also wanted to codify that companies planning overseas listings would have to comply with relevant laws and regulations covering the sector they belong to.

Currently, companies incorporated on the mainland and seeking to list in Hong Kong can follow what’s known as a direct listing via an “H-share model,” where approval from the CSRC is required, or what’s known as an indirect listing via a “small red chip” model.

Private mainland companies that list in foreign markets often use the “small red chip” model. The VIE structure used by Chinese companies such as Alibaba Group Holding, Sina and Didi when they sold shares in the U.S. falls under this model. It allows them to get around regulations that ban or restrict direct foreign investment in sectors highlighted in the negative list. Indirect listings do not require registration with or approval from the CSRC because technically they are not mainland companies, so the watchdog has no legal means to supervise them.

This lack of a legal foundation for supervising overseas listed companies has been one of the major pain points for Chinese regulators, especially when misconduct and violations of foreign market rules are involved, Fang Xinghai, a vice chairman of the CSRC, said in an interview with English-language state-run broadcaster CGTN.

For example, when Starbucks challenger Luckin Coffee was involved in an accounting fraud scandal in 2020 that eventually led to its delisting, problems arose for both U.S. and Chinese regulators.

“The SEC (U.S. Securities and Exchange Commission) had to come to us for cooperation in terms of investigation, because all Luckin’s operations are in the Chinese mainland,” Fang said. “But … we did not know that Luckin had gone to New York and had been listed there, because it never went through the CSRC. Technically, it was registered in the Cayman Islands and it was considered a foreign company and not under the jurisdiction of the Chinese securities regulators.”

The problem with the current system is that it doesn’t treat companies in the same way and it lacks clarity, lawyers Yu Zheng and Liu Yinhong at Jincheng Tongda & Neal wrote in a report published on Dec. 26. The rules for overseas listing procedures are different depending on a company’s ownership structure, are unclear on the definition of an “overseas listing” and do not provide a clear process for seeking regulatory approval for share sales, they wrote. The rules also lack a clear penalty system for violations.

As a result, companies and intermediaries basically stopped following the rules on registration or approvals, especially in the past five years, the lawyers said. This undermined the securities regulator’s authority in matters related to overseas listings.

The cases of Luckin and Didi “had a negative impact on Chinese companies’ image and financing in international markets, which is an embarrassment,” they added.

What the new regulations say

The CSRC’s proposed regulations now stipulate that regardless of where a company is registered – whether on the mainland or in any other jurisdiction – or what type of corporate structure it adopts, it must go through a filing process with the CSRC if more than 50% of its revenue, profit or assets came from the China market in the previous financial year; if its main management team mostly consists of Chinese nationals or executives who habitually reside in China, and its main business operating location is in China.

“By this definition, all ‘red chip’ China concept stocks will be fully regulated, including those listed in the U.S., Hong Kong and any other country or region,” analysts at Citic Securities wrote in a Dec. 26 report, referring to the collective term for all overseas-listed stocks of Chinese companies whose main operations are on the mainland.

The CSRC’s draft rules also set out what type of fundraising will be covered – including offerings of equity shares, depositary receipts, convertible bonds and other equity-like securities, as well as overseas listings of securities for trading.

This covers any activity involving overseas share issuance, including IPOs, dual primary listings, spinoff listings and companies going public through a backdoor listing or special purpose acquisition company (SPAC), analysts at China International Capital Corp. (CICC) wrote in a Dec. 24 report. The rules should also apply to asset purchases funded through share issues, share incentive plans and Hong Kong-listed mainland companies’ non-tradable shares that are made available for trading on the offshore market, the report said.

The rules also make it clear on what grounds a company can be stopped from proceeding with an overseas IPO, including violations of domestic law and endangering national security.

Foreign financial intermediaries such as investment banks that act as sponsors and underwriters of a mainland firm’s overseas listing will also be covered by the regulations. They will be required to file with the securities regulator and submit annual reports detailing overseas securities offerings and listings of mainland companies that they worked on in the past year.

In a Q&A on the draft rules, the CSRC said the commission will also strengthen cross-border cooperation with overseas regulators to crack down on illegal behavior and misconduct. This will include establishing a mechanism to allow the sharing of regulatory information, although the statement didn’t elaborate or say when it might be set up.

“This new regulation gives companies a formal process to follow and gives overseas regulators confidence in the Chinese companies that go to list in their markets. And if these companies have certain problems in terms of regulation, there will already be an understanding between the CSRC and the SEC prior to the listing, so regulation will be much easier,” Fang said in the CGTN interview.

VIEs: the elephant in the room

A key area of concern for companies, investors, intermediaries and the markets has been the impact of the new regulatory system on the VIE structure, which has also become the subject of heightened scrutiny from U.S. regulators in the wake of the Didi debacle.

In its Q&A on the draft rules, the CSRC said that companies using the VIE structure would still be eligible to list overseas after filing with the CSRC, provided they comply with relevant domestic laws and regulations, which it didn’t specify.

But the rules issued by the NDRC and MOFCOM in their national negative list raise questions about the viability of VIEs. For the first time, the list clarifies that domestic companies in restricted sectors can sell shares overseas if they win approval. Although the rules stop short of a ban on the practice, they forbid investors from participating in the company’s operations and management, and stipulate that they will be subject to the same requirements as those governing foreign investors buying shares in companies listed on the mainland’s stock market.

That means total foreign ownership in an overseas-listed Chinese company in a restricted sector, regardless of whether it uses the VIE structure, would be capped at 30%, with no single investor allowed to hold more than 10%. However, this will only apply to new listed companies, and foreign investors will not have to adjust their holdings in existing overseas-listed enterprises to meet the rules, the NDRC said in its Q&A.

“Companies previously used VIE structures to skirt restrictions on foreign investment, but now, businesses on the negative list are allowed to seek overseas listings, so technically, there is no need [for a VIE structure] anymore,” one market source told Caixin.

Yet, these rules only apply to companies at the listing stage. They provide no clarification on whether the VIE structure can be used by firms to obtain early-stage financing before going public.

Li Shoushuang, a senior partner at law firm Dentons China, questioned in an opinion piece published in Caixin how VIE-structured companies could possibly ensure they keep their foreign shareholdings under the required cap, given that when they do an IPO they often issue shares equivalent to about 25% of their enlarged share capital, which leaves little room for maneuver.

The VIE structure isn’t the only issue that needs to be clarified, analysts say.

In its report, CICC said it is not clear how exactly the new overseas listing rules will work with the CAC’s new cybersecurity review procedure, which requires companies to submit “IPO-related documents” for review. Some analysts have interpreted the CAC rules as potentially exempting some companies from the review process if they seek a listing in Hong Kong.

The procedures and guidance for the filing process have not been issued either, although the CSRC said in its Q&A these will be formulated and issued after the public consultation and legislative procedures are completed and the rules are implemented.

CICC questioned how the rules will be applied to what it described as “frequent overseas share sales” such as share incentive plans, a common strategy used by companies to incentivize their employees and generate loyalty, as well as conversions of American depositary shares.

Implications for Hong Kong

Hong Kong has traditionally played second fiddle to the U.S. as a destination for mainland companies who want to boost their profile in the global investment community as well as raise foreign currency. But analysts say the new rules could accelerate a shift that’s already underway toward listing closer to home.

According to estimates conducted by accounting firm Deloitte China in a review of Hong Kong and mainland IPOs in 2021, there were 42 listings by Chinese companies in the U.S. and $15.03 billion of funds raised for the full year. Although both the total number of IPOs and proceeds raised by Chinese companies in the U.S. have risen from 2020’s level, there were only four new listings in the last two quarters. Deloitte estimates that an acceleration in listings of China concept stocks will be a highlight of Hong Kong’s IPO market this year.

Of the five largest listings in Hong Kong up until mid-December, three were primary listings – Kuaishou Technology in February, JD Logistics in May and Xpeng, which undertook a dual-primary listing in the Asian financial hub in July, about one year after going public in New York. The other two – Baidu and Bilibili – both conducted secondary listings in March.

Deloitte’s review didn’t include Chinese artificial intelligence giant SenseTime Group, which raised HK$5.78 billion ($742 million) before its Hong Kong debut on Dec. 30.

“Hong Kong and the U.S. have long been top destinations for mainland new economy enterprises to list their shares,” Guotai Junan Securities analysts Liu Xinqi and Li Yixuan wrote in a Dec. 26 review of the CSRC’s draft rules. They pointed out that discussions between Chinese and U.S. stocks regulators to deepen cooperation on financial supervision are ongoing and until the outcome is known, the climate of uncertainty over U.S. IPOs for Chinese companies is likely to continue. But as Hong Kong’s cooperation with mainland regulators is more established, companies may find it easier to opt for a listing in the city, they wrote.

According to calculations by Citic Securities, 79 U.S.-listed Chinese companies are eligible for a secondary listing in Hong Kong. Among them, 53, with a total market capitalization of HK$2.4 trillion, use the VIE structure.

As for Didi, there’s a bumpy road ahead. The company announced on Dec. 3 it will delist from the NYSE and one source has told Caixin it is working on a plan to transfer trading of the shares to Hong Kong under the city’s listing-by-introduction regime, which involves no new fundraising or share issuance. But with compliance issues still to be resolved and a new listing regime to grapple with, that could be a lengthy and complicated process.


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