China’s filing-based system ushers in VIE 2.0 but regulatory openness to be tested

News Analysis 16 March

China’s filing-based system ushers in VIE 2.0 but regulatory openness to be tested

  • China’s new listing rules create a level-playing field for all companies regardless of capital structure, listing venue
  • MOFCOM/NDRC’s list provides sectoral guidelines for ADR IPOs though flexibility expected
  • US-China relations the ultimate rule setter

Effective 31 March, China's filing-based listing system [备案制 bei4 an4 zhi4] will lay a much-needed legal groundwork for the existence of many of its companies that adopt a variable interest entity (VIE) structure, a grey-area system that was coined to make Sina Corporation's Nasdaq listing - the maiden issuance American Depositary Receipts by a Chinese company - back in 2000 possible.  

Fast forward to 2021, geopolitical tensions and cybersecurity concerns between China and the US rendered an overnight freeze of the ADR listing market, following Didi Chuxing’s USD 4.4bn New York IPO in June. Up to date, 337 Chinese companies have raised USD 112.7bn – nearly the size of Slovakia’s gross domestic product - by issuing American Depository Receipts.

A VIE structure is a legal workaround designed to enable investors to synthetically participate in the growth of companies that were restricted from foreign investment due to their sensitivity or because they provided critical infrastructure, explained Drew Bernstein, co-chairman of New York-based audit firm MarcumAsia. Nonetheless, the VIE structure had never been formally endorsed by any Chinese regulator.

Chinese issuers often could not answer US authorities’ inquiries over this pending issue and failed to meet the disclosure requirement, according to a source close to a US exchange. But this hopefully can be solved moving forward, the same source said.

Historically, indirect listing of small red chip companies and VIE structure companies fell into a “regulatory vacuum” with very weak oversight, whereas direct listings, such as H-share listings, and indirect listings of big red chip companies would need approval from the China Securities Regulatory Commission (CSRC), said Qifei Xu, partner at Haiwen & Partners.

Red chip companies refer to international-incorporated vehicle companies with major assets based in mainland China. Small red chips are the ones ultimately controlled by Chinese nationals and big red chips by Chinese enterprises, especially by state-owned enterprises (SOEs).  

Possibility of substantial reviews

Under the new rules, a “level-playing field” is created for all Chinese companies regardless of capital structure or listing destination, said Benran Huang, managing associate at Zhao Sheng Law Firm, Linklaters' joint operation partner in China.

The new regulatory framework will require issuers to submit a filing within three days after applying to a foreign stock exchange.  

The types of issuances to be put under CSRC's regulations range from initial public offerings (IPOs), direct public offerings (DPOs), reverse takeovers (RTOs), special purpose acquisition companies (SPACs), and a dual or secondary listing after an overseas IPO. For subsequent financing, issuers can file with CSRC within three days after the completion of issuance.

Oscar Chen, partner at Duan & Duan Law Firm, warned that it remains to be seen whether the filing-based system would at the end of the day turn out to be a facto “substantial review” in practice.

As reported earlier by this news service, these are part of China’s broader stock-market reforms that also created a fast-track registration system for domestic listings.

Under the new system, companies will be geared toward picking an exchange based - mainly if not solely - on considerations of whether this is a strategically sensible move, rather than considerations of the regulatory differences among the different exchanges.

This, said John Xu, corporate partner at Linklaters, will kill the room for “regulatory arbitrage," aka opportunistic listing decisions.

Companies already listed are not required to back-file for their listings, but they will have to file with the CSRC after completing subsequent fundraisings on the same listing venue, Chen at Duan & Duan said.

All considered, this should address longstanding concerns when it comes to dealing with VIE companies, for both the US and Chinese regulators. More importantly, by acknowledging VIE-structure entities, China is conveying a message to the markets that she remains open to keep the ADR listing channel alive.

As this is the first time China is imposing stock-listing rule changes across the entire spectrum of issuance types, at home and abroad, financial and legal advisors expect it would take months for market participants to have a better handle on the nitty-gritty of the regulators' playbooks.

"We might experience a turbulent period of one or two months in the beginning but soon we can expect a clearer roadmap," a Beijing-based IPO banker said. A formal pre-filing communication channel set up by CSRC for companies also shows the regulator is keen on helping the market participants walking the uncharted routes, the banker said.

VIE or no VIE

It goes without saying that CSRC's new rules will bring VIE entities into a new era — VIE 2.0 — when this type of company can gain official endorsement for listing.

CSRC has highlighted five scenarios under which overseas listings will be no-nos.

They are listings that are explicitly prohibited by (Chinese) laws and regulations, listings that may endanger national security, issuers or controllers who have committed crime or are undergoing probes, and listings involving a material ownership dispute.

The market regulator has also required a thorough check on the issuer’s shareholders and a disclosure on the ultimate beneficial owners of the issuer’s major shareholders in the filing with CSRC, Lu at Han Kun and Xu at Haiwen said.

This may present challenges for foreign investors due to confidentiality concerns, so how this will pan out in practice is worth monitoring, Xu at Haiwen said.

The new regime adds another layer of regulatory scrutiny to VIE entities when it comes to overseas listings, on top of existing cybersecurity reviews, said Xu at Linklaters. Under China’s regulatory context, “overseas listings” refer to IPOs outside mainland China, but include Hong Kong.

The sectors that are made off-limits to foreign investors are stipulated in the so-called ‘negative list’ published by the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC).

Since the list's first release in 2018, it has been revised three times.

MOFCOM revealed earlier this month that China will further relax restrictions on the ‘negative list’ for foreign investment.

The new process should provide a bright line as to which companies the Chinese regulators truly believe to be too sensitive to permit foreign investment, and then a green light for those that do not impact public security concerns, Bernstein said. Given that investors abhor uncertainty, moving from a world of shades of gray to black and white is a major move in the right direction, he added.

At the end of the day, the listability of VIE companies will be put under test, Lu at Han Kun said. He believes that eventually, the regulators will allow select industries to adopt a VIE structure.

"We believe CSRC will take a case-by-case approach to review VIE structures," Xu at Linklaters said.

Politics of IPOs

For many Chinese companies, overseas listings will remain attractive because domestic A-share listings in general still have stricter qualification requirements, Xu at Haiwen said.

For those backed by USD funds in particular, overseas capital markets provide a far more efficient exit, said two bankers at CITIC Securities and Orient Securities.

The new rules bring a net positive to Hong Kong listings, according to Chen at Duan & Duan. Under the new regime, filing materials and procedures for Hong Kong listings are further simplified, with the listing timeline shortened too, according to the investment banking department of CICC.

"We feel the market sentiment is recovering and more companies are pursuing US IPOs this year than the last year," Lu at Han Kun said.

On the US side, the U.S. Securities and Exchange Commission (SEC) now starts to be more responsive and allowing registration statements of Chinese issuers to go effective, Bernstein with MarcumAsia said.

All these early signs are likely net-net positive for Chinese companies eager to embrace the American Dream again.

But let's not forget that above all these, the US-China relationship, which has become more politics-driven than an economic one in recent years, sets the tone for all aspects including how far Chinese companies can go in terms of overseas listings eventually.