Enticed by the giant market, U.S. and other foreign investors have invested vast amounts in the Chinese stocks listed in the U.S. In many cases, while their operations are in China, the company listed in the United States is a holding company that is based outside of both countries and may not own stock or other equity in the China-based operating company.
In these cases, the U.S.-listed company has contractual arrangements with the China-based operating company. Even though the U.S.-listed company does not own any equity (i.e., have ownership) in the China-based company, it purports to exercise power over and obtain economic rights from the operating company based on these contracts. The operating company often is structured as a variable interest entity, or VIE. Investopedia defines a VIE as a business structure in which an investor has a controlling interest despite not having a majority of voting rights.
The operations and financial position of the China-based operating company are included in consolidated financial statements prepared by the U.S.-listed company. For example, non-Chinese shareholders of U.S.-listed Alibaba (BABA, Financial) actually own a piece of a Cayman Islands-based shell company, which in turn relies on contracts via a wholly-foreign owned enterprise to control the Chinese operations.
This arrangement for Alibaba is illustrated below.
This convoluted structure is designed to get around China’s laws that forbid foreign ownership in sectors like telecommunications and internet news, advertising and media.
However, this separation creates a thick layer of risk for investors. Contracts are only as good as the ability to enforce them and nobody has any idea how the arbitrators or courts in China would enforce these contracts in the case of a dispute, especially when considering these contracts were constructed to avoid explicit regulations to exclude foreign control.
All or most of the value of an investment in these companies depends on the enforceability of the contracts between the U.S.-listed company and the China-based VIE. Any breach or dispute under these contracts will likely fall under Chinese authority and law. Many of these agreements require that disputes be handled before a Chinese arbitration body. This raises questions about whether, and how, a U.S.-listed company or its investors could seek recourse in the event of an adverse ruling as to its contractual rights. This area is extremely gray to say the least.
Recent Chinese regulatory action
With a VIE structure, a company can also list in Hong Kong or the U.S. without asking China’s securities regulator for approval. Recently, ride-hailing company DiDi Global Inc. (DIDI, Financial) did just that, which did not go over very well with the Chinese government. In response, the Cybersecurity Administration of China immediately put restrictions on Didi's business. The stock is down nearly 70% from its high after it went public in late June as China pulled DiDi's app from app stores, citing data security concerns. It's not clear why these concerns suddenly arose, but are also likely connected to rising tensions between the U.S. and China. The company certainly knew some of these data security concerns and related regulations were in the works, but apparently decided to front run these regulations to get to the initial public offering. If Didi had delayed and listed in Hong Kong as the government desired, even with the VIE structure, the company itself would not have drawn the Chinese government's ire. Didi is now retreating and said it will delist from the U.S. and then relist in Hong Kong.
In late 2020, Chinese government regulators nixed the IPO of Ant financial, a spin-off of Alibaba, for different reasons. Its likely that Chinese authorities thought that Ant was attempting to skirt banking standards (like capitalization and assessment of credit worthiness) while trying to operate more like a bank (i.e., taking deposits and issuing loans and credit). Similarly, this past summer, it forced education services stocks like TAL Education (TAL, Financial) and New Oriental Education and Technology (EDU, Financial) to become essentially non-profit overnight and forbade them from listing stocks and raising foreign capital. The government also banned after-school tutoring businesses from advertising and said they could not operate during public holidays, weekends and winter and summer vacations. The government accused these education companies of driving up the cost of education for the public in China, making it unaffordable for the common people to compete in getting their children educated. Access to higher education is highly competitive in China and families spend huge sums in trying to get their kids into good universities.
High-flying companies like meal delivery platform company Meituan (HKSE:03690, Financial) as well as Alibaba were fined heavily in the spring of 2021 for anti-trust violations and curbs were placed on internet video gaming companies. These actions coming one after another has unnerved foreign investors and has sent Chinese overseas-listed stocks (mostly with VIE structures) plummeting. The iShares MSCI China ETF, shown below, seeks to track the investment results of an index composed of Chinese equities that are available to international investors.
U.S. regulatory action
In January 2021, several Chinese companies were delisted from the U.S. exchanges, including telecom giants like China Mobile (HKSE:00941, Financial) and China Unicom (HKSE:00762, Financial), which were accused of having ties to the Chinese military. So coupled with domestic pressures, there is an added worry of delisting from U.S. exchanges.
Earlier this year, U.S. Securities and Exchange Commission Chair Gary Gensler stated that Chinese companies would not be allowed to raise money in the United States unless they disclose more information on their legal structures and risks. The agency also has stopped processing Chinese IPOs after the DiDi debacle. Gensler said that all China-based operating companies seeking to register securities with the SEC must prominently and clearly disclose whether the operating company and the issuer, when applicable, received or were denied permission from Chinese authorities to list on U.S. exchanges; the risks that such approval could be denied or rescinded; and a duty to disclose if approval was rescinded; and, that the Holding Foreign Companies Accountable Act, which requires that the Public Company Accounting Oversight Board be permitted to inspect the issuer's public accounting firm within three years, may result in the delisting of the operating company in the future if the PCAOB is unable to inspect the firm.
China currently imposes significant restrictions on non-Chinese auditors to examine the accounting of operating companies and if the latter requirements come into place, this will cause a head-on collision between U.S. and Chinese regulations unless this issue is resolved. If this does not happen, delisting in the U.S. for Chinese companies will then become a fait acomplii.
Draft rules on VIEs
On Dec. 23, the China Securities Regulatory Commission released proposed rules for domestic companies if they want to list overseas. These rules propose to regulate overseas securities offering and listing activities by domestic companies, either in direct or indirect form (collectively referred to as overseas offering and listing by domestic companies), and promote lawful use of overseas capital markets by domestic companies to achieve regulated and sound development, in accordance with statutes including the Securities Law of the People’s Republic of China and the Company Law of the People’s Republic of China
The public comment period ends Jan. 23, 2022. The CSRC’s proposed rules said an overseas listing could be stopped if authorities deemed it a threat to national security. Domestic companies need to comply with relevant provisions in the areas of foreign investment, cybersecurity and data security, a draft said, without much elaboration. This is the first time the Chinese government has acknowledged the VIE corporate structure and is seen as a tacit acknowledgement that the structure may be legal. CSRC said that, "If complying with domestic laws and regulations, companies with VIE structure are eligible to list overseas after filing with the CSRC." It is not yet clear if the currently listed VIE's will be required to go back and register with CSRC and come in compliance.
Companies would need to get the CSRCs approval before cooperating with investigations by overseas regulators. The regulator reiterated that it would keep collaborating with overseas peers on cross-border securities regulations, including strengthening information-sharing and audit inspections cooperation.
“In recent years, some overseas listed companies have committed serious violations of laws and regulations such as financial fraud, which has damaged the overall international image of Chinese companies, and has adversely affected the overseas financing of Chinese companies,” the CSRC said. This appears to be in reference to frauds perpetrated by companies such as Luckin Coffee Inc. (LKNCY, Financial), which admitted to falsifying accounting or revenues and expenses.
Conclusion
While this these draft rules are a step in the right direction, much remains to be resolved with respect to Chinese tech securities. We still don't know the rights of foreign investors in the VIEs and if these rights can be enforced in a court of law. However, given the size of the market caps of the Chinese VIE-structured tech industry like Alibaba and Tencent (HKSE:00700, Financial), it's unlikely China will yank the rug from under these companies and damage their capital market for a generation. More likely, China will move now to regulate this sector and clarify the rights and limitations of foreign investors more fully.
However, it also appears increasingly clear that Chinese tech companies are not free to operate in a lassize faire manner like their counterparts in the West. China is determined that they will remain subservient to the state and conform to its requirement for "common prosperity." This will mean that the price multiple for Chinese tech would be much smaller than that awarded to their western counterparts.
Given the continued fear of delisting of Chinese securities, I think it's better for now to buy these securities in Hong Kong. However, investors should be aware that loss of liquidity caused by a delisting action in the U.S. can cause the stock price to remain depressed for some time. One question the investor must grapple with when investing in Chinese securities is whether or not it is worth the hassle. Each investor must work out his or her own cost and benefit ratio.
