Did China take another step to financial decoupling with new VIE rules?

Business & Technology

Changes to rules that affect Chinese companies that issue shares abroad could spell a slowdown for IPOs and change the way China’s booming tech sectors raises money.

Illustration by Derek Zheng

Yesterday, we reported that Chinese ride-hailing giant Didi Chuxing’s shares took a 20% hit after Chinese regulators targeted the company with a number of moves, including suspending downloads of its app. This happened just six days after the company listed on the New York Stock Exchange, raising $4.4 billion.

Today Bloomberg reports that sources say the China Securities Regulatory Commission “is leading efforts to revise rules on overseas listings that have been in effect since 1994” that would “require firms structured using the so-called Variable Interest Entity (VIE) model to seek approval before going public in Hong Kong or the U.S.”.

What are VIEs?

Chinese law does not allow foreign entities to own media and internet companies, but until recently, such companies have not been able to raise capital in China, where local stock markets and government policies make it difficult for tech startups and other high-risk, high-growth startups to get funding.

VIEs solved this problem with a legal framework first used by Sina during its 2000 Nasdaq IPO. Reduced to its essence, this is how it works:

  • The Chinese company that legally owns and operates the business in China is owned by founders or trusted parties.
  • A company is established in the Cayman Islands (or other tax efficient base). This is the legal entity that the publicly listed company owns.
  • The Chinese company signs an agreement that gives control and profits to the Cayman Islands company.

What could the new rules mean?

Bloomberg’s report does not say regulators plan to ban the use of VIEs, but to require approval. But the news comes the day after the government clampdown on Didi, which was “is a strong signal from Beijing to discourage listings of Chinese tech companies in the United States,” according to businesspeople cited by Li Yuan of the New York Times.

However, Bloomberg suggests that the new rules “could bestow a level of legitimacy on the VIE structure that’s been a perennial worry for global investors given the shaky legal ground on which it stands.”

Why do Chinese companies still want to IPO in the U.S.?

This year alone, “37 Chinese companies have listed in the U.S., surpassing last year’s count, and raised a combined $12.9 billion,” according to Bloomberg data. Why are they still coming? Pull factors include:

  • Large amounts of capital available
  • Willingness of investors to take risks on unprofitable startups companies
  • Prestige
  • Windfalls for founders and early investors outside of China

Those factors have not changed, but it seems certain that the numbers of Chinese companies that list in the U.S. will fall in the second half of 2021.

More on the Didi fallout and listings of Chinese companies in the U.S.:

Didi accused of failing to disclose warning to delay IPO in class action suit / Caixin (paywall)

Didi duo lose $1.5 billion as shares plunge on China’s crackdown / Bloomberg (paywall)

Down $831 billion, China tech firm selloff may be far from over / Bloomberg (paywall)

How did Didi get in trouble with data regulators? / TechNode

Chinese listings in U.S. flop despite fundraising frenzy / FT (paywall)