Capital Decoupling: Chinese tech blocked from USA listing?

The decoupling of China and the US appears to be continuing. This decoupling commenced with a trade war, which had little to do with trade but now appears to be primarily in respect of technology. The technology decoupling is more complex than tariffs and quotas. Technology decoupling is multi-faceted. The most recent aspect of this struggle is to make it more difficult for Chinese centric tech companies to list on US capital markets. Interestingly in this regard both the US and China are establishing (very different and competing) hurdles for these companies.

01 VIE Models – a Brief History

Before considering the current travails, it may be useful to have some background in respect to US listings by Chinese tech companies.

In the late 1990s / early 2000s China started to be fertile ground for technology companies. Prior to this wave of technology the vast majority of billionaires in China had made their fortune in real estate. These Chinese start-ups were keen to expand but they faced two major dilemmas: 1) the best place to raise capital for tech companies was listing on the NASDAQ (PRC markets were limited and conservative in selecting candidates for listing); but 2) Chinese domestic companies would not be able to obtain approval from the Chinese regulator to list overseas. In many cases, a third complication was that many tech companies were operating in areas off limits to foreign investment (i.e., so a foreign company could not directly hold a Chinese subsidiary operating in a restricted sector).

The first variable interest company (VIE) was organized to untie this Gordian knot of Chinese tech companies needing to raise capital overseas but Chinese companies not being permitted to list overseas.

A VIE structure typically has a 1) top company – normally a Cayman entity which holds a Chinese wholly foreign owned enterprise (“WFOE”) that operates a business in China to the extent it is not restricted for foreign invested companies; and 2) the founders (i.e., Chinese nationals) would then establish a domestic entity (i.e., the VIE entity) to operate the aspects of the business which was off limits to foreign investment (e.g., value added telecoms or media etc.). Such VIE entity would contractually be a “captive” domestic company to the WFOE and would be limited to holding the restricted operational licenses and carrying out the restricted business.

This structure has been highly successful for the last 30 years and caused many copycat transactions to follow.

As a result, many PE, international institutional investors and other funds have joined the bandwagon and invested in China high-tech companies via such structures. The intention is clear, invest early in anticipation of a lucrative IPO exit. There have long been concerns in some legal quarters as to the inherent fragility of the VIE structure – how enforceable will such contracts be in practice? The issue may be amplified in that many took the original “model” too literally and much of the legal work has been based on templates (lacking bespoke safeguards), imports foreign legal concepts that may be ill suited to enforcement in China and that the long line of success has resulted in few deal makers, lawyers or accountants challenging the concept.

Given this has been a wildly successful model for the last 30 years is it reasonable to have concerns about the model going forward?

02 Headwinds

At present headwinds to the model are emanating from both sides of the geopolitical divide:

Issue 1: The US Audit Position – Dec 2 2021- SEC Adopts Amendments to Finalize Rules Relating to the Holding Foreign Companies Accountable Act

There is a tension that, on the one hand, the US may demand that China centric US publicly listed companies to share their financial audits with the SEC or with the US based Public Company Accounting Oversight Board (PCAOB). On the other hand, PRC laws restrict these Chinese centric tech companies to provide foreign governmental authorities materials relating to securities business activities (including accounting materials) without approval from competent PRC governmental authorities on the grounds of national security and state secrets.

Matters have escalated that in December 2020, then-US President Donald Trump signed the Holding Foreign Companies Accountable Act (HFCA Act) into law. The HFCA Act requires the SEC to prohibit the trading of securities of a non-US company on US stock exchanges if the PCAOB has determined it has been unable to inspect the company’s accounting records for three consecutive years due to a position taken by an authority inthe company’s jurisdiction (such companies are considered to be Commission-Identified Issuers). The HFCA Act also requires such companies to make disclosures about their ownership by governmental entities and the irrelationships with political parties.

This was followed on December 2, 2021, when the SEC adopted detailed rules to implement the requirements of the HFCA Act. According to such rules, the earliest any trading prohibitions would apply from is 2024. This is because it only applies to a company that has been a Commission-Identified Issuer for three consecutive years based on annual reports filed from 2022. The SEC also requires a Commission-Identified Issuer to include additional disclosures in its annual report, including the percentage of the shares of the company owned by governmental entities, whether such governmental entities have a controlling financial interest with respect to the company; the name of each official of the Chinese Communist Party who is a member of the board of directors of the company or its operating entity, including any VIE.

The Chinese provisions which collide with the US audit position include:

• Article 6 of the Provisions on Strengthening Confidentiality and Archives Administration in Overseas Issuance and Listing of Securities promulgated in 2009 provides when preparing an “overseas issuance and listing of securities, working papers and other archives formed in the territory of China by the securities companies and securities service institutions that provide the relevant securities service shall be stored in the territory of China. Where the working papers referred to in the preceding paragraph involve State secrets, State security or vital interests, such working papers shall not be stored in, processed with or transferred to non-confidential computer information systems; without the approval of the relevant competent authorities, such working papers shall not be carried or shipped overseas, ortransmitted to overseas institutions or individuals by any means such as information technology”;
• Article 12 of Notice of the Ministry of Finance on Issuing the Provisional Rules for Accounting Firms Engaged in Audit Services in Respect of Overseas Listing of Chinese Enterprises promulgated in 2015 stipulates that, “in the event that any issues (including but not limited to lawsuits) arising from overseas listing of Chinese enterprises requires the overseas judicial department or regulatory authorities to review the manuscript of the audit work or the overseas regulatory authorities needs to access the manuscript of the audit work for the purpose of performing their duties, the matter is subject to the regulatory agreement concluded between the domestic and overseas regulatory authorities”;
• Article 177 of the PRC Securities Laws promulgated in 2019 further requires that “without the consent of the securities regulatory authority of the State Council and the relevant State Council department(s), no organisation or individual may provide the documents and materials relating to securities business activities to overseas parties arbitrarily”; and
• Article 36 of the PRC Data Security Law promulgated in 2021 also explicitly stipulates that “no organization or individual within the territory of the People's Republic of China may provide foreign judicial or law enforcement authorities with the data stored within the territory of the People's Republic of China without the approval of the competent authorities of the People's Republic of China”.

Issue 2: China Data Concerns – in recent years the PRC government has shown great concern in respect of cybersecurity and safeguarding Chinese sourced data.

Data makes life more convenient, more entertaining and more efficient. However, the modern, interconnected world has given rise to new dangers. Hackers can break into systems to steal information, bank details, bring down targeted websites, access government websites etc. Data can be used to manipulate purchasing decisions, social attitudes or even how citizens think. Like data the risk is expanding exponentially. Infrastructure is operated exclusively online. People obtain most of their news from social media. Information which is innocuous by itself can be geo-politically significant if collected en-masse. Accordingly technology is crucial for economic development but can also pose risks to society. To this end the PRC authorities have issued a number of data related laws in relatively quick succession such as the PRC Cybersecurity Law (2017), PRC Data Security Law (2021), PRC Personal Information Protection Law (2021), PRC Trial Provisions on Management of Automotive Data Security (2021) etc.

These concerns extend beyond China’s borders. Specifically, data centric companies (which are basically all tech companies) will require a security review before proceeding with an offshore IPO.

On January 4, 2022, China’s Cybersecurity Administration of China (CAC) formally announced the amendment against the Measures for Cybersecurity Review (which has just come into effect in 2020), which specifies that China centric companies seeking to list on foreign markets need to undergo a security assessment if they hold data on more than 1million data subjects. This is a low threshold for a China tech company –WeChat for example has 440 million users per day – i.e., basically equivalent to the whole population of Europe. Indeed, the CAC may, in their discretion, initiate a review even if the volume threshold is not reached.

It is currently unclear if the rules extend to include Special Purpose Acquisition Companies (SPACs) and Reverse Takeovers(RTO).

What is clear is that the security assessment will not be one and done. In accordance with the draft Administrative Measures on Network Data Security (released in November 2021), it is proposed by the CAC that companies listing outside China will need to carry out annual data security assessments. The assessment will be a comprehensive review of a company’s data compliance, including:

• How they handle important data;
• Identifying data security risks and what measures have been taken to mitigate against such risks;
• Review of internal data security policies and measures;
• Status as to how the company implemented relevant PRC laws, regulations and national standards;
• Data security incidents andactions taken for resolving such incidents;
• Security assessment on the sharing, entrusted processing and cross border transfer of important data;
• Complaints received in relation to data security.

Such assessment report would need to be submitted to the CAC before 31 January of each year.

Issue 3: China Overseas Listing Position

On December 24, 2021, the China Securities Regulatory Commission (CSRC) promulgated Provisions of the State Council on the Administration of Overseas Securities Offering and Listing by Domestic Companies (Draft for Comments), as well as the Administrative Measures for the Filing of Overseas Securities Offering and Listing by Domestic Companies (Draft for Comments) (the “Administrative Measures”).

Under the above two draft regulations, an overseas offering and listing applicant will have to submit materials including its prospect us and opinions from industry regulators, if applicable, to the CSRC for filing within three working days after it submits the overseas offering and listing application documents or makes the first overseas announcement of the planned deal. The CSRC will make a decision on whether the candidate can go ahead with their overseas offering and listing plan or need clearance from other relevant regulatory bodies within 20 working days if adequate materials are submitted.

According to the CSRC's Answers to Journalists' Questions, to the extent of complying with domestic laws and regulations (including but not limited to laws and regulations on foreign investment, industry access, network security etc.), a VIE enterprise that meets the compliance requirements may be listed overseas after filing for record.

In addition, according to the Administration Measures, a direct or indirect overseas offering and listing for domestic companies in China is prohibited under any of the following circumstances:

• if the intended securities offering and listing falls under specific clauses in national laws and regulations and relevant provisions prohibiting such financing activities (for example, disciplinary training institutions shall not be listed for financing, and capitalized operation is strictly prohibited);
• if the intended securities offering and listing in overseas market may constitute a threat to or endanger national security as reviewed and determined by competent authorities under the State Council in accordance with law (for example, cross border transfer of certain important data or personal information may constitute a threat tonational security);
• if there are material ownership disputes over equity, major assets, and core technology, etc.;
• l if, in recent three years, the domestic company or its controlling shareholders and actual controllers have committed corruption, bribery, embezzlement, misappropriation of property, or other criminal offenses disruptive to the order of the socialist market economy; or are currently under judicial investigations for suspicion of criminal offenses or under investigations for suspicion of major violations;
• if, in recent three years, the board directors, supervisors, or senior executives have been subject to administrative punishments for severe violations, or are currently under judicial investigations for suspicion of criminal offenses or under investigations for suspicion of major violations;
• other circumstances as prescribed by the State Council.

03 The Extent of the Problem

If the various headwinds derail planned IPOs or force existing PRC centric companies to delist from US stock exchanges then the impact will be material. At the end of 2020, there are over 170 Chinese centric companies listed on the NASDAQ and NYSE with a total market capitalization exceeding USD 1.2 trillion. There must be many more hundreds of Chinese tech companies which have outside investors who are anticipating a lucrative US IPO.

Many of these investors and companies are nervous that the company’s access to US capital markets and their exit will be blocked – so what will happen and what to do?

There will be no easy fix. Some will be privatized. Possibly China private equity and VC will step up. Some will seek to undertake the security assessment and list overseas but uncertainty remains as to the scope and nature of such assessment. Security reviews will be bespoke to the company given how data is used, collected and protected differently. Also, the assessment will not be a one off as the CAC indicated in its November draft regulation that companies listing abroad will need to carry out an annual security assessment and comprehensive data compliance audit. Such reports will need to be submitted to the CAC. For this reason, investors in China centric companies seeking to list offshore would be well advised to review the company’s level of data compliance and cybersecurity resilience.

We believe the most likely options are as follows:

Option 1 – Go to Hong Kong SAR

The most likely option for investors will be for the China centric company to list in Hong Kong SAR. The HKSE and SFC(equivalent to the US SEC) have a transparent IPO process and clear guidance. There is no quota system and has a stable listing application process (normally at least one year).

Hong Kong SAR may solve the US audit problem but it may not be the solution for all issues. Beyond concerns as to the liquidity and depth of capital markets it should be noted that the China concerns in respect of data will also apply in some measure to HK listings as well.

Although it is now implied by the CAC through the finalised amendment of Measures for Cybersecurity Review that it would not require Chinese centric companies to proactively apply for a cyber security review prior to the listing in HK market, however, it is noteworthy that the cyber security review may still be triggered at the wide discretion of the CAC as well as other PRC authorities.

Moreover, even if a HK listing case is exempted from the cyber security review, the general administrative mechanism of data cross border transfer would still apply (i.e., if a certain threshold is reached, a prior security assessment conducted by the CAC will be required).

As such, data compliance is still a critical issue to be considered for a HK listing and there remains uncertainty as to transmitting data outside China during the listing process.

Also, for listing in Hong Kong SAR, as a general principle, a VIE-structured applicant must prove the use of VIE is“narrowly tailored” to only operate in industries that limit foreign investments to the extent that the licenses operating its business could not have been obtained if the VIE is a foreign invested entity. If a company has a VIE structure that is not narrowly tailored, restructuring of the VIE may be necessary.

Option 2 – Dismantle the VIE structure

High-tech industries and strategic emerging enterprises with a VIE structure may apply for issuance of stock in China if thresholds are met and approved by the CSRC, National Development and Reform Commission(NDRC), Ministry of Commerce (MOFCOM) and other relevant governmental authorities. Despite this we are not aware of any successful cases to date(other than Ninebot which has issued Chinese Depository Receipts rather than stock per Shanghai Stock Exchange).

As it is difficult for VIE structures to issue stock in China, the solution may be to dismantle the VIE structure to enable a China listing.

In most cases the dismantling of a VIE structure would include the following steps:

• Firstly, the entity to belisted after the dismantling of the red chip structure needs to be identified. In a VIE structure, there will usually be two core entities in the PRC - the actual operating entity in the territory (i.e., Domestic Company) and the controlling entity without actual operations (i.e., WFOE). The choice of which entity to be the future domestic proposed listing entity is a priority issue in the overall dismantling plan.
• The founders, other domestic shareholding entities (which may typically include domestic investors, employee shareholding platforms etc.) make capital increases to the Domestic Company by using RMB. In implementing this step, the founders may also consider bringing in new domestic investors to fund the dismantling of the red chip structure.
• The group companies will terminate the series of VIE control agreements signed between Domestic Company and WFOE (including the release of the relevant equity pledges to the Domestic Company).
• The Domestic Company will use its own funds and the funds obtained from Step (2) above to support the acquisition of the equity interest in WFOE, and the shareholders of WFOE remitting the aforementioned proceeds to the Cayman company and the foreign investors by way of dividends or paying share repurchase consideration.

In practice, in order to achieve the purpose of the Domestic Company holding the equity interest in WFOE and the related funds being used to retire the offshore investors, there are also variations, such as the Domestic Company increases its capital to the Cayman company, which will be used by the Cayman company to directly repurchase the shares of the offshore investors. Upon completion of the restructuring, the Domestic Company will hold an indirect equity interest in WFOE through an offshore Cayman company. As there is no transfer of equity in the domestic company, this option may be relatively more tax efficient than acquiring the equity in WFOE directly, but the Domestic Company will need to go through the relevant ODI procedures for this purpose and should be able to obtain sufficient funding to do this.

After obtaining the ODI approval/filing then there are a number of ways to dismantle the VIE structure as follows:

• Repurchase of the founderand/or investor's shares in the Cayman company. This step is usually accompanied by the conversion of foreign warrants, convertible bonds and preference shares into ordinary shares and the termination, release and cancellation of employee options.
• If the offshore investors wish to continue to hold shares in the Domestic Company (subject to the relevant foreign investment restrictions) the offshore investors may invest in the Domestic Company by injecting the consideration obtained from the repurchase of their shares in the Cayman company.
• The founders complete the liquidation of the overseas shareholding entity by transferring the equity of the overseas shareholding entity and dissolving the overseas shareholding entity, and at the same time completing the regulatory registrations, such asNo.37 filings/registration, etc.; WFOE may choose to retain or cancel according to the company's business needs at that time.

Option 3 – Share Transfers to other shareholders or third parties

The key issue here will be how to find a suitable buyer. Most likely, certain China private equity or strategic investor may step in. However, a lack of enough potential buyers may inhibit the potential price that could be achieved. If no suitable buyer could be found then the following options may need to be considered:

• Redemption by the Founder and/or the Company: Usually under the Investment Agreement or the SHA, failure to complete IPO will be one of the redemption trigger events. However, the question will be how they will be able to make good on this in practice.
• Liquidation: Rare in practice, but the investor may still be entitled to liquidation preference in the event of liquidation if they have such preferred rights under the Investment Agreement or SHA.

04 Summary

There are grounds for investors to be concerned that in the medium-term Chinese centric tech companies may be denied access to US capital markets.

For companies already listed, there will be difficult decisions as to next steps (e.g., de-list, Hong Kong listing or privatization). These listed companies have serious businesses and vested interests.

However, the more complicated issue may well be for investors in companies planning to list. These companies do not face the same scrutiny or clear solutions. What is the plan forward? Do the contracts hold? How to align or balance various stakeholders’ interests? Unlike the term sheets, the solutions for the canny investor are likely to be bespoke. As there is no obvious solution at present, the author would be delighted to discuss with investors in such position how best to resolve the matter.