Regulations in both China and the US have tightened significantly and shares in US-listed Chinese companies have taken a beating from which might take quite long to recover.
Photo from CFP
By LIU Chenguang, ZHANG Lingxiao
It’s been a very long couple of months for China’s investors, and anyone who invests in Chinese stocks. But it’s been even worse for Chinese companies trading on overseas exchanges - especially in the US - or those who have plans to.
First, the Chinese regulators came for Didi, and a bunch of tech companies dropped balls of their US listing plan. Then share price of tutoring schools plummeted after new regulations that prohibited off-campus tutoring from going public. Now the US regulators showed up. Gary Gensler, chairman of the US Securities and Exchange Commission posted a video on Twitter last week, saying that many Chinese IPOs would “pause, for now.”
The main concern of the SEC is Variable Interest Entities, widely used in Chinese IPOs. Under this arrangement, a China-based operating company establishes an offshore shell company — the Cayman Islands is a popular choice — which itself does not own the operating company but has a right to its incomes through contracts and agreements. The shell company then issues shares on a foreign exchange.
The concerns of China are, on the surface at least, quite different. At least two clear policy strands have emerged. The case of tutoring schools is a social issue. And data security concerns over the tech companies, are exactly that: security concerns.
For as long as there have been schools in China, after-school tutoring has played an important role in the education of almost all Chinese, like it or not. Tutoring – including English lessons – was always done in person and the tutor was most frequently a local teacher or retired teacher. China is working to relieve children of unnecessary academic burdens, and that means fewer after-school classes.
Despite the obvious conflicts in the imperfect system, the fact was that a large slice of the money that once went into the pockets of China’s teachers and remained in the local economy, was draining away to poorly qualified teachers, and shareholders, overseas. It was an obvious problem, crying out for a solution.
In terms of data security, China is concerned about citizens’ data being stored on overseas servers for some pretty simple reasons. Such is the ubiquity of data collection, that the details of people’s movements – at a second-by-second, meter-by-meter level – are an important factor in the operation of many apps. The Chinese government simply does not want this information to be held overseas. And that is just one example of what could be considered quite mundane data. These are concerns shared by almost every government in the world.
The effect of these changes in Chinese society might be a restoration of a comfy feeling of security, but in the markets, it’s been the proverbial rollercoaster. But this rollercoaster may have already paused briefly at its peak and begun to drop precipitously on its way to a bumpy dead-end against the buffers at the bottom.
Traders have made huge losses. Lucrative IPO deals blazing on the horizon have spluttered and gone out one by one. Is this the end for the ever-popular VIE structure? Is the closing bell ringing for all for US-listed Chinese stocks?
Since last year, Chinese companies have repeatedly found themselves the punchbag of regulators in both countries. The first blow came last December when Donald Trump signed the Holding Foreign Companies Accountable Act. Chinese companies must open up their audit records within three years, or be kicked out of US exchanges. The SEC took the first step toward this mass eviction in March.
Another punch came from the Chinese side. On July 4, giant ride-hailing company Didi was removed from app stores less than a week after its IPO in the States. Two days later, the State Council issued statements on cross-border data security and “illegal capital market activities.” On July 10, the Cyberspace Administration of China passed rules on security reviews for companies with more than a million users before they can go public overseas. Didi shares are now trading at half of their opening price.
Late last month, news about tutoring schools sent shares down again; not only education stocks, but Big Tech and major indices.
Veterans smell panic in the air. PANG Ming, the chief economist at China Renaissance Securities, said the market should not overinterpret Gary Gensler’s message. It was nothing new. The market had probably underestimated the degree to which regulations would tighten on both sides. Wang Jinlong, CEO of Haitou Global, said the administration had clearly signaled its determination to rein in speculation many times. Other hot investments, such as SPAC and cryptocurrencies, have also felt the power of the regulators' long arm.
Listings abroad are not, on paper at least, much affected. On August 1, the China Securities Regulatory Commission reiterated that companies were encouraged to seek IPOs abroad, so long as all laws and local listing requirements were followed. This came after a comment by the chairman of the CSRC that described US government action as “slow and inadequate.”
What happens next is unclear. How, and to what degree, will Chinese companies open up their books to US regulators? Chinese law restricts auditors from transferring certain financial information out of the country. This is a matter of regulatory sovereignty and one that the two countries must solve together.
Only a handful of Chinese companies have gone public in the US since Didi’s travails began. The future of US-listed Chinese companies depends on China’s domestic policy as well as US-China relations. Regulators are already casting their eye over tech companies. Both Alibaba and Tencent have been through recent uncomfortable encounters with concerned departments. No one is safe.
Chinese companies have widely used the VIE structure to get access to foreign capital, which would otherwise be unavailable due to restrictions on foreign ownership. Two out of three Chinese companies traded in the US - including many household names such as Alibaba and Trip.com - use this arrangement. It’s not difficult to see how the setup could be problematic.
What happens if VIEs are banned one day? And exactly what information should be disclosed? Gensler wants investors to know exactly what they are buying into. There is, he says, a considerable difference between the world’s largest e-commerce company, for example, Alibaba, and “a shell company in the Caymans.” And he might be right. Gesler wants “full and fair disclosure of […] what money is flowing between Cayman and China.”
Even China acknowledges a lack of transparency in the VIE structure. US investors do not understand VIE. Lawyers and investment bankers are evasive about it and investors should be aware that the stock may lose all value if the VIE is banned. The uncertain legality and vulnerabilities to changing domestic regulations conspire to make the structure look very shaky indeed, but it was the best structure available for some time.
The VIE first came under attack in 2011, when Jack Ma unilaterally transferred Alipay out of Alibaba’s US-listed entity. Chinese stocks have since been the target of SEC investigations and activist short-sellers. VIE listings slumped and never recovered. Then in 2020, Luckin Coffee admitted to having fabricated over 2 billion dollars in sales which may have led directly to the Holding Foreign Companies Accountable Act, but the VIE is not going away any time soon.
“Although China wants to support RMB funds and companies to be listed on the STAR Board, neither can be rushed,” said WANG Jinlong, CEO of asset management platform Haitou Global. The VIE structure will continue to play its part in connecting Chinese companies to investors around the world. US investors don't want to be cut off from opportunities in China. China has the largest number of pre-IPO companies and big, fast-growing markets. More practically, a number of dollar funds hold huge Chinese investments.
An obvious plan B is to go public in Hong Kong. Investor sentiment there is high, and Hong Kong is well-connected to the mainland market. A big drawback, however, is valuations. Hong Kong is not as enthusiastic as the US about tech companies that haven’t turned a profit, so it’s not the greatest option for venture capital trying to exit.
US-listed companies can be privatized and then re-listed in Hong Kong — an expensive and time-consuming option. Most companies choose dual or secondary listings. Dual listings mean the company complies with rules in both places and is seen as more valuable. Secondary listings are quicker, cheaper, and thus more popular. Shares can be bought and sold between Hong Kong and the US, but if the prices tank in one market, the other suffers too.
Strict listing requirements, even for secondary listings, in Hong Kong might deter some companies now listed in the lax US. Hong Kong is a very dynamic market but still cannot match the US in volume and liquidity. US investors have a higher regard for younger or riskier operations. Hong Kong is more conservative.
But companies who choose dual listings are eligible to also trade in Shanghai, a big draw for those who may one day seek to be listed there – the most risk-averse market - where IPO requirements are most rigorous. The STAR Board is an important step toward more openness, but it’s not the Nasdaq.
To become the next Nasdaq? That will be a lot of hard work for both companies and the exchange.