China’s recent regulation of variable interest entity structures has led to a drop in Chinese companies’ US listings

Over the past two decades, Chinese issuers have widely used the variable interest entity (VIE) structure to raise overseas capital while, at the same time, ‘satisfying’ China’s regulation of foreign investment in industries that are closed or restricted to foreign capital. As a multi-firm vehicle, a typical Chinese-style VIE structure (see the Sina example below) connects the Cayman-incorporated listed shell company with the China-based operating entity through a package of contractual agreements to achieve capital injection from the former into the latter in exchange for the managerial power and economic benefits via several conduit companies.

Notwithstanding its broad use since 2000, the VIE structure has been neither recognised nor denied by Chinese authorities in the general sense. Instead, cases challenging the VIE structure have repeatedly revealed that Chinese authorities are reluctant to clarify the legality of the VIE structure. The strategic ambiguity can help Chinese authorities maintain regulatory flexibility while funnelling foreign investment into the Chinese capital markets to leverage economic developments, which nevertheless contains multifaceted legal risks to foreign investors. In the event of invalidation of VIE structures, involved foreign investors could find themselves lacking effective remedies at both local and international levels. Besides, agency problems between investors of the Cayman-listed shell company (the principal) and the key person of the Chinese operating entity (the agent) within a VIE structure have occurred a couple of times in capital markets, typically Alipay’s VIE digression event in 2011, in which Jack Ma (the founder of Alibaba) spun off Alipay from Alibaba to be an independent company under his name without notifying Softbank and Yahoo (the largest two shareholders of Alibaba) and caused Yahoo’s immediate drop in stock price by 9.8 per cent.

Against the backdrop of inter-jurisdictional capital market competition, China has recently adjusted its national regulation of variable interest entity structures. The Shanghai Stock Exchange Sci-tech Innovation Board (SSE STAR Board) was established in mid-2019 to adopt a permissive policy of domestic listings with VIE usage and accommodated the first Chinese VIE issuer in October 2020. However, in a recent article, ‘Variable interest entity structures in China: Are legal uncertainties and risks to foreign investors part of China’s regulatory policy?’, I find that the first Chinese listing with a VIE structure does not endorse the legality of the VIE structure in the general sense. Instead, the ambiguity surrounding the use of the VIE structure in industries where foreign investment is prohibited is yet to be clarified. Besides, the long-awaited Foreign Investment Law of China (‘FIL’) was enacted in 2020. However, compared to its 2015 draft version proposing several stipulations regarding foreign investors, actual control and the nature of contractual control that could clarify the legality of the VIE structure, the formally enacted FIL removed such stipulations entirely. On these grounds, by maintaining the strategic ambiguity of the VIE structure, China’s recent regulation has demonstrated a continuation of the previous policies.

Most recently, triggered by Didi’s US listing in mid-2021, Chinese authorities have promulgated the Measure for Cyber-security Review, requiring domestic issuers seeking to go public overseas to pre-pass the state cyber-security review if they have the personal information of over one million Chinese users. In this way, China has tightened the state control of domestic issuers’ overseas listings. In response to China’s new regulatory policy, the SEC has asked prospective Chinese issuers with a VIE structure to carry additional disclosures to bring VIE risks to investors’ knowledge. As a result, the regulatory uncertainties on both sides have led to a sharp drop in Chinese companies’ US listings. From the promulgation of the Measure for Cyber-security Review to the end of 2021, only two medium-sized Chinese companies went public in the US.

My article conducts a close examination of the ambiguous legality of the VIE structure in Chinese regimes and regulatory practice, discusses the VIE risks to foreign investors, and reveals the continuation of China’s policy and its potential impact. It narrows the gap created by the fact that China’s regulation of VIE usage from 2015 onwards is rarely examined in scholarly work. It concludes that upon establishing the SSE STAR Board as a new landing zone, China’s tightened control of domestic companies’ overseas listings may serve as a powerful driving force to retain certain issuers with the use of a VIE structure on Chinese capital markets.

Fa Chen is Teaching Associate in Law at the University of Cambridge.