The rules will reduce regulatory uncertainty but they may present challenges for some firms and intermediaries while raising the cost of compliance, say Daniel Tang and Joyce He.
Towards the end of 2021, China released two draft rules on overseas stock listings for public comments. These new draft rules, namely the “Provisions of the State Council on the Administration of Overseas Securities Offering and Listing by Domestic Companies” and the “Administrative Measures for the Filing of Overseas Securities Offering and Listing by Domestic Companies”, will reshape the way Chinese companies’ raise funding outside of Mainland China in the future.
The draft rules are widely perceived as a significant step by the China Securities Regulatory Commission (CSRC), the country’s top securities regulator, to dispel market doubts and concerns about the ability of Chinese companies to float their shares in Hong Kong and on other overseas stock exchanges. These concerns arose after the fallout over the Chinese ride-hailing app Didi’s initial public offering (IPO) in late June 2021.
Overseas Offering and Listing Redefined
Previously, Mainland regulators would only oversee domestic companies’ overseas listing, while listing applicants set up outside of Mainland China, namely “red-chip” companies and companies with variable interest entity (VIE) structure to be listed on the New York or Hong Kong stock exchanges, fell outside of its jurisdiction.
The draft rules cover both direct and indirect overseas offerings of stocks, depository receipts, convertible corporate bonds and other equity-like securities, as well as overseas listings of stock by domestic companies.
“Direct overseas listings” refer to the offering and listing on overseas stock exchanges by domestic companies. “Indirect overseas listings” cover fund raisings outside of Mainland China by offshore entities whose main places of business or business activities in China either derive a majority of their revenue or profits domestically, or whose senior management personnel are Chinese citizens.
This redefinition of the scope of overseas listings extends the CSRC’s jurisdiction over red-chip structures and listings involving VIE structures. In addition, companies going to other markets via special-purpose acquisition companies (SPACs) should also follow the same filing requirements as overseas IPOs.
Hence all companies, whether they are established in China or overseas, will have to go through the CSRC filing procedure first if their major operations are in Mainland China and they wish to raise funds elsewhere.
VIE Structures’ Eligibility Clarified
The VIE structure has mostly been used by companies for IPOs on overseas stock markets, primarily in the US, to skirt Chinese rules restricting foreign investment in sensitive industries such as education, media and telecommunications. This structure allows founders to set up offshore vehicles to exert effective control over, and enjoy the economic benefits of, Chinese operating companies via contractual arrangements.
Under the draft rules, companies with VIE structures that meet compliance requirements are eligible for an overseas listing after filing with the CSRC. The draft rules and the CSRC’s public remarks put to rest earlier speculation that China would ban listings featuring VIE structures.
The companies with VIE structures that already listed overseas would feel immediately relief as the draft rules follow the principle of non-retroactivity, and they are not required to adjust their ownership structures.
The draft rules, if passed, will establish a unified filing-based regulatory system for overseas listings, which is intended to streamline regulatory oversight by Chinese authorities.
At present, direct overseas listings of domestic companies require the approval of the CSRC. The draft rules will change the approval system to a filing system, under which the CSRC will only review the filing materials as a compliance formality. This represents a relaxation of the current requirements on direct overseas listings of domestic companies.
Currently, indirect overseas listings of domestic companies do not require the CSRC’s approval. However, in practice, listing applicants relying on VIE structures are strictly regulated by relevant overseas authorities and stock exchanges because of the risk of contractual defaults.
Under the draft rules, if an overseas entity is recognised as a substantial domestic company to be listed overseas indirectly, it must first complete the filing process with the CSRC before the listing, and will be subject to post-IPO filings as well. This is a positive development as it will improve regulatory certainty for prospective issuers with VIE structures.
The CSRC will also establish a supervision and coordination mechanism with other relevant governmental authorities to strengthen policy coherence, information sharing and supervision coordination.
Companies Prohibited from Overseas Listing
Domestic companies are prohibited from listing overseas, if:
- national laws and regulations prohibit such listing and financing activities;
- the proposed overseas listing may constitute prejudice to national security;
- there are material ownership disputes over equity, assets, and core technology;
- in the last three years, the domestic company or its major shareholders, actual controllers have committed corruption, bribery, embezzlement, misappropriation of property, or other relevant criminal offenses, or are under investigation for suspicion of criminal offenses or major violations of laws and regulations; or
- in the last three years, any of the domestic company’s directors, supervisors or senior management personnel has been subject to administrative punishments for severe violation or are under investigation for criminal offense or major violations.
Domestic companies seeking to list overseas should apply for security reviews such as foreign investment security reviews, cyber security reviews and others required by law and regulations before filing their applications for overseas listings.
The issuer may be required to divest relevant business and assets within Mainland China or take other effective measures to mitigate or avoid any impact on national security resulting from such overseas listing.
Starting from February 2022, internet platform operators with at least one million users must undergo a cybersecurity review before going public overseas, except for listings in the Hong Kong market.
In addition, shortly after the release of the CSRC draft, the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM) rolled out the updated “Special Administrative Measures for Foreign Investment Access (2021 Edition)” (the ‘Negative List’), prescribing new restrictions for overseas listings of Chinese companies engaged in prohibited businesses.
Such companies can only apply for overseas listing after obtaining clearance from domestic regulators. Foreign investors are not permitted to participate in the operation and management of such domestic companies, and foreign shareholdings in Mainland-listed Chinese companies with businesses in the “prohibited category” must not exceed 30% in aggregate or 10% individually.
Registration of Foreign Security Firms
Foreign securities firms that engage in sponsoring or lead underwriting of overseas IPOs of domestic companies are required to file with the CSRC within 10 working days after the first engagement of such business, and submit annual reports on their business involving overseas listings of domestic companies before 31 January.
Failure in filing or to submit annual reports may result in the foreign securities firm being ordered to carry out rectification, and the securities regulator in the jurisdiction where the foreign securities firm being notified. In severe situations, any new filing documents from the foreign securities firm can be rejected by the CSRC for a period of three months to one year.
The draft rules state that if any violations are found in the documents produced by securities companies, the CSRC may take various administrative measures, including issuing an order for the firm to make rectification, subjecting the firm to a regulatory interview, issuing a warning letter, confiscating revenue generated from the deal, or imposing a fine.
This would create new compliance challenges for foreign underwriters as once they are registered with the CSRC, they would need to follow Chinese rules and could be subject to the above penalties in case of violations.
The rules will not apply retroactively but it remains unclear whether companies that have filed for listings but haven’t yet been listed will fall under the new rules.
The draft rules, if passed in their current form, will reduce market and regulatory uncertainty related to the VIE structure. However, the VIE structure may face more and tougher scrutiny under the new rules, meaning that overseas IPOs will likely take longer to complete. In addition to the risk of contractual default, companies with VIE structures seeking to float their shares overseas will also need to weigh their compliance risks.
For example, Hong Kong’s new listing regime for SPACs already requires a successor company in a de-SPAC transaction to meet all listing requirements such as those relating to minimum market capitalisation and financial eligibility. Where such a successor company has – as is most likely to be case – most of its operations and management personnel based in Mainland China, the de-SPAC transaction will also be subject to the new regime governing indirect overseas listings.
In summary, we believe that the new draft rules will bolster Hong Kong’s IPO market, especially if geopolitical tensions between China and the US persist. The rules will reduce regulatory uncertainty, although they may also increase the cost of compliance.
Daniel Tang is a partner, and Joyce He is a senior legal and tax manager, at Withersworldwide in Hong Kong.