China has proposed revising its approach to regulating foreign investment. A good summary is here. Investments in most sectors will be treated the same for foreigners and locals. A negative list will restrict foreign investment in certain sectors. China has published proposed rules for this new approach, but it does not include the negative list. A good working assumption is that the negative list will include most of the industries that are in restricted or prohibited categories on the current foreign investment catalog. The proposed law is here (in Chinese). The Ministry of Commerce will accept comments until February 17.
One of the important changes is that variable interest entity (VIE) arrangements are specifically covered. A VIE will be treated as foreign invested if it is foreign controlled. In the common Chinese use, VIEs sign a series of contracts with a Cayman Islands incorporated, publicly listed company or its wholly foreign owned enterprise (WFOE) subsidiary. Those contracts give control of the VIE to the public company and under the new rules make the VIE a foreign invested enterprise. That means the VIE cannot operate in sectors on the negative list.
But there is a twist. If Chinese individuals or corporations control the foreign company (parent companies of overseas listed Chinese companies are typically incorporated in the Cayman Islands) then the foreign company will be treated as a domestic company for purposes of the foreign investment rules. That would mean the VIE is treated as being controlled by a domestic company and would not be subject to the foreign investment rules.
Companies that are controlled by Chinese will have their existing VIE arrangements validated. That means that existing VIE contracts should be enforceable. At present, Chinese law will not enforce contracts where an illegitimate purpose is concealed under the guise of legitimate acts. The proposed law will legitimize foreign investment through a VIE when the company is controlled by Chinese. That should make the contracts enforceable.
The new law will create winners and losers in China.
Alibaba, Baidu and other companies with dual class share structures or other arrangements that keep founders in control. These companies can continue to use their VIEs. Hopefully, they will be allowed to transfer the VIE to the public company structure so that it becomes a WFOE. That would remove many of the operational difficulties associated with VIEs and provide some better legal protection for shareholders.
Ant Financial Services Group (ANT), Alibaba’s finance arm formerly known as Alipay. Alipay was a former VIE of the Alibaba Group that was taken out of the group in 2011 by Jack Ma much to the chagrin of Yahoo! investors. Alipay has been the poster child for VIEs gone wrong. The new law may allow ANT to be listed in a U.S. IPO, since the new rules would appear to allow a company like ANT to have foreign investment provided it remained Chinese controlled.
US Exchanges. Few stock markets permit the use of control structures that allow founders to remain in control of their companies even when they sell down their shares below 50%, but the US exchanges do. Those control structures usually involve two classes of shares – a Class A owned by founders with full voting rights, and a class B owned by public shareholders with identical rights as class A except for no right to vote. Alibaba achieved a similar result using the Alibaba partnership. Hong Kong and China do not permit companies to list with control structures, insisting on one share/one vote. The Hong Kong Stock Exchange lost the Alibaba IPO because of its unwillingness to change its rules.
Tencent, CTRIP, and other companies that are not controlled by Chinese. Some overseas listed Chinese companies have not used the control structures. Their VIEs are likely to be treated as foreign invested enterprises, and will need to comply with the negative list. The regulator could give special permission for these companies to continue to use their VIEs, and I expect they probably will. An alternative may be for these companies to move their VIE to the Shanghai Free Trade Zone, which has indicated it intends to allow wholly owned foreign investment in e-commerce.
Multinational companies (MNCs). Many MNCs use the VIE structure although this is rarely disclosed (Amazon is an exception, disclosing use of a Chinese VIE). These VIEs will be subject to the negative list. I am less optimistic that MNCs will be able to obtain special permission, and may need to rely on using the Shanghai Free Trade Zone.
Hong Kong Stock Exchange. Hong Kong does not allow companies to list using control structures to keep founders in control. The Hong Kong Stock Exchange lost the Alibaba IPO over this rule, and stands to never see another IPO of a Chinese company in a restricted sector if they do not change their rules.