China: New regulations threaten use of Cayman structures

Didi, which operates the most widely used ride-hailing app in China, is the latest Chinese company with a Cayman variable interest entity to list its shares on a US stock exchange.

The Chinese government issued new guidelines on 6 July aimed at clamping down on “illegal securities activities” and increasing the supervision of Chinese companies listed on foreign stock exchanges.

The proposed measures will amend the rules for overseas stock offerings and increase the extraterritorial application of Chinese Securities Law for companies already listed abroad.

They will also improve the verification of funding sources for securities investments and control leverage ratios, the Chinese Cabinet said in a statement.

Commentators have speculated that this will put a chill on US stock offerings by Chinese companies and affect commonly-used structures in the Cayman Islands utilised for that purpose.

According to the US-China Economic and Security Review Commission, there are nearly 250 Chinese companies listed in New York with a combined market capitalisation of $2.1 trillion.

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This year alone, 34 Chinese companies raised $12.5 billion from listing in the US.

In April, a representative of the New York Stock Exchange estimated another 60 Chinese companies were planning to go public this year.

Cayman has been, for some time, the destination of choice for Chinese companies to raise funds overseas and list their shares on the US stock market.

Of the about 250 Chinese companies listed in the US, most are incorporated in the Cayman Islands. This includes Chinese internet giant Alibaba, which raised $25 billion with its initial public offering in 2014.

Chinese companies use so-called variable interest entities (VIEs) to sidestep restrictions on foreign investments in technology, healthcare and other key industries.

The VIEs enable investors to exercise control through contractual arrangements rather than majority voting rights.

As such, the company structure allows the Chinese owners to retain full voting rights over the original business, which assigns some of its revenue to the foreign shell company that can issue shares to foreign investors and provide an investment in return.

Although VIE structures are used by almost all Chinese internet companies, they have been surrounded by regulatory uncertainty as they have been neither explicitly approved nor outlawed by the authorities.

While the new measure might add some legitimacy to their use, it is expected that VIEs in the future would have to seek regulatory approval in China before going public in Hong Kong or the US.

The “political compromise” that allowed the VIE structure as a way around foreign ownership restrictions is “under serious threat”, Martin Chorzempa, a senior fellow at the Peterson Institute for International Economics, told Bloomberg. China “can now discourage its promising firms from listing abroad, which could boost its ambitions to develop financial markets on the mainland”.

A Reuters opinion piece suggested that, over the long term, “companies that have relied on the Cayman Islands to escape Beijing’s reach will find it harder”.

VIEs are also controversial with some stock market analysts who are pointing out that investors technically do not own shares in Chinese companies but rather in the Cayman entities that have listed in the US.

Since 2015, a number of the US-listed Chinese companies went through so-called take-private transactions. These involve larger shareholders – often including the original founder of the company – voting in favour of delisting the company and offering to buy out the outstanding shares.

This has led to frequent litigation in the Cayman courts over the value of the companies, with minority shareholders typically suggesting that they were the victims of “low-ball offers” for their shares.

While the majority shareholders can push the deal through, minority shareholders are able to request a fair value appraisal from the Cayman court.

In one case, Shanda Games, the court determined the company was worth more than double than the price paid to minority shareholders.

In other cases, the subsequent higher valuations in Chinese stock market listings of companies suggested they were undervalued during the take-private transaction.

There are other contentious points around whether minority shareholders can dissent to certain mergers and the underlying company valuation in these transactions.

Despite these issues, demand for Cayman structures has continued unabated.

The ride-hailing company Didi Global Inc., which listed in New York in June, despite calls by Chinese regulators to delay its stock offering, is a Cayman Islands holding company that is backed by Japan’s SoftBank, Apple and other international investor groups.

The company raised $4.4 billion but its share price fell by more than 25% just days later after Chinese regulators ordered the company’s app to be removed from app stores in the country in a spat over data security.

The internet regulator said that Didi’s ride-hailing app had “problems of seriously violating laws on collecting and using personal information”.

China’s equivalent to Uber is now subject to a class action lawsuit by IPO investors who argue that the registration documents omitted material risks arising from the Chinese government enacting data security laws and regulations for the protection of personal information.

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