New | Proposed rules on variable interest entities deter HK listing
New regulations may see variable interest entities face restrictions in floating in city and encourage them to set up in Shanghai instead
Proposed regulations on variable interest entities (VIEs) in a new draft of China's foreign investment law may put more obstacles in the way of companies with such structures seeking to list in Hong Kong while encouraging e-commerce firms to incorporate in the Shanghai free-trade zone, lawyers and accountants said.
Chinese companies have been using VIE structures to list overseas, allowing foreign capital to get around Beijing's foreign ownership restrictions on some sectors, such as the internet industry. Alibaba Group Holding, Tencent Holdings and Baidu all use such structures.
"In some cases where [China] has imposed shareholding restrictions on foreign investments in certain industries, the VIE structures may shield the shareholders in real control," said Roy Lo Wa-kei, a deputy managing partner of accounting firm Shinewing. "The proposed law would require more disclosure.
"The government could gather more data from VIE firms through the new regulation. But the risks for the companies would be they might have to reveal any practice of non-compliance covered by the VIE structures."
The draft of the foreign investment law published by the Ministry of Commerce would legitimise VIE structures but also require companies using such structures to prove they were ultimately controlled by Chinese investors, otherwise they would be treated as foreign-invested enterprises and might fall foul of a "negative list" of industries with foreign investment restrictions.
The law is now in a consultation period, with the deadline for submitting comments on February 17.
Haiwen & Partners, a Beijing-based law firm, said the regulations on VIEs could lead to obstacles for firms with such structures seeking to list in Hong Kong.
"For companies with VIE structures that are not yet listed, the clauses on [Chinese] investors selling stakes in offshore companies to foreign investors could be subject to restrictions in the law on foreign investments, such as foreign ownership," Haiwen said in a note to clients. "In some cases, the clauses could not be implemented, thus there may be legal obstacles if they want to list in Hong Kong.
"More disclosure would also be required when they list in the United States.
"For companies with VIE structures that are already listed, restrictions on the transfer of [mainland] shareholders' shares in foreign investment would severely reduce the liquidity of their shares, and affect the valuation of such companies."
Paul Gillis, a professor at Peking University's Guanghua School of Management, said Alibaba, Baidu and other firms with dual-class share structures would benefit in the proposed regulatory change as dual-class share structures could help keep the company founders in control, which in turn would ensure their firms were not deemed foreign-invested enterprises.
However, companies such as Tencent, with VIE structures but without dual-class shares, might be treated as foreign-invested enterprises.
"The proposed law encourages companies to set up using a dual-class share structure," Gillis said. "Hong Kong does not permit such companies to list, which will be a huge win for New York."
The US exchange permits dual-class share structures, which was why Alibaba listed in New York instead of Hong Kong.
"The consultation paper points to a positive direction that VIE structures will be formally recognised by the [mainland] government and governed by the proposed new legislation," a Tencent spokesman said. "As this is in the early stage of consultation, we are monitoring the progress closely."
Alibaba declined to comment.
In order not to loose access to the Chinese market due to the regulatory change, e-commerce companies without ultimate mainland control might want to incorporate in or move their VIEs to the Shanghai free-trade zone, which had indicated it would allow wholly owned foreign investment in e-commerce, Gillis said.
Paul Weiss, another law firm preparing to submit comments on the draft law, said more clarity was needed on whether a company would be deemed to have ultimate Chinese control.
"For example, what if the [Chinese] and foreign investors both satisfy the control definition? What if a founder of a VIE structure has de facto control over the business but only holds a small minority interest in the foreign parent entity controlling the VIE structure and does not have special board appointment rights?" it said in a note to clients.
