A securities regulation reform is taking place in China. The Chinese regulators are trying to entice its foreign-listed tech giants back to the home stock exchanges—the Shanghai Stock Exchange and Shenzhen Stock Exchange.
Many Chinese tech companies, such as Alibaba, Tencent and Baidu, have earned a place alongside the most powerful tech giants in the world. But most of these Chinese tech giants were not listed on Mainland China’s stock exchanges. For example, Tencent was listed on the Hong Kong Stock Exchange in 2004. ((Nisha Gopalan, Tencent Prices IPO At Top End of Range, WSJ (June 14, 2004), https://www.wsj.com/articles/SB108715183007335644.)) Another pioneer, Baidu, the largest search engine company in China, was listed on NASDAQ in 2005. ((Michael Liedtke, Baidu Shares Quadruple, Prompting Comparisons to Google, Wash. Post (Aug 6, 2005) http://www.washingtonpost.com/wp-dyn/content/article/2005/08/05/AR2005080501754.html.)) Alibaba, whose business is slightly similar to Amazon, was listed on the New York Stock Exchange in 2014, which was the world’s largest IPO at that time. ((Ryan Mac, Alibaba Claims Title For Largest Global IPO Ever With Extra Share Sales, Forbes (Sept. 22, 2014) https://www.forbes.com/sites/ryanmac/2014/09/22/alibaba-claims-title-for-largest-global-ipo-ever-with-extra-share-sales/#7a46bed28dcc.))
Why did the tech giants choose foreign markets in the first place? There are mainly three reasons, and the first is timing. To be listed in Chinese stock exchanges, the issuance must be approved by the Chinese Securities Regulation Commission (“CSRC”), whose IPO supervision committee performs rigid, time-consuming evaluations before approving an issuance. ((Jane Li, Why Chinese companies are flocking to the US for a listing, South China Morning Post (Oct. 19, 2017) http://www.scmp.com/business/china-business/article/2115971/ant-financial-backed-online-lender-qudian-surges-nyse-debut.)) It takes months or even years for a successful IPO, and the likelihood that an issuer will receive approval is much less predictable than on the U.S. exchanges. Such a marathon process is unacceptable for technology companies that need immediate funding.
Second, the Chinese regulators are more paternalistic—they want to make sure that only companies that have already made great achievements are listed. Therefore, the standards for getting listed are high. The most devastating rule is that the potential issuer must have net earnings of approximately USD $5 million in the past three years. ((Id.)) However, many emerging companies during their growth stage have a negative balance sheet because they heavily rely on outside investments and have not yet made a net profit. If they had already obtained sufficient cash flow, why would they still need to raise funds via a public offering?
The third issue lies in the corporate structure of tech giants, the Variable Interest Entity (“VIE”) structure. This structure was created because most emerging internet companies relied heavily on foreign venture capital and fund investments during their beginning stages, but the Chinese government heavily regulates foreign investment in the internet industry. ((See Jennifer Surane, China’s Oversea IPOs, Bloomberg (Mar. 30, 2016), https://www.bloomberg.com/quicktake/chinas-fraught-ipos.)) Put simply, the VIE structure turns a Chinese company into a foreign company by setting up a shell company in, for example, the Cayman Islands. Then, the shell company can safely attract foreign investments and transfer capital back to the parent company. Although Chinese regulators allowed such companies to operate, it was still difficult for them to go public because they are operating in a legal grey area.
That being said, it is very likely that these three problems no longer present significant issues after the securities regulation reform this year. On March 30, 2018, CRSC published the Guideline on Emerging Companies’ Stock Issuance by Chinese Depository Receipts (“Guideline”). This Guideline will give emerging companies that were previously listed on foreign exchanges a chance to list on the Chinese exchanges through the Chinese Depository Receipts (“CDR”) system. ((Daniel Ren, Beijing Fast Tracks Foreign-listed Chinese Tech Firms’ A-share Flotation with CDR System Launch, South China Morning Post (Mar. 30, 2018) http://www.scmp.com/business/companies/article/2139703/beijing-fast-tracks-foreign-listed-chinese-tech-firms-share.))
Depository receipts are nothing new. They represent surrogate securities that allow domestic investors to hold overseas shares. For instance, American Depository Receipts (“ADS”) package overseas equities and sell them on U.S. exchanges. The underlying securities are held by overseas financial institutions. Similarly, with China Depository Receipts issuers’ shares will be transferred to overseas banks and then the banks will sell those shares on the respective foreign exchanges. ((Id.))
If the tech giants are listed on the Chinese exchanges, they are likely to be welcomed by domestic investors who understand the companies’ values and reputations much better than foreign investors. Most importantly, domestic investors, at least when considered in aggregate, have really deep pockets. Importantly, however, the tech giants will still face the volatility of China’s capital markets and heavy-handed government regulations.