China to toughen rules for tech companies seeking foreign funding

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China is preparing a blacklist that should tightly restrict the main channel that start-ups use to attract international capital and register abroad, with the aim of limiting the role of foreign shareholders in the next generation of companies technologies of the country.

The blacklist will target new companies in sensitive sectors that use so-called variable interest entities to manage their activities in China, according to four people familiar with the matter. They did not expect the changes to apply to existing businesses.

VIEs are a legal structure that has been used for decades by Chinese tech groups – including industry leaders Alibaba and Tencent – to bypass foreign investment restrictions and raise billions of dollars from investors. international.

The list, which is being formulated by Chinese authorities including the state planner, the Ministry of Commerce, the securities regulator and the central bank, follows a crackdown on the tech sector during the l ‘last year that culminated in an announcement last week by ridesharing group Didi Chuxing that it was delisting from the New York Stock Exchange.

The scope of the list was not yet clear, but people familiar with the matter said the new negative list for VIEs could include areas that are data-intensive or involve national security concerns. The United States has taken similar steps to restrict Chinese investment in Silicon Valley startups.

Chinese authorities have accused the country’s large Internet consumer groups of focusing on eliminating competition instead of helping the country catch up with the United States in semiconductors and other advanced technologies.

Regulators have taken antitrust and data security measures against major companies, starting with billionaire Jack Ma’s Ant Group, which was forced to cancel what would have been the world’s largest initial public offering last year. .

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Two people close to financial regulators said the negative list was not intended to affect existing companies that used the VIE structure. Instead, it aimed to ensure that future national champions vital to the country’s economy would not be dominated by foreign shareholders.

“The VIEs are not completely dead, but they are essentially [for future purposes], said one of the locals.

“In the future, foreign investors will be able to invest in traditional industries rather than technology,” the person said, adding that these industries did not need to use the VIE structure to attract foreign capital.

Chinese tech groups turned to VIEs two decades ago, but authorities have not formally addressed the complicated legal structures, preferring to leave them in a regulatory gray area.

The system has enabled large investors such as SoftBank of Japan and Sequoia Capital China to funnel billions of dollars from foreign pension funds and sovereign wealth funds, family offices and university endowments into the most popular internet start-ups. promising from China.

This is done by taking shares in offshore holding companies established in the Cayman Islands, which then enter into a series of contracts with the Chinese onshore companies and their Chinese national founders, who own their shares.

When successful, these companies launch their offshore shell companies in the United States or Hong Kong. Of the 241 Chinese companies listed in New York, 79% use VIEs to manage their business in China, according to a Financial Times review of Capital IQ data.

Visualize a Chinese variable interest entity

Beijing could publish the blacklist as early as this month, two people said. Another person said the list’s publication may depend on how the United States handles the new rules for Chinese companies doing business in New York.

China’s securities regulator said on Sunday that a Bloomberg News report that the country was banning VIEs from overseas IPOs was false, adding that it was also not pushing companies using the structure to withdraw from US stock exchanges.

Chinese authorities have banned VIEs from investing in the country’s education sector this year. Foreign investors have also generally avoided using the structure for the more sensitive industries, such as defense or biotechnology companies that process DNA data.

Lawyers and investors said a negative list that existing grandfathered structures could help fully legitimize VIE legal contracts governing hundreds of Chinese tech companies.

Alex Roberts, a lawyer at Linklaters in Shanghai, said the Chinese government attempted to regulate VIEs six years ago, drafting a law that would have reclassified them according to their ultimate controllers.

“But the proposal was ultimately shelved. . . probably because of the enormous economic and social benefit that some of the biggest Chinese companies which use these legal constructions bring to the country ”, he declared.

The state planner, the Commerce Ministry, the securities regulator and the Chinese central bank did not immediately respond to a request for comment.

Additional reporting by Andy Lin in Hong Kong

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