China to Close Loophole Used by Tech Firms for Foreign IPOs

China is planning to ban companies from going public on foreign stock markets through variable interest entities, according to people familiar with the matter, closing a loophole long used by the country’s technology industry to raise capital from overseas investors.

The ban, intended in part to address concerns over data security, is among changes included in a new draft of China’s overseas listing rules that may be finalized as soon as this month, said the people, asking not to be identified discussing private information. Companies using the so-called VIE structure would still be allowed to pursue initial public offerings in Hong Kong, subject to regulatory approval, the people said.

The China Securities Regulatory Commission stated on its website on Wednesday that a media story claiming that businesses utilizing the VIE structure will be banned from listing overseas is false, without providing any specifics.

Companies currently listed in the United States and Hong Kong that utilize VIEs would need to make changes to their ownership structures to make regulatory evaluations more transparent, especially in sectors where foreign investment is prohibited, according to the sources. It's unclear whether this would imply a reorganization of shareholders or, more dramatically, the delisting of the most sensitive companies — measures that might reignite worries of a technological decoupling between China and the United States. The proposed regulations' specifics are still being debated and may change.

Following the New York IPO of ride-hailing giant Didi Global Inc., which went forward over regulatory worries, the reform would be one of Beijing's most significant efforts to tighten down on abroad listings. Since then, authorities have moved quickly to block the influx of companies wanting to go public in the United States, effectively shutting off a road that has earned billions of dollars for technology companies and their Wall Street investors.

It's all part of a year-long effort to slow China's internet sector's rapid rise and what Beijing has called a "reckless" spread of private capital. Banning VIEs from international listings would eliminate a loophole that has allowed technological powerhouses like Alibaba Group Holding Ltd. and Tencent Holdings Ltd. to avoid foreign investment rules and list offshore for the past two decades. It might stymie the plans of companies like ByteDance Ltd. to go public outside of the United States.

A request for comment from the China Securities Regulatory Commission was not immediately returned.

While a blanket ban on the VIE structure isn't being considered, a block on international listings and increased scrutiny for Hong Kong IPOs would mean the model would no longer be a viable option for many entrepreneurs to get funding. Regulators have already urged several investment banks to halt working on new VIE agreements, according to a source familiar with the situation.

The loss of the VIE method would endanger a lucrative line of business for Wall Street banks, which have helped almost 300 Chinese companies raise $82 billion in the United States through first-time share sales over the last decade.

Given their precarious legal position, VIEs have long been a source of concern for worldwide investors. The VIE framework, which was pioneered by Sina Corp. and its investment bankers during a 2000 IPO, has never been publicly acknowledged by Beijing.

Nonetheless, it has allowed Chinese corporations to circumvent foreign investment restrictions in sensitive industries such as the internet. The structure permits a Chinese company to move earnings to an offshore organization with shares that international investors can buy, such as the Cayman Islands or the British Virgin Islands.

While the structure has been employed by practically every major Chinese internet company, it has become more concerning for Beijing as technology companies have entered every aspect of Chinese society and accumulated vast amounts of customer data. The Cyberspace Administration of China announced in July that companies with more than 1 million users' data must get clearance before pursuing listings in other countries.

If it is determined that the listing may have a possible impact on national security, a cybersecurity study may be needed for corporations considering IPOs in Hong Kong. The adjustment hasn't deterred data-rich businesses like Cloud Village Inc., a music streaming service, and SenseTime Group Inc., an artificial intelligence company, from expanding in the city.

Authorities had little legal options until recently to halt sensitive international offerings, like the Didi IPO. According to those familiar with the situation, officials have requested the ride-hailing company to prepare a strategy to delist from the United States, which is an unusual request.

According to statistics provided by Bloomberg, only one mainland-based Chinese business has priced an IPO in the United States since the crackdown on Didi began in early July, while 29 have issued shares in Hong Kong. NetEase Inc.'s Cloud Village will make its debut in the city on Thursday, while SenseTime's much-anticipated IPO is set to begin trading in the week of December 13.

China fully supports companies that pick Hong Kong as their principal listing venue, according to a top official at the securities regulator. Shen Bing, director-general of the CSRC's department of foreign affairs, stated that China does not believe delisting from the US is healthy for firms, global investors, or the China-US relationship.

The United States has mimicked China's increased regulatory vigilance. The Securities and Exchange Commission has put a hold on planned Chinese company IPOs until adequate disclosures of political and regulatory risks are provided, warning that investors may not realize they are purchasing shares in shell firms rather than direct interests in enterprises.