Background

Since the Trump administration began to impose tariffs on goods from China as a result of Section 301 Investigations, the Sino-U.S. trade relationship has deteriorated into an intense stage where both have been adopting sanctions and reciprocal actions. With the global breakout of the Covid-19 pandemic, the tension extends over other areas regarding investments and capital-raising activities between the United States and China- for example, the stock market. After a series of policies by both countries aiming to adopt stricter limitations over Chinese companies’ U.S. listings, the number of Chinese companies planning to list in the United States has plummeted from a record-breaking pace earlier this year, according to Bloomberg.

China’s Regulatory Movements

China’s data protection and market access regulations affect Chinese companies’ U.S. IPO decisions, which all start with a Chinese ride-hailing company.

On June 30, 2021, the company, Didi Global Inc. (Didi), debuted on New York Stock Exchange (NYSE). This high-profile IPO broke the time record of Chinese companies going public in the United States. However, after only 48 hours, the Cyberspace Administration of China (CAC) said on its website that it launched an investigation into the company under Measures for Cybersecurity Review 2020, issued by the CAC effective from June 1, 2020. This is the first time that the CAC has conducted an investigation based on the Measures. On July 4, the CAC announced the investigation result that Didi should be removed from app stores due to unlawful collection and use of personal data. Furthermore, on July 10, the CAC suddenly promulgated new Measures for Cybersecurity Review 2021, to everyone’s surprise. The 2021 Measures makes it harder for Chinese companies that hope to go public overseas by restricting the collection and use of personal information and data. Some significant modifications caught people’s attention. First, it provides that any company with access to more than a million users’ personal information shall apply for cybersecurity review before going public overseas. Second, it includes the China Securities Regulatory Commission (CSRC) in the review committee. Third, companies shall provide IPO documents as one of the review materials. Finally, the review concentrates on the risk that core data, important data, or large amounts of personal information are exported illegally. Moreover, it analyzes the exposure to such data or personal information that is impacted, controlled, or maliciously used by foreign governments after foreign listings. The recent data protection policies impede Chinese companies’ overseas IPO plans.

The issuance of “Negative List” 2021 on October 9 also struck those Chinese entrepreneurs who plan to raise funds by IPO in the United States. Special Administrative Measures for the Access of Foreign Investment are administrative rules restricting or permitting foreign investment into certain areas as rated by the National Development and Reform Commission (NDRC) and Ministry of Commerce (MOFCOM). The Negative List restricts or completely bans foreign investors from sensitive industries as an essential part of the Special Administrative Measures. If an industry is listed, a company in that particular industry either forgoes the opportunity of overseas IPO or adopts delicate corporate structures to overcome the barrier. Some companies may structure as Variable Interest Entities (VIE). The Negative List is updated yearly, reflecting China’s latest resolution to attract foreign investment while ensuring national security. Starting from 2018, the Negative Lists are gradually liberalizing foreign investment restrictions. However, the 2021 Negative List adds limitations on specific industries that have an abiding interest in going public on the U.S. exchanges: 

First, it provides that non-state-owned companies shall not engage in the news services industry, such as news collection, editing, and broadcasting businesses, live broadcast, and republishing news by foreign entities. Second, it shuts the door for certain training institutions to go public. Any institution providing curricular training for students of compulsory educational age shall not raise funds by IPO. Turning down the possibility of IPO directly in the text may be the harshest restriction ever composed in the Negative List, which shows the resolution of the Chinese government to regulate the education industry. Third, it names cryptocurrency mining and trading as prohibited. 

The United States’ Recent Response

Faced with China’s ever-changing regulations, the U.S. Securities and Exchange Commission (SEC) hit the headlines on July 30 with the statement of Gary Gensler, the Chair of the SEC. He asked the SEC to seek further disclosure requirements on Chinese issuers structured as Variable Interest Entities (VIE) before approving any registration. VIE is a traditional corporate structure used by China-based companies that want to raise capital offshore without the intervention of foreign investment restrictions and tax expenses. The China-based company incorporates an offshore shell company as the issuer. The shell company creates a wholly foreign-owned enterprise (WFOE) in mainland China through complicated transaction agreements. The China-based company then enters into contracts with the WFOE to transmit its profits. In this case, the offshore shell company becomes the “shadow company” and launches itself on U.S. exchanges.

According to the statement, the SEC requires additional disclosures from such issuers, such as “detailed financial information, including quantitative metrics”, and delisting if the Public Company Accounting Oversight Board (PCAOB) is unable to inspect the issuer. After a month of review of Didi’s IPO by China, the statement is easy to connect with the crackdown on Didi. Two reasons lead to the statement. First, the SEC wanted to fight back on the uncertainty of Chinese regulations and policies to protect U.S. investors, which is the core purpose of 1933 Securities Act and 1934 Securities Exchange Act. Didi’s review and punishment materially affect its performance on the exchange, which causes millions in losses for U.S. investors. The SEC believes that only transparency can protect against the unsophisticated investors’ irrationality. Disclosure reminds them that they are not dealing with a reputational China-based company but an offshore shell company. Second, it serves as the response to China’s stricter data protection regulations by emphasizing the importance of the full disclosure requirements. China’s strict scrutiny over cross-border data makes it harder for Chinese issuers to disclose material information regarding the company’s operation, which contradicts the full disclosure requirements of the SEC. 

Compliance Requirements from Two Jurisdictions

For a Chinese company that wishes to raise capital on the U.S. exchanges, compliance dilemmas and legal challenges arise from both jurisdictions. At the outset, the company’s business may fall into the scope of newly added foreign access restrictions of the Negative List 2021, under the which it has to be structured as VIE. Because of the dual identity of a China-based holding company and an offshore issuer, the company must comply with both states’ laws and regulations. Under the statement made on July 30 by the SEC, the candidate company shall make full disclosures, including detailed financial information containing cross-border data originating from the China-based company. The cross-border data transmission itself may invoke Article 2 of Measures for Cybersecurity Review 2021, which provides that data operators conducting data handling activities that influence or may influence national security shall conduct a cybersecurity review. Under Section 6 of Article 10, the review focuses on whether the important data or large amounts of personal information are affected, controlled, or maliciously used by foreign governments.

Since no public reviewing criteria or guidance exists yet, there is a risk that the cross-border data further inspected by the SEC during the registration period would be considered illegal under the Measures. Apart from the Measures, China’s Data Security Law, effective from September 1, 2021, poses the risk of implicating information that may constitute important data to the SEC. Under Article 36 of the Law, a China-based company may be responsible for providing data preserved in mainland China to foreign law enforcement institutions unless otherwise authorized by the relevant Chinese authority. Established under Section 4 of the Securities Exchange Act of 1934, the SEC aims to enforce the federal securities laws. Therefore, the SEC would likely be considered a foreign law enforcement institution, and registration would thus violate the Data Security Law of China. However, with the passage of the Holding Foreign Companies Accountable Act in 2020, Chinese issuers failing to share audits or inspections could be delisted after three years, beginning in 2021. Consequently, chances are slim for companies to be compliant under both jurisdictions, leading to mass cancellation of U.S. IPOs.

Conclusion: The Future

The winter of Chinese companies going public in the United States has inevitably come. What would the future be like? First, the United States is busy implementing the promise of a stricter oversight policy. On November 4, the SEC approved the proposal filed by the PCAOB, which creates a new framework to disqualify audit work conducted by foreign-based accounting firms, which might cause delisting of Chinese companies if they do not abide by it. The good thing is, the door would not completely shut. On August 1, the CSRC spokesperson made a statement to ease the tension between Sino-U.S. securities regulations and seek cooperation with the SEC. The statement emphasizes that China always respects companies’ choices of where to raise capital if they comply with the existing domestic laws. The CSRC said it would cooperate with the SEC to work out regulatory problems. What’s more, the statement reveals forthcoming events. It mentioned that China will take steps to launch more practical opening-up measures to urge the high-quality developments of its domestic capital markets. The launch of the Beijing Stock Exchange on November 15 demonstrates that the Chinese government is determined to do so. A financial commentator from Taiwan commented that creating a new domestic stock exchange shows China’s resolution to upgrade its capital markets and eliminate the dependence of the United States capital markets. The regulatory developments depend on a lot of factors, such as the operation of the Beijing Stock Exchange, increasing tensions with Taiwan, and the virtual talk between Biden and Xi that happened on November 15.

To sum, as China develops its new domestic exchange and the United States tightens its oversight policy, the golden era of Chinese companies going public on U.S. exchanges has passed. It probably will never return, at least in the near future.

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Xinyun Luo is an LL.M. Digital Advisor for the Georgetown Journal of International Law. Before Georgetown, she interned at Baker McKenzie working for the Business Compliance Team under International Merger and Acquisition Department in Beijing. Prior to this experience, she graduated from East China University of Political Science and Law. Her interest focuses on international business transactions and securities law.