A Review of the CSRC’s New Rule on the Pilot Programme of Share and Depository Receipt Issuance by Innovative Enterprises

Major listing venues worldwide seem to have entered into something of an arms race. Not long after the Hong Kong Stock Exchange’s (“HKSE”) consultation paper on the listing regime for companies from emerging and innovative sectors and the unusual “non-IPO” listing of Spotify on the New York Stock Exchange, the China Securities Regulatory Commission (or “CSRC”) sought to claim its fair share of the competition with a new opinion paper. The paper, Several Opinions on Launching the Pilot Programme of Shares or Depository Receipts by Innovative Enterprises (or the “Opinion Paper”), was put together by the CSRC and promulgated by the General Office of the State Council, giving it a high level of authority. Since coming into the spotlight on March 30, 2018, it has fuelled another race between law firms to remark on, interpret, or translate it while the essence of its significance has not yet been concisely captured, regardless of its eye-catching title. This article seeks to do just that.

I.

A Stream of Thoughts on the Opinion Paper by a Market Participant

The idea of the Opinion Paper, in a nutshell, is to set the regulatory baseline of a new regime under which selected PRC based enterprises (in the Opinion Paper, the “Pilot Enterprise”) in seven specific industries will be allowed to directly offer A shares (to be explained in Part 2) or Chinese Depository Receipts (“CDR”) in the PRC and list on PRC stock exchanges, regardless of the fact that the issuers may be incorporated outside of China, may have listed overseas, or, though incorporated in the PRC and unlisted, still remain unprofitable or have accumulative loss. Apparently, this new regime is to outdate the decades-old practice of A share issuance and listing, making it potentially a rather ambitious breakthrough. However, it is still within the legal framework of the Securities Law framework of the PRC.

The below diagram seeks to illustrate a professional market participant’s path in considering the possibilities of a company’s options under the new regime:

To help clarify this diagram, the following footnotes explain the above five stages:

1. The company has to be primarily PRC-based ideally operating in one of seven specific industries – namely internet, big data, cloud computing, artificial intelligence, software and integrated circuits, high-end equipment manufacturing, and biotech. Originally focused on direct financing of mainland enterprises, China’s equity market was never meant to be an international hub for attracting multinational companies. This is even truer as a result of the current PRC central government’s policy of emphasising its support of China’s non-financial economy. As further clarified below, whether listed or unlisted, red-chip or not, the Company has to be PRC-based. The industries, though not meant to be an exhaustive list, most probably will be limited to the seven designated sectors for the foreseeable future. In this sense, the new regime to be opened by the pilot programme is not meant to be an “International Board (国际板)”, but essentially, the rebirth of the once abortive “Strategically Innovative Board (战略新兴板)”.

2. The company can be listed or remain unlisted. If listed, it has to be a red-chip enterprise (the myth of “red-chip” will be busted in Part 2 of this article.). The Pilot Enterprises that are eligible for admittance include listed red-chip companies, unlisted red-chip companies, and PRC-incorporated companies. Therefore, an overseas listed company may still be able to offer A shares or CDRs in the PRC, as long as it is red-chip structured. An unlisted domestic company can naturally do so. While, for an unlisted red-chip company, it actually has two options: to choose an offshore entity for offering A shares or CDRs, or use its PRC-incorporated entity to offer A shares. If it chooses the latter, it no longer needs to unwind the red-chip structure, as had been required by the CSRC since 2009.

3. The foremost entry barrier for a listed Pilot Enterprise is that market capitalisation has to be RMB200 billion or more, regardless of its revenue or profit. After setting this bar and conducting a roll-call of the overseas listed red-chip companies, there may only be eleven companies that fit the criteria, among which, the ones not yet listed in the PRC and in “innovative” sectors are Alibaba, Tencent, China Mobile Communications Corporation, Baidu, JD.com, Netease, and China Telecommunications. An unlisted Pilot Enterprise must either (i) generate RMB 3 billion in revenue and achieve RMB20 billion in valuation or (ii) have rapid income growth, own world-leading technologies, and be ahead of market competition. Although in practice a 20 billion valuation is achievable, the 3 billion in revenue requirement would be very difficult to meet simultaneously. Also if an unlisted company is to follow the non-quantified standard, it will be intensely scrutinised, and frankly, find it almost impossible to be considered for such a carefully crafted pilot programme.

4. The CSRC will establish a special counselling committee staffed by authoritative industrial experts, renowned entrepreneurs, and senior investment experts. The aforementioned three stages of filtering are most likely done by this counselling committee, before the primary decision on candidates of Pilot Enterprises is made. Afterwards, the CSRC will determine the exact Pilot Enterprises, which can then move forward to submit application for issuance of A shares or CDRs to be reviewed and subject to a final decision by the CSRC. 5. The company should then consider which securities it wants to offer, A shares or CDRs. Although an evaluation of pros and cons may be involved, which is explained further in Part 3(ii), let’s first refer back to Stage ○2 and consider this question only from the perspective of theoretical possibilities of the different types of Pilot Enterprises. For an already-listed red-chip company, A shares or CDRs are both options. The Opinion Paper is silent about whether a company can choose both A shares and CDRs, but it may be the case that the two are mutually exclusive. For an unlisted red-chip company, there are two options: to uses its offshore entity for issuing A shares or CDRs, or issue only A shares domestically in the same way as a non-red-chip domestic company.

II. Some Jargon-Translation and Clarification

(i) What is “red-chip”?

“Red chip” itself is a market-created business jargon. Although many people seem speak about it on daily basis, it is subject to many misconceptions outside of a very small professional community. Even among the market practitioners, the term carries ambivalent meanings. For example, the HKSE used to define a red chip company as a company that has at least 30% of its shares in aggregate held directly by PRC entities and/or indirectly through companies controlled by them, with the PRC entities being the single largest shareholders in the aggregate; a company may also be a red chip company if less than 30% but more than 20% of its shares are held directly and/or indirectly by PRC entities, and there is a strong influential presence of PRC-linked individuals on the company's board of directors. The HKSE now simply says red chip companies are enterprises that are incorporated outside of mainland China and are controlled by mainland government entities. Hang Seng Indexes Company Limited (Hang Seng Indexes) deems that a red chip refers to a company with a minimum of 30% shareholdings held by mainland entities (including state-owned organizations, and provincial or municipal authorities of the mainland) and at least 50% of their sales revenue (or profits/assets if more relevant) derives from the mainland. In other words, the term “red chip” generally refers to stocks that are traded on overseas stock exchanges and are issued by companies established outside of the PRC but tied to business interests mainly within the PRC and controlled by PRC legal or natural persons, or a company structure thereunder. In this sense, to decide whether a company is “red chip” or red-chip structured, the key is to weigh both its ownership and its company structure.

However, in the Opinion Paper, the definition only considers the factors of company structure, i.e. red-chip enterprises are foreign-incorporated enterprises whose main business activities are based within the PRC. Without ownership requirement, the inclusion of this term will be enlarged significantly. It is still unclear whether the CSRC will add the ownership requirements in the coming affiliated documents. If not, foreign-owned or foreign-controlled enterprises that centre their main business activity in the PRC will at least theoretically qualify as Pilot Enterprises. For instance, a branch of Greater China’s business in an international technology conglomerate may even qualify.

(ii) The only shares available to Pilot Enterprises will be A shares

The Opinion Paper provides that Pilot Enterprises will be allowed to directly offer and list shares in the PRC. What it is not clear is the category of the shares to be offered. Pursuant to PRC laws, there are two types of shares that can be publicly offered and traded in the PRC, namely, A shares, i.e. shares offered by PRC companies and priced in RMB, and B shares, i.e. shares offered by PRC companies and priced in foreign currencies. However, according to the press release of the CSRC regarding the Opinion Paper, a CSRC official made it clear that if Pilot Enterprises are to offer shares, they shall abide by CSRC’s two rules governing A share offerings, namely the Measures for the Administration of Initial Public Offering and Listing of Stocks and the Measures for Administration of Initial Public Offerings and Listing of Stocks on Chinext (collectively the “A-share Listing Rules”). This means that the shares to be offered by Pilot Enterprises, if any, under the pilot programme, will only be A shares.

According to the A-share Listing Rules, an issuer must adhere to a number of criteria. Notable examples being, that the issuer must at least be a PRC-incorporated joint stock corporation, must be profitable, and not be suffering accumulative loss. The CSRC has decided to amend these two rules to offer special treatment exclusively to Pilot Enterprises. It is presumed that the amended A-share Listing Rules will be promulgated and effective at the same time with the CSRC’s implementation regulations of the pilot programme.

(iii) Depository receipts with Chinese characteristics

Even to the most-favoured Pilot Enterprises, CDRs can only be offered by the offshore entities of red-chip companies. The CDR arrangement in the Opinion Paper largely borrows from international securities markets, esp. the U.S. capital market, and the matured experiences of depository receipts (“DRs”), but with certain Chinese characteristics. This article is not going to rephrase the typical DR arrangements from the Opinion Paper, under which the concerned parties include issuer, depository agency, custodian agency, underwriter, clear house, and exchanges. Instead, I only highlight the Chinese characteristics of the CDR arrangement as follows:

(a) Holders of underlying securities. Different from typical DR arrangements, where DRs are deposited to a custodian agency which is usually in the same jurisdiction as the issuer, the CDR is said to be held by the depository agency within the jurisdiction of the PRC. If this is a intentionally set arrangement, PRC government’s wishful reaching to this unfamiliar area might have played a part in this particular arrangement, though it may have even further implications, one being that this means the depository agency within the PRC is going to directly hold securities issued by an offshore company, and another being that the PRC government may affect the working mechanisms of exchange between CDRs and underlying securities. If a PRC depository agency holds foreign securities, pursuant to PRC laws, a series of procedures for overseas direct investment and foreign exchange need to be completed. As such, the affiliated policies of or between the NDRC (National Development and Reform Commission), MOFCOM (Ministry of Commerce) and SAFE (State Administration of Foreign Exchange) will probably follow. Meanwhile, if the holder of underlying securities of the CDR is a PRC entity, the exchange between underlying securities and CDR will just be between persons in the PRC, which will certainly make the exchange much easier since it does not necessarily involve foreign exchange issues.

(b) Governing law and dispute resolution. The governing law of depository agreements has to be PRC laws. And dispute arising therefrom shall only be submitted to PRC courts, to the exclusion even of arbitration.

(c) Exchangeability between underlying securities and CDRs. The Opinion Paper defers the question of exchangeability to the CSRC through subsequent implementation rules, perhaps because it is such a complicated and somewhat sensitive issue for a country having undergone decades of foreign exchange control. However, as said above, if the underlying securities have to be held by a PRC depository agency, the exchange from CDRs to underlying securities may not involve foreign exchanges. Even so, it is widely believed that the CSRC may simply not allow exchangeability, or at the very most only allow limited exchangeability (e.g. a one-way exchange). Nonetheless, we believe the exchange from CDRs to underlying securities is not suffering from material hurdles under the current legal framework, while the other way around would prove much more challenging.

(iv) Governing laws and jurisdiction

This point, together with the following (v) and (vi) are only applicable to red-chip issuers (listed companies and the offshore entities of unlisted red-chip enterprises).

Similar to the practice of international securities markets for overseas issuer, the Opinion Paper provides that a red-chip company’s shareholding structure, corporate governance, and compliance can be governed by the laws where it is incorporated, while the offering, listing and trading of its securities within the PRC shall be applied to PRC securities law. However, it is further provided that the red-chip issuer’s arrangements of investor protection overall shall not be inferior to the ones required by the PRC. However, there may be no clear standards of such overall judgement thus the decisions are almost certainly subject to case-by-case reviews.

(v) Use of proceeds

It was once rumoured that the proceeds of CDR issuance by red-chip enterprises would not be allowed to exchange and remit out of China, and not be used by onshore entities. The Opinion Paper explicitly provides for the possibility of either exchanging and remitting proceeds out of China, or of using them domestically. Since CDRs are to be held by PRC depository agencies, and both shares and CDRs are required to be collectively registered with, deposited to, and cleared by the China Securities Depository and Clearing Co., Ltd., we believe the remittance of proceeds out of China should not be a big issue. What may be more complicated is the repatriation of funds back to China if CDRs are allowed exchange to underlying securities and further go listed on international securities markets. That may be one reason the CSRC treats exchangeability with caution. (vi) Financial report

The Opinion Paper provides that (i) Pilot Enterprises shall document its fiscal period, and (ii) its financial report should either be produced by PRC GAAP or under other Ministry of Finance recognised accounting rules to the same effect, be produced by IFRS or US GAAP, and provide differential adjustment information in accordance with PRC GAAP. This is actually quite a flexible arrangement for red-chip companies – for one thing, the fiscal period needs not to be same as a calendar year, as current PRC-listed companies have (to be clear, calendar year as fiscal year currently is not mandatory but a tacit requirement) to adhere to; for another, accounting rules other than the one used by PRC GAAP are acceptable.

III. Some Intriguing Ambiguities

(i) The true purpose and a possible slippery slope

A listed company and an unlisted company under the Opinion Paper are polar opposites. If listed, a company’s market capitalisation needs to be a whopping RMB 200 billion, while, if it happens to remain unlisted, it only needs to have a valuation of 1/10 (RMB20 billion) that of the listed companies (RMB200 billion). This essentially reveals the CSRC’s true purpose in persuading the relatively large amount of unlisted innovative companies (the so-called “unicorns”) into choosing the domestic capital market as their first listing venue. However, the slippery slope may be just around the corner – a listed red-chip company that is definitely not qualified may be incentivised to finish privatisation and become an unlisted company, which in turn may qualify. A simple fact of delisting can change its situation completely. This is just like the once rife practices of a number of former red-chip companies, that delisted from overseas equity markets, unwinding their red-chip structure, to get listed in A share markets (IPOs or through merger), in order to enjoy the absurdly high valuation increase. Such practices were later halted by the CSRC by window guidance. The impulse of many listed red-chip companies seeking the differentiated treatment of unlisted companies may face yet another ice bucket from the CSRC. (ii) CDRs are more favoured, for now

The CSRC may be more ambitious than previously imagined. For one thing, before the Opinion Paper, the message of permitting CDR issuance by red-chip enterprises was widely spread. The Opinion Paper does not stop at CDRs, but also provides the possibility of direct share issuance by the non-PRC entities of red-chip enterprises. However, the CDR remains more favoured. Not only because the CSRC official has indicated the policy to promote CDR issuance, but throughout the Opinion Paper the CDRs are systemically preferable compared to shares.

The following chart may give an idea of this preference:

It appears the CSRC, by offering two sharply contrasting options, somewhat tries to convince red-chip companies to choose CDRs rather than shares. Considering both CDR and shares are to be offered to investors in the PRC and traded publicly, and CDRs have been explicitly defined by a CSRC official as a type of basic security, similar to ordinary shares, rather than a derivative, it should carry the same weight and have the same effect as shares. Thus, the reason why the new regime is favouring CDRs over shares is anybody’s guess.

(iii) The possibility of a second listing

This is particular to the choice of a Pilot Enterprise (specifically, a red-chip company) doing a second listing on an international securities market after its offering of CDRs or shares under the new regime. The Opinion Paper has not touched upon this issue. We also believe subsequent implementation rules probably would not explicitly prohibit red-chip Pilot Enterprises from offering shares or DRs and listing them on other securities markets. There are at least two reasons to make such assumption: (a) the issuance of securities and corporate governance of a foreign entity shall be subject to the laws of the jurisdiction in which the foreign entity is located, and if the board or shareholders of that company make the decision to publicly offer shares outside of China, it is against the PRC government’s coherent policy to explicitly say no to such arrangement without solid basis in international law; and (b) there are and still will be lots of private red-chip companies seeking to do overseas listings, meaning that barring this approach would impact too many interest groups and do considerable collateral damage to the overall financial environment of PRC companies.

(iv) From cherry-picking to beauty contest

Taking into consideration of the background of the Opinion Paper, the small number of enterprises potentially qualified (both listed and unlisted) and PRC government’s proven coherence of promoting various pilot programmes previously, it may be safe to assume that the opening of the pilot programme is almost certain to be limited to some pre-selected companies within a shortlist. To some extent, the criteria and thresholds of Pilot Enterprises set by the Opinion Paper may even be reverse-engineered in light of such selected companies. Since the standards of the CSRC in making such primary selection of the shortlist will probably remain non-public along with the shortlist itself, the few companies obviously qualified may be the first to receive signals and submit applications accordingly, in which sense the pilot programme indeed starts as “invitation only”. After the first batches of experiments, if things go right, the pilot programme may be further promoted to include more companies and finally evolve to an “application-review-decision” system, just as the current regime of A-share listing. Till then, the special counselling committee will be just another internal procedure of the CSRC before the regular A-share listing review process, though with murkier standards and broader discretion. It may not be a safe assumption that they will make wiser selections for really innovative enterprises to stand out.

IV. The Possible Clash of Policies

One, or arguably the most conspicuous, breakthrough of the Opinion Paper is the acceptance of variable-interest-entity structure (“VIE”) - namely, that VIEs, as a type of red-chip enterprise, are also allowed to publicly offer CDRs or even shares and get listed in the PRC. This is actually the first ever official acknowledgement of VIEs and their validity on a state level. Not to mention that the Opinion Paper, though as a CSRC-drafted rule, has been approved by the State Council and forwarded by it. As so many central governmental agencies have allegedly shown their concerns regarding VIE structure (most notably, the widely circulated total repudiation of VIEs by the CSRC in 2011), although the stance the CSRC takes is only in a rule governing capital markets, its impact will be much farther-reaching than that.

As is widely known, the VIE structure for most adopters serves as a get around for the restrictions of foreign investments in certain industries, notably, value-added telecommunications, education, medical services, and others. The HKSE even made a listing decision (HKEX-LD43-3), amending it several times, whereby the HKSE required that the VIE-structured applicant must prove that its operation company (the VIE company, aka “OPCO”) is controlled through a structured agreement by foreign incorporated listing entities only operating in industrial sector that limit foreign investments. Therefore, the licenses operating its business could not have been possessed if the OPCO is a foreign invested enterprise, or “FIE”. Even the Securities and Exchange Commission, which is supposed to review the listing application in disclosure-based standards, needs applicants to at least provide certain justifications for its VIE structure. However, the underlying rationale for setting up VIEs is exactly why the VIE structure must have sounded so alarming to the PRC government - namely, that possible foreign ownership of socially vital industrial sectors have strong national security implications. It is only because of the wide-spread market practices and the large number of interest groups involved that the central government remained purposefully blind to the VIEs. The CSRC was no exception.

The CSRC takes the stance to interrupt the catch-22 situation. Although approved by the State Council and forwarded by the General Office, the Opinion Paper is still a CSRC-drafted document. If the inconsistent attitudes towards VIEs and the relevant industrial policies of foreign investment are not carefully managed, or other central governmental agencies do not perfectly coordinate, the acceptance of the VIE by the Opinion Paper and the following implementation rules of the CSRC may clash with the other governmental policies.

The draft Foreign Investment Law of the PRC further complicates this issue, solving some problems but creating others. Once thought to be a remote possibility, the draft Foreign Investment Law was clearly mentioned in the 2018 National Congress as pending submission to the Standing Committee of the National Congress for review. The latest known public version of this law is the discussion draft published by the MOFCOM in January 2015, whereby the MOFCOM aimed to, upon its enactment, replace the major existing laws and regulations governing foreign investment in the PRC. Among other things, the draft Foreign Investment Law purports to introduce the principle of “actual control” in determining whether a company is considered an FIE. The draft Foreign Investment Law specifically provides that entities established in China, but “controlled” by foreign investors, will be treated as FIEs, i.e. an entity organized in a foreign jurisdiction, but by the MOFCOM as “controlled” by PRC entities and/or citizens, and treated as a PRC domestic entity that will be able to invest in the “restriction category” that could appear on any such “negative list.”

Pursuant to the draft Foreign Investment Law, any companies with a VIE structure in an industry category that is in the “restriction category” and appearing on any such “negative list,” may still be deemed legitimate if the ultimate controlling person(s) is/are of PRC nationality (either PRC state owned enterprises or agencies, or PRC citizens) because the offshore entities in such a structure would still be treated as PRC domestic entities. Conversely, if the actual controlling person(s) is/are of foreign nationalities, then the VIEs will be treated as FIEs, in which case, the relevant VIE structures will likely to be scrutinised and subject to foreign investment restrictions and approval from the MOFCOM and other supervising authorities. Simply put, the draft Foreign Investment Law adopts a “see-through” approach to determine foreign investment in the PRC (including VIE companies). Although the final version of the law may differ from the discussion draft, this approach is unlikely to be entirely discarded.

As mentioned previously, the biggest concern for other governmental agencies arising from the CSRC’s acceptance of VIEs is how VIEs circumvent foreign investment restrictions. If a VIE structure is deemed domestic, rather than an FIE, according to the “see-through” mechanism under the draft Foreign Investment Law, such concern is supposedly solved. However, it is still too early to assume an “all-is-well” ending, for at least the following reasons:

(a) The enactment of the Foreign Investment Law still needs considerable time, while the initiation of the pilot programme by the CSRC may come soon, if not imminently, and the first batch of Pilot Enterprises would probably include VIE enterprises (e.g., five of seven listed red-chip companies that potentially qualify are VIE-structured). If the CSRC approves the CDR issuance of VIE companies before the Foreign Investment Law, and because under the current legal framework the VIE structure (at least the offshore entities) is still an FIE, then the businesses are certain to entail foreign investment restrictions, and other governmental agencies may find themselves in a predicament to either carry out their duty in pointing out the illegitimacies, and thereby going against the CSRC’s approvals, or to ignore it which is technically an act of omission.

(b) Even if the enactment of the Foreign Investment Law is clear set, its approach only considers accepting VIEs extant before its enactment (it does not to allow VIEs established afterwards). Thus, the pilot programme, together with the Foreign Investment Law, may provide a market incentive to establish lots of VIEs, an undesirable outcome for the PRC government. The incentive could go beyond companies operating in foreign-restricted sectors, and reach all companies, because the CSRC cannot take a similar stance to the HKSE and require that VIE arrangements should only exist in foreign-restricted business sectors, opening other governmental agencies to further ridicule. It is also worth mentioning that establishing a VIE is very different from other types of red-chip restructurings, entailing almost has no expenses. For a company potentially qualifying as a Pilot Enterprise, regardless of whether its business involves foreign investment restrictions, its optimal choice may be to establish VIE and offer CDR or shares in the PRC, while remaining open to second listing in international capital market. The acceptance of VIEs actually offers an arbitrage opportunity to take advantage of both the PRC capital market and the international market.

(c) Assume further that the Foreign Investment Law comes into effect and the pilot programme simultaneously proceeds, the possible clash of policies still has not been entirely solved. Although a VIE may be deemed as controlled by PRC persons, thus treated as domestic, its ultimate source of investment may still include foreign investors. However, the industrial policies of foreign investments not only consider whether or not to allow foreign investment, or how much is to be allowed, but also mandates the qualification requirements for foreign investors in certain sectors. The best example is value-added telecommunication (“VA Telecom”). The rule by the Ministry of Industry and Information Technology requires that the main foreign investor for such businesses have operation experience in the VA Telecom business. Even if a VIE-structured VA Telecom company is overall treated as domestic, the foreign investors backing it would still be required to have relevant experiences, which may be an impossible qualification requirement for almost all ordinary financial investors.

Considering the above possible clashes, our guess for the future lay-out of CSRC’s pilot programme and the Foreign Investment Law includes: (1) the CSRC’s implementation rules may soften acceptance for VIEs, (2) the Foreign Investment Law may defer the question of VIEs and retain the “neither admit or deny” status quo, or (3) the pilot programme may indefinitely stay as “invitation only,” thus avoiding the creation of an undesirable incentive to the market. To be clear, these are just educated guesses, at best. Nevertheless, if the problem of the inconsistencies between different central governmental agencies are not solved, namely the ones underlying the market-friendly pilot programme and the Foreign Investment Law, certain legal dilemmas or even risks may remain.