China Law & Policy (Spring 2022) — Impact of China’s 2021 New Negative Lists on Overseas Listing

On December 27, 2021, the National Development and Reform Commission (“NDRC”) and the Ministry of Commerce (“MOFCOM”) jointly issued updated versions of the “negative lists” applicable to foreign investment in China. The Special Administrative Measures (Negative List) for Foreign Investment Access (2021 Edition) (“2021 National Negative List”) and the Special Administrative Measures (Negative List) for Foreign Investment Access in Pilot Free Trade Zones (2021 Edition) (“2021 FTZ Negative list”, and together with the 2021 National Negative List, the “New Negative Lists”) both took effect on January 1, 2022. Notably, both lists reflect further liberalization in the sense that the 2021 National Negative List now only includes 31 items (versus 33 in 2020) and the 2021 FTZ Negative List now only includes 27 items (versus 30 in 2020).  The official version of the New Negative Lists can be found here and here.

However, putting aside the continuing reduction of items on the New Negative Lists, the most newsworthy feature of the New Negative Lists is probably the explanatory notes that appeared this year.  Most notably, the New Negative Lists explicitly permit Chinese companies operating in prohibited fields to list overseas if such companies meet certain requirements spelled out in the notes (the “Listing Restrictions”).   Set forth below is a description of these requirements, as well as some of the implications for foreign investors in China.

1. Pre-approved by national authorities

Before listing on an overseas stock market, Chinese companies engaged in fields prohibited¹ from receiving foreign investment must be pre-approved by “national authorities.”²

The Listing Restrictions do not specify which “national authorities” would be responsible for granting pre-approval, and there has been no further guidance provided to date.  Based on the existing approval regime around offshore direct investment by Chinese companies, it is possible that “national authorities” may encompass NDRC, MOFCOM and any authorities responsible for the listing candidate’s specific industry.

2. Foreign investors are prohibited from participating in the management of the Chinese company

Foreign investors in a Chinese company operating in a restricted industry must be passive and cannot “participate” in the management of the company. The Listing Restrictions do not indicate what types of activities would qualify as “participation.”  For example, it is not clear whether the appointment of foreigners to the board of directors or management would constitute “participation.” Further, the Listing Restrictions are also ambiguous on whether the prohibition on “participation” applies before or after listing.  Although the syntax of the Listing Requirements could be read to imply that they only apply to companies listing overseas, any prohibition on investors “participating” in management would be more relevant before listing when investors frequently contract for board seats and other minority protections.  After listing, many of these rights typically fall away.  As a result, if the restriction on foreign investor participation in management only applies to a listed company, this may have limited impact on investor.

3. Limitation on the equity ratio of foreign investors

The Listing Restrictions set a number of limits on the share-holding percentages allowable for foreign investors into applicable companies. According to the NDRC/MOFCOM Public Q&A³, the equity ratio (which refers, among others, to foreign investors investing in domestic securities market through “qualified foreign institutional investors” (“QFII”), “RMB qualified foreign institutional investors” (“RQFII”) and other stock market transaction interconnection mechanisms) limiting foreign investors shall be governed mutatis mutandis by the relevant regulations on the management of domestic securities investments made by foreign investors. This indicates that the foreign equity holding ratios should be as follows:

• The equity ratio of a single foreign investor and any affiliate shall not exceed 10% of the total number of the company shares.
• The equity ratio of all foreign investors and any affiliate shall not exceed 30% of the total number of the company shares.
• The equity ratio of foreign investors in a listed company shall be calculated on a consolidated basis.
• Companies listed overseas before the establishment of the New Negative Lists that exceed the cap do not need to reduce the percentage of foreign ownership.

It is not clear how authorities intend to enforce these requirements for companies listed offshore.  For example, the Hong Kong Stock Exchange requires a minimum public float of 25% of total issued share capital for listing. ⁴ Assuming that an H-share company listed more than 25% of its shares, it is not clear who would be responsible for preventing a foreign investor from accumulating a position exceeding 10%.  Nor is it clear what the consequences would be in China in such case.

Similar to the prohibition on “participation” by foreign investors in companies subject to the Listing Restrictions, it is unclear whether the equity ratios only apply after listing or would apply prior to listing.  However, there is no apparent mechanism for enforcing the prohibition outside of the listing process.

Impact on the Variable Interest Entity Model

There has been extensive speculation that the Listing Restrictions were targeted at reigning in variable interest entities (“VIE”).  That being said, it is still not clear that the Listing Restrictions have much impact on VIEs.  Specifically, the Listing Restrictions do not appear to apply to offshore listings of so-called “red chip” structures—e.g., companies set up in places like the Cayman Islands, but whose sole asset may be a Chinese operating company.  To the extent that red chip companies make extensive use of VIE structures—since it permits them to participate in restricted industries while still attracting foreign investment—any move to restrict VIEs would have to encompass such companies.  One possibility is that it may become more difficult to get a clean Chinese legal opinion in connection with red chip listings.  In this respect, it will be interesting to see how the Chinese bar interprets the application of the Listing Restrictions to red chips.

Another possibility is that the Listing Restrictions are only the precursor of more extensive changes that would more clearly impact red chip companies. On December 24, 2021, the China Securities Regulatory Commission (“CSRC”), together with other government bureaus, released draft Provisions of the State Council on the Administration of Overseas Securities Offering and Listing by Domestic Companies (the “Draft Listing Measures”) and Administrative Measures for the Filling of Domestic Enterprises' Overseas Issuance and Listing of Securities (the “Draft Filing Measures”) for comments. The Draft Listing Measures define “indirect overseas IPOs” explicitly as cases where a domestic company, with its main business activities within China, lists securities overseas in the name of an offshore company on the strength of the equities, assets, earnings or other similar rights and interests of the domestic company. Further, the Draft Filing Measures indicate a plan to establish a filing requirement which would cover both direct and indirect listing of Chinese companies.

If the Draft Listing Measures are adopted, and regulators take more clear jurisdiction over “indirect offshore IPOs”, then the Listing Restrictions would be more directly applicable even in the case of red chips and could have a more far-reaching impact on VIEs.  First, VIEs are largely used to facilitate investment by foreign investment funds into restricted sectors.  However, if participation of foreign investors in a company will limit its IPO opportunities, that will make foreign investment increasingly unattractive (and, conversely, make  investment in such a company less attractive to foreign investors).  In such a context, a VIE does little to help and potentially becomes irrelevant as a structure.

Another consequence would be to restrict participation from overseas Chinese in sensitive sectors.  There are any number of storied, venture-backed companies over the last thirty years where members of the founders group were born in China, but held a foreign passport.  Such participation may be challenging given restrictions on foreign participation.

Finally, it would not be surprising if a market developed in secondary positions for red chips with foreign investment that had to restructure their investor base as a precursor to listing.  There is past precedent for this in connection with foreign-backed Chinese companies that sought to list domestically and had to redeem foreign investors to qualify for listing.

However, notwithstanding the above, neither the Listing Restrictions nor the Draft Listing Measures would appear to otherwise directly outlaw VIEs.  As a result, to the extent that VIEs are used outside of the context of red chips operating in restricted or prohibited sectors, the new regime would not appear to have an impact.

Conclusion

Given the ambiguities in the Listing Restrictions and the Draft Listing Measures, they will increase uncertainty and may discourage foreign investment in the short term until a new status quo is established and widely understood.  Existing investors in companies that fall subject to the Listing Restrictions and who are focused on achieving exit through an IPO may find themselves forced to engage in difficult negotiations with the invested company and PRC co-investors.  For companies that are not focused on an IPO, the Listing Restrictions arguably have no impact.

For many observers, the most interesting thing about the Listing Restrictions may be the fact that they do not directly impact VIEs.  That could change upon the adoption of the Draft Listing Measures.  O’Melveny will continue to monitor and report on how those measures may evolve before they are finally adopted.

1. Activities like printing publications and construction and operation of nuclear power plants are described as “restricted” (rather than prohibited) to foreign investors on the New Negative Lists, and many of the items on the New Negative Lists explicitly allow for substantial foreign stakes (for example, foreign investment in value-add telecoms can go up to 50%).  To the extent that the Listing Restrictions are explicitly applicable to “prohibited” categories of investment, it is unclear what (if any) relevance the Listing Restrictions have to any category of investment that appears on the New Negative Lists which is not “prohibited” to foreign investment.

2. Pre-approval does not remove the requirement of securing approval from the Chinese Securities and Regulatory Commission for overseas listing (where applicable).  The NDRC and MOFCOM have clarified this in a public Q&A  (the “NDRC/MOFCOM Public Q&A”) and were at pains to state that “pre-approval” only applies to clearance on of any prohibitions set out in the New Negative Lists.

3. See here.

4. Or 15% if the market cap exceeds HK$10 billion at the time of listing and subject to a waiver granted by the Stock Exchange.

* O’Melveny recognizes legal consultant Yingqi Gu for her valuable contribution in researching and drafting this article.

O’Melveny & Myers LLP is a foreign law firm registered with the Ministry of Justice of the People's Republic of China. Under current Chinese regulations, we are allowed to provide information concerning the effects of the Chinese legal environment, but we are not authorized to practice Chinese law or to render legal opinions in respect of Chinese law. We work in cooperation with a number of Chinese law firms. Should you require a legal opinion in respect of any Chinese law matter, we would be happy to assist you in obtaining one from a Chinese firm.

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