(Bloomberg) — Officials in China’s financial capital of Shanghai are closing a route used for decades by companies operating in the technology sector to draw foreign investment.
Startups that have recently applied to Shanghai’s National Development and Reform Commission for permission to inject money into affiliated entities incorporated in places like the Cayman Islands are being turned away, according to people familiar with the matter. Such outbound direct investment is one common way Chinese companies have established and then put money into so-called variable interest entity structures — a process to attracting foreign investment and list overseas.
Firms that approached Shanghai’s NDRC are being told the process for outbound investment into VIE structures is being halted, the people said, asking not to be named speaking on a sensitive issue. The changes follow a directive from Beijing, one person said.
China is moving to plug regulatory gaps that for decades allowed technology giants like Alibaba Group Holding Ltd. and Tencent Holdings Ltd. to sidestep restrictions on foreign investment. In July, regulators proposed rules that would require nearly all companies seeking to list in foreign countries to undergo a cybersecurity review.
The NDRC didn’t immediately respond to a request for comment.
If rolled out across the country, Shanghai’s restrictions would have far-reaching implications for Chinese upstarts already squeezed by a flurry of regulations targeting online companies in finance, education, ride-hailing, e-commerce and more.
Regulators are discussing tougher oversight of VIEs nationwide, though the rules have yet to be finalized, the people said. It’s unclear what these will mean for existing VIEs, many of which trade on exchanges in Hong Kong and New York.
Offshore listings came under scrutiny after Didi Global Inc. forged ahead with its American float despite objections from officials worried about data leaks and national security.
The Nasdaq Golden Dragon China Index — which tracks some of China’s biggest firms listed in the U.S. — dropped 0.4% on Friday, taking the year’s decline to 25%.
For years, companies registered in China that wanted to bring in foreign investors but couldn’t under local laws would go about setting up a VIE structure and using an offshore shell company that was tied back to the domestic business by contractual agreements. The Chinese firm would then apply to regulators like the NDRC for approval to invest in the offshore entity, a sign-off required under the country’s strict controls on capital outflows.
VIEs operate in a legal grey zone, leading some to suggest the additional oversight could bestow a level of legitimacy on a structure that’s been a perennial worry for global investors, depending on how Beijing treats existing entities.
An explainer on the legal twist Didi and Alibaba used to list overseas
The changes threaten a lucrative line of business for Wall Street banks, which have helped Chinese firms raise about $78 billion through first-time share sales in the U.S. over the past decade. They also add to concerns of a decoupling between China and the U.S. in sensitive areas like technology.
China’s recent crackdowns on a slew of technology companies have rattled global investors and triggered warnings from the U.S. Securities and Exchange Commission. Gary Gensler suspended new initial public offerings of China-based companies in August until they provided more details on risk disclosures, including information about their VIE structures.
(Adds stock move in ninth paragraph)
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