What Every Investor In Chinese ADRs Should Know About China's New Draft Foreign Investment Law

|
Includes: BABA, BIDU, FB, GOOG, TCEHY
by: Inner Scorecard

Summary

China's new draft foreign investment law changes the way that foreign ownership of Chinese business is regulated.

Foreign enterprises will now be defined as enterprises with foreign control, rather than merely foreign ownership.

This change is relevant because foreign enterprises face restrictions on what areas of business they can engage in.

The net result of the changes is to clarify the framework behind the regulation of Chinese companies with foreign ownership, acknowledging the VIE structure.

Foreign shareholders of Chinese companies listed overseas should see no changes to their ownership.

Don't worry. The Chinese government won't steal your shares away from you.

On January 19, the Chinese Ministry of Commerce, the executive agency responsible for regulating foreign direct investment in China, released its new draft of China's Foreign Investment Law.

In this article, I will focus on what the changes to the currently existing laws, if implemented, would mean to outside passive minority investors in Chinese equities. (The laws will have an even stronger impact on foreign companies directly investing in China, but that is beyond the scope of this article.)

Reading The Draft Law

To be clear, the draft law is currently just a draft, and has been posted on the Ministry of Commerce's website for public comments.

The chief change in these draft laws is that enterprises will be classified as foreign based not on who owns them, but on who is in control.

Let's read the draft law to see why. All translations to English in this article are mine.

According to Article 11 of the draft law, the definition of foreign investor is an investor who is either actually a foreign national, corporation registered according to foreign laws, a foreign government body or international organization, or most critically, "domestic enterprises that are controlled by the preceding entities."

Similarly, a Chinese investor is defined as an investor who is a Chinese national, the Chinese government and its entities, or a 'domestic enterprises controlled by the preceding entities."

And what does control mean here? According to Article 19, "The 'actual controller' referred to in this law, means a natural person or corporation who directly or indirectly controls a foreign investor or foreign-invested enterprise."

VIE Investments Going Forward

This conception is quite different from the existing regulatory regime, which defines Chinese companies with any foreign ownership as foreign-invested enterprises.

That in turn is quite relevant for investors because Chinese law disallows foreign ownership in certain industries and types of business, and restrict foreign ownership in others. For example, foreign companies cannot directly legally engage in software as a service business in China, because they cannot legally obtain the necessary license.

But wait, you may say. Aren't big Chinese internet companies such as Alibaba (NYSE:BABA), Baidu (NASDAQ:BIDU) and Tencent (OTCPK:TCEHY) publicly listed on exchanges outside of China in New York and Hong Kong where most shareholders aren't Chinese nationals?

The trick is that shareholders in these companies don't actually directly own Alibaba, Baidu or Tencent. Instead, they have rights to a non-Chinese company in the British Virgin Islands or elsewhere which has contracts in place with the actual operating entities of Alibaba, Baidu or Tencent. These contracts give the shareholders in the non-Chinese company economic rights that are somewhat equivalent to being a shareholder.

It's really a way to get around Chinese law. The Chinese government doesn't really like that. But at the same time, the Chinese government can't really just kick out foreign investors. Foreign capital is needed to launch innovative enterprises in China. It has benefited the country.

So what happens to existing companies with a VIE structure, such as Alibaba, Baidu or Tencent? The official explanation to the draft law, which does not have a concrete mechanism for dealing with these, says that these contractually controlled foreign-invested enterprises can apply to the relevant agency for their agency's approval that the company is in fact actually controlled by a Chinese investor, and if so, can continue operating. The explanation lists different levels of scrutiny that the companies would have to undergo, from something like mere filing, to examination of whether the structure is that of actual control, to a case-by-case examination. But all the possibilities would almost certainly allow the VIE structure to continue in existence in companies like these.

So by defining enterprises as "foreign" that are actually controlled by foreigners, the Chinese government is cleverly excluding this class of company from the definition of foreign, since the founders control them anyways through things such as dual-class share structures.

What It All Means for Investors

So foreign investors should be able to continue enjoying the ride, if not actually influencing the companies they are "shareholders of." It's not a terrible position to be in. If the draft law is implemented, the law and the Chinese government will finally have acknowledge the existence of the contractual form of "shareholding" in publicly listed Chinese companies.

This means, perhaps, that seemingly self-serving moves by Chinese entrepreneurs such as Jack Ma of Alibaba to have total actual control over their companies, instead of hurting foreign investors, actually protected their stakes from being seized from the government! Perhaps he knew what was coming.

Actually, he and others of his stature certainly did, or at least indirectly influenced these rules through the viewpoints of their substantial interest group in Chinese society being reflected in policy and legislation. Although private entrepreneurs still aren't very included in the Communist Party and the ruling class in general, they are some of the richest people in the country now, and even though China does not have a formally democratic system, the interests of powerful and influential groups in society are in fact incorporated into legal and policy decisions.

On the other hand, investors in US technology companies such as Facebook (NASDAQ:FB) and Google (NASDAQ:GOOG) which are actually foreign companies should continue to expect that these companies will not be able to legally do business in China. And this, too, reflects interest groups in Chinese society, a discussion of which Facebook and Google are not a part of. That's just the way Chinese regulations and policy works.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.