Focus on CSRC’s new CDR opinion paper

By Raymond Shi, Tian Yuan Law Firm

The Several Opinions on Launching the Pilot Programme of Shares or Depository Receipts by Innovative Enterprises (the opinion paper) by the China Securities Regulatory Commission (CSRC) induces a series of analyses and reviews of its implementation. This article seeks to offer some critical thoughts from a different angle.

The expansion of “red chip”. “Red chip” itself is market-created business jargon. Generally, it refers to stocks that are traded on overseas stock exchanges and 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. To decide whether enterprises are “red chip”, the key is to weigh both the ownership and company structure.

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However, in the opinion paper, the definition only carries the factor of company structure, i.e., red-chip enterprises are foreign-incorporated enterprises of which the main business activities are based within the PRC. Therefore, the inclusion of this term is enlarged significantly in a way that foreign-controlled enterprises that centre their main business activity in the PRC will at least theoretically qualify as pilot enterprises. For instance, the branch of Greater China’s business in an international technology conglomerate may even qualify.

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 capitalization needs to be a whopping RMB200 billion (US$31.4 billion), while if it happens to remain unlisted, it only needs to have one-tenth of the valuation. 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 may be incentivized to privatize itself and become an unlisted company, which in turn may qualify as a pilot enterprise. The simple fact of delisting can change its situation completely.

CDRs are more favoured for now. The opinion paper does not stop at Chinese depositary receipts (CDRs), but also provides the possibility of direct share issuance by non-PRC entities of red-chip enterprises. However, the CDR is systematically favoured in the opinion paper. It appears that the CSRC, by offering two sharply contrasting options, tries to convince red-chip companies to choose CDRs rather than shares.

Considering that both CDRs 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 anyone’s guess.

From cherry-picking to beauty contest. It may be safe to assume that the opening of the pilot programme is almost certain to be limited to some preselected companies within a shortlist. However, if things go right, sooner or later the pilot programme may be further promoted to include more companies, and finally evolve to an “application review decision” system. Until then, the special counselling committee in charge of picking innovative enterprises will be just another administrative procedure in a review process, although 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.

The possible clash of policies. The opinion paper admits variable interest entity (VIE) structures bluntly. This is the first official acknowledgement of VIEs’ validity on a state level. As is widely known, the VIE structure for most adopters serves as a get-around for the restrictions of foreign investments in certain industries. However, the underlying rationale for setting up VIEs is exactly why the VIE structure must have sounded so alarming to the central government, since VIE concerns more vital national interest areas such as national security implications.

The Foreign Investment Law (FIL) in draft may solve some problems, but creates others. In a word, if adopting the “see-through” ownership approach by the FIL, a VIE may be deemed as domestic, since it is ultimately Chinese owned or controlled. The concern of the VIE’s dodge of foreign investment restrictions is supposedly solved. However, more problems may remain:

1.If the CSRC approves VIE companies’ securities issuance before the FIL, the legal concern of VIE will present itself immediately when the law has not been clear.

2.Since the draft FIL does not to allow VIEs established afterwards, together with the pilot programme, the FIL may provide a market incentive to establish lots of VIEs before the FIL, an undesirable outcome for the PRC government. The incentive can be explained as: the CSRC cannot take a stance to require that VIE arrangements should only exist in foreign-restricted business sectors, opening other governmental agencies to further ridicule; and establishing a VIE entails almost no expenses, therefore any company can potentially qualify, regardless of whether its business involves foreign investment restrictions, or should have established VIE and offer CDR or shares in the PRC, while remaining open to a second listing in international capital markets.

3.Although a VIE is treated as domestic, its ultimate source of investment may still include foreign investors, therefore the qualification requirements for foreign investors in certain sectors may still apply. The best example is value-added telecommunications company (VA Telecom). Even if a VIE-structured VA Telecom company is overall treated as domestic, the foreign investors backing it would still be required to have VA Telecom experience, which may be an impossible qualification requirement for almost all ordinary financial investors.

Raymond Shi is a partner at Tian Yuan Law Firm in Beijing. He can be contacted on +86 135 8154 9696 or by email at