The 1997 publication of the Red Chip Guidelines may be a relic of the past century, but the concept and terminology surrounding the red-chip structure persist. Since Sina’s historic debut on the Nasdaq, its model, also known as the variable interest entity (VIE), has become a crucial avenue for private enterprises in China to access international capital markets. At one time, it spread across the nation, propelled by the wave of globalisation.
As globalisation gradually recedes, an increasing number of companies are dismantling their red-chip structures and returning to the A-share market. For various reasons, they often fail to meet China’s foreign exchange registration requirements.
The foreign exchange registration requirements for overseas investments by Chinese domestic residents were introduced with the implementation of the Notice of the State Administration of Foreign Exchange (SAFE) on Issues Relating to the Registration of Overseas Investments by Individual Domestic Residents and Foreign Exchange Registration of Mergers and Acquisitions by Foreign Capital (circular 29) on 1 April 2005.
The Notice on Relevant Issues Concerning Foreign Exchange Administration for Domestic Residents Engaging in Overseas Financing through Round-Trip Investment via Special Purpose Companies (circular 75) took effect on 1 November 2005, replacing circular 29.
On 4 July 2014, the Notice on Relevant Issues Concerning Foreign Exchange Administration for Domestic Residents Engaging in Overseas Financing and Investing through Round-Trip Investment via Special Purpose Companies issued by the SAFE (circular 37) was implemented, superseding circular 75. Circular 37 further standardised the cross-border capital transactions and foreign exchange registration requirements for domestic residents engaged in investment and financing activities through special purpose companies.
FX registration issues
The foreign exchange registration rules for Chinese residents’ overseas investments emerged within the context of the red-chip structure and have evolved alongside it. However, the lagging nature of the legal framework has already set the stage for the aftermath of dismantling red chips.
There are currently two main common foreign exchange registration problems that follow the dismantling of a red-chip structure.
- Non-registration from the outset
At the time the red chip was set up, rules concerning foreign exchange registration may not have been in place. As a result, domestic residents did not complete the initial foreign exchange registration for their overseas investment holdings.
Even after the promulgation and implementation of laws and regulations, these individuals may have failed to carry out the necessary supplementary registration procedures, as well as procedures for alterations or cancellations, as required by the regulations.
- Subsequent registration neglected
Some individuals did comply with the regulations and completed the initial or supplementary foreign exchange registration for their investments. However, they neglected to follow up with the required registration procedures for the changes or the cancellation of shareholdings in subsequent transactions.
When it comes to enterprises seeking an A-share IPO after dismantling a red-chip structure, they must positively address the historical context of the red-chip structure and foreign exchange registration, ensuring compliance.
How should proposed listing enterprises handle situations where there are legal flaws in their foreign exchange registration (especially when they no longer have the chance to rectify registration conditions)?
The first lesson from numerous real-life cases is that it is necessary to understand the primary concerns of auditors within the comprehensive registration system:
- Assessing whether legal flaws might render the applicant ineligible for filing or expose them to significant legal risks;
- Examining whether key individuals such as the actual controllers, major shareholders or top executives have any involvement in legal flaws, large-scale illicit fund transfers across borders, or serious violations of the law that could have consequences for the applicant; and
- Ensuring all legal responsibilities and risks have been disclosed.
Second, it is essential to provide targeted responses to relevant questions, considering the specific circumstances of the company:
- Clearly state that the responsibility for the failure of individual domestic residents to register for foreign exchange lies solely with the individuals themselves, rather than the company to be listed, and provide explicit legal justification;
- Differentiate whether the legal flaws involve the actual controller, major shareholders, or core personnel such as directors and supervisors. If they are implicated, elaborate on the nature of flaws, the application of penalties and their criteria, and the fact that the application for remedial formalities is already underway, etc., to argue that flaws will not constitute a material breach of law on the part of the relevant persons;
- With shareholders or core personnel such as directors who have previously failed to register for foreign exchange, if they no longer hold shares or positions in the company, explicitly state that such legal flaws will not impact the issuer’s application for listing; and
- Alongside comprehensive disclosure of legal risks, the company can further mitigate potential legal risks by analysing the statute of limitations for administrative penalties and having the actual controller commit to assuming full liability.
There are two noteworthy wrong practices when handling related issues:
- Intentionally concealing or evading relevant legal flaws under certain circumstances. Some may believe they can avoid addressing foreign exchange registration issues during the IPO application process by assuming that the foreign exchange authorities or banks have no record of the matter. However, relying on the transparency and openness of the registration system audit, the information provided by the enterprise will inevitably be made public. Hoping that regulators won’t detect these issues is not a viable approach.
- Failing to conduct in-depth analysis and substantiated arguments based on the company’s specific circumstances and simply relying on a certification from the foreign exchange management authority may partially reduce legal risks, but this solution lacks practicality and can even lead companies into a dead end when attempting to address the issues.
As the reforms and opening-up in China continue to progress, the requirements for foreign exchange management will also be continually refined. Regarding historical legacy issues, the author believes that as long as the principles of objectivity, legal responsibility and full disclosure are upheld, even the most challenging aftermath can be overcome.
Yang Ke is a partner at Tian Yuan Law Firm. He can be contacted at +86 10 5776 3888 or by e-mail at email@example.com
Zhang Qi is an associate at Tian Yuan Law Firm. She can be contacted at +86 188 1085 7938 or by e-mail at firstname.lastname@example.org