Red chips are returning to China, are foreign funds prepared?

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In recent years, a significant number of growth enterprises opted to erect red chip structures and list on foreign capital markets. During this process, the enterprise would bring in an offshore fund at the proposed listing platform level to take an equity interest prior to or at the same time that the Chinese actual controller would take a roundabout route to indirectly acquire or control a Chinese operating entity through an offshore trust or offshore company.

While this was to take advantage of the market credibility, managerial strengths and listing ability of well-known investment funds, certain enterprises also needed to bring in a genuine foreign investor to convert the Chinese company into a foreign-invested enterprise (FIE) so as to circumvent restrictions on round-trip acquisitions in the Provisions on the Acquisition of Domestic Enterprises by Foreign Investors issued by six ministerial-level authorities in August 2006.

Yang Run
Yang Run

Yet times change and the world with time. The attitude of foreign capital markets toward China concept stocks has undergone several ups and downs. China’s foreign investment policies are progressively liberalizing. The emergence of the New Third Board has caused the Chinese capital markets to continuously increase in size and price-earnings ratios to steadily rise. Such advantages as cultural, language, market and technical familiarity that come with local listings have given Chinese entrepreneurs pause to consider returning to their domestic capital markets.

Dealing with the shares held by the foreign fund after dismantling a red chip structure. Generally speaking, these can be broadly handled in two ways.

The first option is via red chip structures, wherein the link to domestic equity is made by way of an equity arrangement; this generally is the option for those in industries where foreign investment is permitted or encouraged. From the perspective of foreign investment access, dismantling a red chip structure does not require the foreign fund to make any changes. Foreign investment falling below 25% after the dismantling can also be acceptable.

From a listing perspective, China’s capital markets do not have restrictions against FIEs. Both the A-share markets and the New Third Board contain a large number of FIEs. Of course, where maintaining FIE status would require transforming the shareholding structure or some other change, approval or recordal procedures would need to be carried out with the commerce authority. For a listing, this will increase time costs, but not present substantive obstacles.

The second option is via a company with a variable interest entity (VIE) red chip structure. This generally is the option for those in industries in which foreign investment is prohibited or restricted.

When dismantling this type of red chip structure, consideration should be given to using a Chinese renminbi fund to make parallel investment in the proposed entity to be listed in China, so as to replace the original investment of the foreign fund on the foreign listing platform and seek a domestic listing as a wholly Chinese-owned company. One typical example is Baofeng Technology and IDG, which recently took the A-share market by storm. They substituted a Chinese renminbi fund when dismantling the red chip structure.

If the foreign fund cannot arrange for a parallel domestic fund to replace it, it needs to consider how to divest early in a suitable manner at a suitable price. This allows it to enjoy the increase in the value of its equity in the enterprise (including anticipated increases) without affecting the China listing schedule.

Of course, if the industry is now falls in the permitted or encouraged categories, the red chip can dismantle the original VIE structure without restraint. The foreign fund can hold equity in the Chinese operating entity directly and the enterprise can apply for listing as a Sino-foreign equity joint venture.

Obtain consideration for the equity, method of payment and tax affairs when dismantling. Both the actual controller and the foreign fund need to ensure that their signed legal documents, the dismantling process and the relevant tax filings are approved by the Chinese regulator and capital market.

Looking at recent examples from the second boards and New Third Board, the author has found that equity transfer at par value based on the registered capital is generally acceptable so long as it is demonstrable that the shares transferor and transferee are genuinely under the same control, and that the transfer is solely for the purpose of dismantling the red chip structure and returning listing to China. This eliminates the need to pay tax, and in some cases it renders the actual payment of the transfer fees unnecessary. Examples from the second board are too many to list; those from the New Third Board include CG Mobile, MK Tech and Gokey.

Will dismantling a red chip structure result in change of control? A change in actual control during the reporting period is anathema. If such circumstances arises, an enterprise generally needs to renew the relevant operating term before it can apply to list. However, the securities regulator places greater emphasis on the reality rather than the form when determining a change in control.

Accordingly, while the red chip structure is being dismantled, if the competent tax authority, which attaches weight even to form, recognizes the process as a restructuring under the same control, the securities regulator is unlikely to deem that a change in control has occurred as a result. Therefore, once the red chip structure has been dismantled, in general the enterprise can initiate the listing application directly without having to wait two or three years.

Could the government come after the enterprise? Some foreign funds worry that, after the enterprise comes home, its liability could be pursued by the tax, exchange control or other such authorities due to a missing approval procedure or foreign exchange registration procedure or due to a lack of a reasonable source of funds at the time of the red chip structure was erected.

The author finds that rapidly dismantling a red chip structure can resolve the historical defects mentioned above and reduce the duration of the enterprise’s violation of the law. Accordingly, this should be done expeditiously. Furthermore, actual tax revenue for the local government can result from restoring a genuine investment relationship and locking in the tax source in China following a red chip structure’s dismantling, and business growth and increase in the value of the equity after a listing. Therefore regulators should be motivated to encourage and protect enterprises which dismantle their red chip structures.

Accordingly, it is the author’s view that dismantling a red chip structure will not result in government authorities pursuing past liability. Of course, liaising in advance and seeking the government’s understanding is important work that cannot be dispensed with when dismantling a red chip structure.

Yang Run is a senior partner of Guangda Law Firm. She can be contacted on +86 20 8732 2282 or by email at ryang@gdlawyer.com