China is tackling its biggest corporate flaw. – Quartz

The Chinese government is cracking down on its biggest tech companies through a series of proposed new rules strengthening state control over companies’ access to capital. The Cyberspace Administration of China, the government’s Internet regulator, has proposed new changes to the rules for overseas registrations.

The proposed changes target the very mechanism that has led to the rise of many of its biggest technology successes like Alibaba, Baidu and Weibo: the variable interest entity (VIE) corporate structure, through which companies create offshore shell companies through which they can attract foreign investors.

What is a VIE?

VIEs are foreign-formed legal persons, often incorporated in the Cayman Islands, under which investors do not receive a direct stake in the business but, through a series of complex contracts, retain almost the same rights as shareholders. This setup is ideal in China where the government is strict on foreign ownership of its most important companies: VIEs allow Chinese companies to access foreign capital and give foreign investors access to the country’s massive market.

VIEs gained prominence in 2000 when Sina and Sohu, two Chinese internet companies, used them to publicly list on NASDAQ. Both companies have used Cayman shell companies and contracts rather than direct ownership to circumvent Chinese and US securities regulations. Since then, many of China’s largest companies have used VIEs as a way to go public on foreign exchanges and raise capital from foreign investors. But they’re not just in China: In the United States, Texas energy company Enron has notoriously used VIEs to protect its troubled balance sheet from investors.

In Chinese law, these arrangements are legally questionable: China has never fully endorsed the VIEs but rarely intervenes either. The government was generally looking the other way, although that could change.

What are the new rules?

China’s proposed new rule change would require all large companies – any company with data of more than one million people – to undergo a formal government review before being listed on the stock exchange, although these rules may not. apply to those listed in Hong Kong. In the future, China may also require approval of public listings through VIEs or any new issuance of shares by already public companies through these means, Bloomberg reported.

It could mean more hoops and control for Chinese companies seeking foreign investment and less enthusiasm from those foreign investors. The government is seeking public comments on the changes until July 25.

China has already cracked down on many of its most successful companies: an investigation into the ride-sharing app Didi this month (apparently cybersecurity) and the suspension of Ant Group’s IPO in 2020. The Beijing’s heightened surveillance has already had a negative effect on many Chinese. tech stocks in the United States and a number of companies recently suspended their IPOs in response to the new scrutiny, including TikTok’s parent company, ByteDance.

This appears to have ended a decade in which the Chinese government was prepared to relax the application of its fast-growing tech companies. As the Chinese government expresses concern over the threat of foreign adversaries gaining access to citizens’ data, the latest crackdown suggests the changes are also aimed at restoring control over the country’s largest companies.