China in Transition

Tightening Regulation of Private Enterprises in China
—Focusing on the Cases of Ant Group and Didi

Chi Hung KWAN
Consulting Fellow, RIETI

Ⅰ.A Series of Shocks to the Stock Market

In China, a series of events has shaken the stock market since November 2020, following the tightening of regulation of enterprises.

  • The initial public offering (IPO) of Ant Group, the largest fintech firm, scheduled for November 5, 2020, was postponed right before the scheduled day for the IPO
  • On April 10, 2021, a fine of around $2.8 billion was imposed on Alibaba Group, the largest e-commerce firm, for violating the anti-trust law.
  • On July 2, 2021, the internet regulation authorities announced the start of an investigation of Didi, the largest online ride hailing service provider, which had recently been listed on the New York Stock Exchange, for national security reasons.
  • On July 6, 2021, the General Office of the Central Committee of the Communist Party of China and the General Office of the State Council announced that they would take strict enforcement actions against securities-related crimes and strengthen the supervision of cross-border securities transactions from the viewpoint of national security (Note 1).
  • On July 24, 2021, the General Office of the Central Committee of the Communist Party of China and the General Office of the State Council announced that they would require providers of after-school tutorial services for children receiving compulsory education at elementary and junior high schools to be registered as non-profit institutions and prohibit those service providers from raising funds through stock listing (Note 2).
  • On August 3, 2021, Economic Information Daily, affiliated with the Xinhua state news agency, criticized online gaming as "spiritual opium." Subsequently, on August 30, the National Press and Publication Administration announced a ban on the provision of services by online game companies to minors except for the one hour from 8 to 9 p.m. on Fridays, Saturdays, Sundays and official holidays (Note 3).

Amid concerns over the possible impact of the tightened regulations on corporate earnings, stock prices of such companies as New Oriental Education & Technology Group, a provider of education services, including after-school tutorial service, and Tencent, the largest provider of online games, fell steeply, and foreign investors' appetite for investment in Chinese stocks weakened. Softbank Group announced that it would hold off investments in China until the extent of Beijing's crackdown on tech becomes clear.

This series of governmental measures to tighten regulations are targeted exclusively at private enterprises. This paper studies the background to and the impact of the tightened regulations, focusing particularly on the postponement of Ant Group's listing and the investigation of Didi for security reasons.

Ⅱ.Background to Tightening Regulation of Enterprises

Among the factors behind the Chinese government's tightening regulation of enterprises are a shift in development strategy from the "get rich first" to the "common prosperity" initiative and the retreat of the market-oriented reform as symbolized by the trend of the state advancing and the private sector retreating (state-owned enterprises' share of the economy expanding and private enterprises' share shrinking), and efforts to enhance national security.

1. Shift in Development Strategy from "Get Rich First" to "Common Prosperity"

To overcome the adverse effects brought by the egalitarianism of the planned economy era, Deng Xiaoping promoted the reform and opening-up initiative, which put efficiency above equality, under the motto of "get rich first." Four decades later, the Chinese people's standard of living has generally improved, but inequality in income distribution has widened further. This is a factor that could threaten social stability and, by extension, sustainable development.

To achieve stable and sustainable growth by narrowing the gap between the rich and the poor, the government under President Xi Jinping, which was inaugurated following the 18th National Congress of the Chinese Communist Party in November 2012, has upheld "common prosperity" as the goal of economic development. Under the Xi government, China pulled all of the 100 million or so people who had been living under the poverty line out of poverty, achieving the poverty reduction goal of the United Nations' 2030 Agenda for Sustainable Development 10 years earlier than the target year (Note 4).

However, despite those achievements, there is still significant inequality in China, between regions, between urban and rural areas and between income classes. Opinions are divided as to whether the wide gaps resulted from excessive market-oriented reform or insufficient reform. Based on the belief that the market reform has gone too far, the Xi government has aimed to achieve "common prosperity" by shifting away from the market economy path and toward strengthening governmental controls.

In particular, the burdens on the people in the fields of education, healthcare and housing have increased in recent years as a result of reforms implemented in those fields under the banner of pursuing the market economy path. Previously, overarching goal for the Chinese Communist revolution was to overcome the challenges that were known as the "three big mountains"—that is, imperialism, feudalism and bureaucratic capitalism. In a similar vein, education, healthcare and housing have come to be called the "new three big mountains."

Overcoming those new challenges is expected not only to improve the Chinese people's standard of living but also to contribute to a rise in the birthrate by mitigating the burden of childcare. The government recognizes the need to strengthen interventions in the market through regulation as a way to accomplish that goal. At the Central Economic Work Conference held on December 16, 2020, the Chinese leaders positioned strengthening antitrust enforcement and preventing unorderly expansion of capital as one of the eight key tasks in 2021.

At the 10th meeting of the Communist Party of China's Central Commission for Financial and Economic Affairs held on August 17, 2021, the Chinese leaders indicated that they will strengthen regulation and adjustment of high income earners, protect lawful income, rationally adjust excessive incomes, and encourage high-income classes and enterprises to increase returns to society. They emphasized the ethics-led "tertiary distribution" (distribution through private donations and charity projects) in addition to the market-led "primary distribution," and the government-led "secondary distribution." In response to the government's call for cooperation, some major private enterprises, such as Tencent and Alibaba, have announced that they will make massive financial contributions to public-interest projects.

2. Retreat of Market-Oriented Reform as Symbolized by Trend of "State Advancing and Private Sector Retreating"

For many years, private enterprises have been at a disadvantage in market competition because of discriminatory treatment due to differences in the ownership structure. Specifically, some business sectors have been monopolized by state-owned enterprises, as private enterprises face very high entry barriers. In addition, while state-owned enterprises receive financial assistance, including loss-compensation subsidies from the government, private enterprises enjoy no such benefits. Furthermore, state-owned enterprises can acquire factors of production, including land and funds, at lower costs, but private enterprises are faced with higher costs. Finally, under the present legal system, the protection of property rights is weaker for private enterprises than for state-owned enterprises. The treatment of private and state-owned enterprises is not equal in terms of the law and its enforcement.

On the other hand, in implementing the reform and opening-up initiative, the Chinese government has maintained the stance of giving precedence to trial and error over regulation, as symbolized by the approach of "crossing the river by feeling the stones" that was mentioned by Deng Xiaoping. In particular, in new fields, such as the digital economy, regulation is relatively loose, and some private enterprises have taken advantage of this to achieve rapid growth. Among the "Fortune Global 500" firms in 2021, 132 are Chinese enterprises (excluding enterprises in Hong Kong and Taiwan), of which 97 are state-owned ones and 35 are private ones (Figure 1).

Figure 1. The Rising No. of Chinese Enterprises in the Fortune Global 500–State-owned Enterprises vs. Private Enterprises
Figure 1. The Rising No. of Chinese Enterprises in the Fortune Global 500–State-owned Enterprises vs. Private Enterprises
Note: The above figure covers only companies in mainland China, with companies in Hong Kong and Taiwan excluded.
Source: Prepared by the author from "Fortune Global 500," Fortune.

However, in recent years, the sluggishness of private enterprises' business performance has become conspicuous against the backdrop of the stalling of the market-oriented reform. As state enterprises or state-owned investment companies have bailed out struggling private enterprises in one case after another with capital injections, the trend of "the state advancing and the private sector retreating" has become evident.

The government is trying to strengthen control of private enterprises through tightening regulation and injecting state-owned capital. It requires private enterprises to make increased contributions not only on the economic front but also on the social and national security fronts.

3. Efforts to Enhance National Security

In China, as a result of the COVID-19 pandemic, the real GDP growth rate in 2020 fell to 2.3%, the lowest level since the country shifted to the path of reform and opening-up at the end of the 1970s. This prompted the government to take seriously the various risks that China is facing and to regard "security" as a prerequisite for development.

In the Outline of the 14th Five-Year Plan (March 2021), national security is characterized as a priority matter, with the word "security" appearing 177 times. It is no exaggeration to say that "security has become a sixth principle under the current five-year plan after the existing principles of innovation, coordination, green development, opening-up, and sharing.

"National security as referred to here covers a broad range of matters beyond national defense, including the economy and finance, external relations, food (in terms of both quality and quantity), energy and resources, cyberspace, public health and medicine, natural disasters, and utilization of nuclear power.

Amid the intensifying confrontation between the United States and China, the Chinese government has concluded that as part of its effort to enhance economic security, it is essential to strengthen control of private enterprises, which have acquired strong influence in the fields of finance and digital economy.

Ⅲ.Ant Group Targeted through Regulatory Crackdown on the Financial Sector

While the development of fintech in China has contributed to improvement in access to financial services and an increase in the efficiency of fund allocation in recent years, it has brought new challenges for financial supervision. (As for the advantages and disadvantages brought by fintech firms, see Column 1). The government is tightening regulatory enforcement against Ant Group and other fintech firms with the stated aim of maintaining the stability of the financial system.

1. Ant Group as a Leading Fintech Firm

Ant Group's predecessor was Alipay, established in 2004 by Alibaba as a platform for online payment for internet shopping. Alipay was formally incorporated as Ant Financial in 2014 and was renamed as Ant Group in June 2020 ("Alipay" has been retained as the name of the platform). Alipay, connected with more than 1 billion users, 80 million shops, and 2,000 financial institutions in China, is the world's largest financial platform.

Riding on the wave of its rapid growth, Ant Group applied for IPO on the Shanghai Stock Exchange's STAR Market, which is called the Chinese NASDAQ, and on the Hong Kong Securities Exchange on August 25, 2020. The company planned to go ahead with its IPO on November 5 upon authorization, raising funds totaling 37 billion dollars, a value which would have represented the largest IPO on record.

According to the prospectus submitted to those two exchanges, Ant Group derives its revenue from the following three business categories: (i) digital payment and business services (the mainstay service is Alipay), (ii) a digital financial platform, and (iii) innovation business and other businesses. In the January-June period of 2020, the business-by-business share in overall sales was 35.9% for (i), 63.4% for (ii) and 0.8% for (iii). The digital platform business is comprised of three lines of operations—small-lot loans (the main products are Huabei and Jiebei), asset management (the main product is an MMF named Yu'e Bao), and insurance–with 39.4%, 15.6% and 8.4%, respectively, of overall sales. The provision of small-lot loans, which is part of the digital platform business category, alone accounts for a larger share than the digital payment and business service category.

In the one year to June 30, 2020, around 500 million users took out consumer loans through the company's small-lot loan platform. As of June 30, 2020, the outstanding balance of consumer loans contracted through Ant Group was 1,732 billion yuan. As part of the small-lot loan business, Ant Group also provides a loan service to small and micro businesses, including online shops affiliated with e-commerce platforms operated by Alibaba, such as Taobao and Tmall, and brick-and-mortar stores that use Alipay, and the outstanding amount of loans was 421.7 billion yuan.

At first, Ant Group financed small-lot loans with its own funds, but as the outstanding balance of loans expanded, the company issued and sold a large amount of asset-backed securities (ABS) that combined small-lot loan claims to investors. To curb fund-raising through this method, on December 1, 2017, the financial regulatory authorities tightened regulation of the issuance of ABS by small-lot loan service providers. In response, Ant Group significantly reduced the issuance of ABS but continued to increase loans in the form of "joint loans," with most of the necessary funds provided by partner financial institutions. The revenues that Ant Group obtained through the provision of joint loans were mostly technical service fees received from partner financial institutions. As of June 2020, 98% of the small-lot loans mediated by Ant Group were covered by funds provided by partner financial institutions or by funds raised through the issuance of ABS. Only the remaining 2% of the total were loans for which Ant Group took on risks for itself.

2. Postponement of Ant Group's IPO

The financial regulatory authorities regard the high leverage of Ant Group, which is mediating a much larger amount of loans than the amount of own funds, as a problem, and is tightening regulation due to concerns that this problem could become a destabilizing factor for the financial system. Against this backdrop, Ant Group was forced to postpone the simultaneous double listings on the Hong Kong Securities Exchange and the Shanghai Stock Exchange's STAR Market scheduled for November 5, 2020, right before the scheduled day for the IPO and forced to reorganize the group.

The trigger for the postponement of Ant Group's IPO can be traced back to a speech made by Jack Ma, the company's founder, at the Bund Summit in Shanghai on October 24, 2020. In the speech, Mr. Ma made an accusation that the Basel Agreement, which constitutes the framework of financial supervision, impedes financial innovation by overly emphasizing risk management and argued that it is necessary to change banks' pawnshop mentality that depends on collateral-based loans and to develop a financial system that takes advantage of information technology.

Amid the controversy touched off by the speech, on November 2, 2020, the People's Bank of China, the China Banking and Insurance Regulatory Commission, the China Securities Regulatory Commission, and the State Administration of Foreign Exchange issued a supervisory guidance to Jack Ma and other senior officials of Ant Group. Later that night, the China Banking and Insurance Regulatory Commission and the People's Bank of China jointly published the Interim Measures for the Administration of Online Micro-lending Business (draft for comments). If the new rules included in the measures are enforced, Ant Group will be required to provide funds to cover at least 30% of the loan value with respect to joint loans that it provides together with partner financial institutions. As a result, a significant capital increase will become necessary in order to maintain the small-lot loan business. As the fund-raising costs increase in line with such capital increases, profitability is certain to decline.

Following the publication of the Interim Measures, the Shanghai Stock Exchange announced the postponement of Ant Group's IPO on the STAR Market, citing the supervisory guidance issued to the company and a "significant change" in the regulatory environment. On the same day, Ant Group announced that its IPO in Hong Kong would also be postponed.

On December 26, 2020, the People's Bank of China and other financial regulatory authorities issued the second supervisory guidance to Ant Group. Specifically, they pointed out the following management problems: (i) an unsound corporate governance mechanism, (ii) weak compliance awareness and disregard of supervisory and administrative requirements, (iii) abuse of an advantageous position in the market to exclude competitors, and (iv) infringement of consumers' legitimate interests. Based on the guidance, the regulatory authorities ordered Ant Group to make the following improvements: (i) return to its core business of providing payment services, enhance transaction transparency, and avoid engaging in unfair competitive practices; (ii) conduct personal credit investigations in accordance with laws and regulations and protect personal information; (iii) establish a financial holding company in accordance with the law, strictly fulfill supervisory and administrative requirements, and secure capital adequacy and the legality of relevant transactions; (iv) improve corporate governance and strictly rectify illegal financial activities, including the provision of credit loans, insurance, and asset management; and (v) conduct securities, fund, and asset securitization operations in accordance with prudential supervision requirements. The third supervisory guidance issued on April 12, 2021, set out more detailed specifics of the requirements as shown below (Table 1).

Table 1. Specifics of the Guidance Issued by the Financial Supervisory Authorities to Ant Group on April 12, 2021
Table 1. Specifics of the Guidance Issued by the Financial Supervisory Authorities to Ant Group on April 12, 2021
Source: Prepared by the author from "Vice President Pan Gongsheng of the People of Bank of China Answers Questions from Reporters with respect to the Guidance Issued Again to Ant Group" (April 12, 2021), Xinhua.

In addition, on April 29, 2021, the People's Bank of China and other financial regulatory authorities jointly issued a supervisory guidance to 13 other major platform operators engaging in financial businesses, including Tencent. Like Ant Group, other fintech firms will be forced to carry out a reorganization.

As a result of the tightening of regulation, fintech firms, like existing financial institutions, will be placed under the strict supervision of the financial regulatory authorities. While that will curb excessive lending and associated financial risks, some people will lose access to the benefits of inclusive finance. fintech firms are unlikely to avoid a decline in earnings, and they will become more careful about introducing new products and services. In order to maximize the advantages of the development of fintech while curbing associated risks, it is necessary not only to realign fintech firms but also to revise financial supervision.

Ⅳ.Didi Subjected to Investigation for Security Reasons

In China, handling of data held by platform operators, as well as the stability of the financial system, is regarded as a matter of national security. As Didi is in a dominant market position in the online ride-hailing service market in China, it holds vast amounts of data. The internet regulatory authorities, which regard national security risks associated with Didi's overseas listing as serious problems, have decided to subject Didi to investigation for security reasons.

1. Didi's Listing in New York

Didi was established in 2012 as an internet company mainly engaging in the business of providing an online ride-hailing service (at that time, the company was called Xiaoju Technology). Since then, the company has achieved rapid growth while repeatedly absorbing and merging with rival firms, including Uber China, which was operated by Uber Technologies, and consolidated its dominant position in the ride-hailing sector. On June 30, 2021, Didi was listed on the New York Stock Exchange, raising funds totaling 4.4 billion dollars.

According to the listing prospectus, Didi's active users totaled 493 million people and active drivers totaled 15 million people around the world in the one year to March 2021. In China alone, there were 377 million active users, and 13 million active drivers. As of the end of March 2021, Didi was doing business in more than 4,000 cities in 15 countries across the world, including China.

Didi's sales amounted to 141.7 billion yuan in 2020. By business category, sales came to 133.6 billion yuan for the mobility business in China (including online ride-hailing service, taxi service, chauffeur service, and taxi sharing service), 2.3 billion yuan for the global business (including the overseas mobility and delivery services) and 5.8 billion yuan for other businesses (including shared bicycle service, car-related services, distribution, autonomous driving, and financial services).

Among Didi's largest shareholders just before the listing were Softbank Vision Fund (a share of 21.5%), Uber (12.8%), Will Cheng (7%), who is the company's founder, and Tencent (6.8%) in that order.

2. Wariness about Data Leakage Associated with Overseas Listing

On July 2, 2021, the Chinese internet regulation authorities announced that they would start an investigation of Didi, which had recently been listed on the New York Stock Exchange, for national security reasons. Didi was ordered to stop accepting new user registrations during the investigation period.

On July 5, 2021, Yunmanman and Huochebang, both of which are truck-hailing service providers, and BOSS Zhipin, an online recruitment site operator, were also subjected to investigation for national security reasons. That was just after the listings of Full Truck Alliance, created through the merger of Yunmanman and Huochebang, and BOSS Zhipin on the U.S. stock market in June.

The Chinese authorities explained that the investigation of those companies was based on applicable laws and is intended to prevent data security risks, protect national security, and secure public interests. (As for the various laws that constituted the basis of the security investigation, see Column 2). The internet regulation authorities are particularly wary about possible leakage of personal information and road data held by the companies to foreign countries. To prevent data leakage, the authorities are undertaking security investigations and are also tightening regulation of Chinese companies' overseas listings.

On July 6, 2021, the General Office of the Central Committee of the Communist Party of China and the General Office of the State Council published the Opinions on Strictly Cracking Down on Illegal Securities-related Activity in Accordance with Law. The document indicated that the authorities will strengthen supervision of cross-border securities transactions in addition to ensuring strict enforcement against securities crimes. Specifically, it stated that China will develop laws and regulations concerning control of cross-border data flows and management of classified information with respect to Chinese companies seeking overseas listings, and establish a system of extraterritorial application of securities laws.

On the other hand, the U.S. regulatory authorities are trying to subject Chinese companies seeking listings in the U.S. market to strict examination from the viewpoint of protecting investors. Specifically, on July 30, 2021, Chairman Gary Gensler of the U.S. Securities and Exchange Commission (SEC) issued a statement revealing that he has instructed the SEC staff to make it mandatory for Chinese companies seeking listings in the U.S. market to disclose information concerning specific risks, including the widely adopted Variable Interest Entity (VIE) structure, before implementing the registration procedure (as for the VIE, see Column 3) (Note 5).

In an interview with Bloomberg on August 24, 2021, Chairman Gensler also revealed that if foreign companies listed in the United States—apparently with Chinese companies in mind—have refused a U.S. regulatory inspection regarding accounting audits for three consecutive years, the SEC will strictly apply a relevant law so that they will be delisted. Companies that continue to refuse inspection may be delisted from the New York Stock Exchange and the NASDAQ market as early as 2024 (Note 6).

Following the tightening of regulation by domestic and foreign financial regulatory authorities, not only will it become increasingly difficult for Chinese companies to go ahead with an IPO in the U.S. stock market, but some Chinese companies already listed in the U.S. market will be forced into delisting.

Ⅴ.Constraint on Development of Private Enterprises

Most of the platform operators that have driven the Chinese economy are private enterprises, and Ant Group and Didi are no exception. The tightening of regulation of those companies could constrain the development of private enterprises and escalate the trend of "the state advancing and the private sector retreating."

As some foreign media have pointed out, the objective of tightening of regulation of platform operators, including fintech firms—apart from the ostensible purpose of maintaining the stability of the financial system and market order—is probably to ensure governmental protection of state-owned enterprises and strengthen governmental control of private enterprises. In fact, anti-trust enforcement has apparently not extended to state-owned banks, which are the largest rent seekers. They are the greatest beneficiaries of the crackdown on fintech firms (Note 7).

On the other hand, amid concerns over the deterioration of the business environment for private enterprises, a series of charismatic entrepreneurs who have led the development of private enterprises have consecutively announced their retirement. Among them are relatively young business leaders such as Jack Ma (born in 1964) of Alibaba, Colin Huang (born in 1980) of Pinduoduo, a major social e-commerce company, and Zhang Yiming (born in 1983) of ByteDance, which operates TikTok, a short-video platform.

Although the real GDP growth rate of the Chinese economy averaged 10.1% on an annualized basis over the 30 years to 2010, it has declined to 6.8% over the 10 years to 2020. In addition to a decrease in the labor force due to the aging of society and a decline in the savings rate (which leads to a slowdown in investments), a slowdown in productivity growth due to the retreat of the market-oriented reform as exemplified by the trend of "the state advancing and the private sector retreating" has contributed to the fall in the growth rate. Unless this trend is reversed, the Chinese economy will lose its vitality, and it will become more and more difficult to realize "common prosperity."

Column 1: The Advantages and Disadvantages of Fintech

While the development of fintech in China has contributed significantly to improving the efficiency of financial services and financial inclusion, it also carries risks that could shake the stability of the financial system, and thus, the entire economy.

Fintech is helping to improve the efficiency of financial services. First, it can significantly reduce transaction costs by taking advantage of big data formed by e-commerce, third-party payments, and social networking and data analysis technology. In addition, fintech businesses do not require the opening of many branches or the hiring of large numbers of staff, which keeps operating costs low. Furthermore, fintech has opened up a different channel of financing from the traditional banking and securities industries, and has made it possible for anyone to receive one-stop financial services anywhere and anytime. Finally, the rapid development and new philosophy of fintech has also inspired traditional financial institutions to innovate in their operations and products and services.

Fintech is also encouraging the development of financial inclusion. Financial inclusion is the provision of appropriate and effective services to all segments of society that have a demand for financial services, based on the principles of equality of opportunity and the ability of businesses to develop sustainably, provided that costs can be borne. Small and medium-sized enterprises, farmers, and the poor are the main targets of such services. While banks and other traditional financial institutions have focused their business operations on a few large customers, fintech companies mainly serve a large number of smaller customers with small transaction volumes. This has been made possible by lower transaction costs brought about by technological advances and innovations in loan screening that take advantage of AI and big data.

On the other hand, the development of fintech-based financial businesses raises the following issues for consideration (Note 8).

First, the externalities inherent to Internet technology make it easier for large fintech companies to form a dominant position in the market. In particular, they can leverage the advantages of easy access to data, information, and customers to strengthen their market dominance.

Second, companies providing financial services are supposed to be licensed and subject to strict regulations, but fintech companies are not subject to adequate financial supervision. Hence, there is a risk that their businesses will expand in an unregulated manner. In particular, large fintech companies often offer multiple financial products and services simultaneously. Under the existing financial supervisory framework, there are clear boundaries between those financial products and services, and the regulatory requirements are also clear. In contrast, major fintech companies are taking advantage of advanced technology and the characteristics of their platforms, such as economies of scale and scope, to reshape some of their financial products and services and escape regulation. For example, some large fintech firms do not have to meet regulatory requirements such as the capital adequacy ratios that are applicable to banks, even though they offer services such as maturity transformation and credit transformation.

And the development of fintech may cause systemic risk. Some fintech companies are now in the "too big to fail" category. On top of that, the complex interplay of financial products from different industries and fields that are handled by these companies makes the risk difficult to grasp, but the scope of the risk is large.

Additionally, fintech companies are vulnerable to issues of security and protection of data, and controllability and stability of the new technologies they use.

Column 2: Legal Basis for the Security Review

China's "Cybersecurity Law" (effective June 1, 2017) states that "critical information infrastructure operators" are required to store personal information and critical data collected or generated domestically in China and must conduct a security assessment if they are transferred abroad (Article 37).

In addition, the Data Security Law (adopted on June 10, 2021, and effective September 1, 2021) states that:

  1. The State shall establish a data security review system and conduct national security reviews of data handling activities that affect or may affect national security (Article 24).
  2. Export controls shall be implemented in accordance with the Data Security Law that fall under controlled items related to the maintenance of national security and interests and the fulfillment of international obligations (Article 25).
  3. If another country or region imposes a discriminatory prohibition, restriction, or other similar measure on China in investment, trade, or other matters related to data and technologies related to data development and use, it may take equivalent measures against that country or region (Article 26).

Under the current "Measures for Cybersecurity Review " (effective June 1, 2020), if "the purchase of network products and services by a critical information infrastructure operator affects or may affect national security," the company must apply for a network security review (Article 5). In addition, the competent department may review network products and services that either affect or may affect national security (Article 15).

Taking into consideration the relevant provisions of the Data Security Law, the draft for comment of the revised "Measures for Cybersecurity Review" (promulgated on July 10, 2021) states that operators holding the personal information of more than 1 million users and newly listing on foreign markets must report for cybersecurity review. It also adds that data-handling activities and overseas listing activities that either affect or may affect national security are also subject to cybersecurity review.

Column 3: VIE Scheme Widely Adopted by Chinese Companies Listed Overseas

A Variable Interest Entity (VIE) is a scheme in which a foreign investor, through an overseas holding company or similar entity, provides funds to a domestically operating company that is engaged in a business subject to foreign investment restrictions, and does not hold shares, which is forbidden, but instead controls it by contract.

Specifically, the company in question is divided into (1) a domestic operating company (Company D), which conducts business, and (2) an overseas-registered holding company (Company A), which is mainly responsible for raising funds and listing the company overseas. The shareholders of the holding company, including foreign investors, control the domestic operating company indirectly through subsidiaries (Company B for tax savings and Company C as a wholly foreign-owned enterprise) and a series of contracts, rather than through shareholding, and enjoy almost the same rights as its shareholders (Figure 2).

Figure 2. The Structure of a Typical VIE Scheme Used by Chinese Companies
Figure 2. The Structure of a Typical VIE Scheme Used by Chinese Companies
1. The solid lines represent equity relationships, and the dotted lines represent contractual relationships.
2. The founders and members of the management team become shareholders of the VIE in most cases.
Source: Prepared by the author

From the early stages of their establishment, Internet companies in China have relied heavily on foreign capital for support. Foreign investors have also been actively investing in Chinese Internet companies in anticipation of the huge potential of the Chinese market. However, in order to protect national security and domestic industry, the hurdles for foreign Internet companies to enter the Chinese market are very high, and foreign investment in the sector has been restricted. The VIE scheme has been used as a means to circumvent the restrictions on foreign investment.

For a long time, China did not allow companies with VIE schemes to list domestically, so these companies had no choice but to list overseas, but this rule was relaxed in 2018 (Note 9).

The VIE scheme has facilitated financing and nurtured a number of high-tech companies in China, but it also carries a number of risks. As pointed out in the report "Risks to Chinese Internet Companies in the U.S. Stock Exchange" submitted to Congress by the U.S.-China Economic and Security Review Commission, while it is legal for Chinese companies to conduct IPOs on U.S. exchanges through VIE schemes in the U.S., it could be considered illegal in China, where the law is not yet in place (Note 10).

Another problem that may arise for foreign investors is that their control over management through the VIE scheme is weaker than through shareholding. If the domestic operating company or its shareholders violate their contracts with the wholly foreign-owned enterprise, the overseas-registered holding company and its shareholders' interests may be infringed.

The original text in Japanese was posted on September 29, 2021.

  1. ^ The General Office of the Central Committee of the Communist Party of China and the General Office of the State Council, "Opinions on Strictly Cracking Down on Illegal Securities Activities in Accordance with the Law," July 6, 2021.
  2. ^ The General Office of the Central Committee of the Communist Party of China and the General Office of the State Council, "Opinions on Further Reducing the Burden of Homework and Off-Campus Training for Compulsory Education Students," July 24, 2021.
  3. ^ The National Press and Publication Administration, "Notice on Further Strictly Regulating and Effectively Preventing Online Video Gaming Addiction in Minors," August 30, 2021.
  4. ^ A keynote speech by President Xi Jinping at the Communist Party of China and World Political Parties Summit (online), July 6, 2021.
  5. ^ Gary Gensler, "Statement on Investor Protection Related to Recent Developments in China," Public Statement, U.S. Securities and Exchange Commission, July 30, 2021.
  6. ^ Robert Schmidt and Benjamin Bain, "SEC Chief Warns ‘Clock Is Ticking’ on Delisting Chinese Stocks," Bloomberg, August 25, 2021.
  7. ^ Nathaniel Taplin and Jacky Wong, "Profits and Politics in China's Tech Crackdown," The Wall Street Journal, April 30, 2021.
  8. ^ Zhou Haojian, "Potential Risks and Supervision Associated with Large Internet Companies Entering the Financial Sector," Jinrong Sibao, November 2, 2020.
  9. ^ China Securities Regulatory Commission, "Some Opinions on Pilot Testing of Domestic Stock Issuance and Depository Receipts of High-Tech Companies," promulgated March 30, 2018.
  10. ^ Rosier, Kevin, "The Risks of China's Internet Companies on U.S. Stock Exchanges," US-China Economic and Security Review Commission Staff Report, June 18, 2014, addendum added: September 12, 2014.

January 17, 2022