Due to the existence in the domestic regulatory environment of restrictions limiting access by foreign investors to certain industries, the variable interest entity (VIE) structure was born as a versatile means to resolve the difficulty of such industries listing abroad to raise financing. As Hong Kong is an international finance centre adjacent to mainland China, mainland enterprises have intrinsic geographical advantages and financing advantages in this regard. For example, the Xiaomi Group recently erected a VIE structure and submitted a listing application to the Stock Exchange of Hong Kong (HKEx). Its market valuation is expected to reach US$60-80 billion.
However, HKEx has tough requirements regarding the oversight of VIE structures, of which listing applicants wishing to use a VIE structure to list in Hong Kong should be aware. This column analyses the issues requiring particular attention in erecting a VIE structure from the perspective of a Hong Kong listing.
A VIE structure differs from the traditional method where equity serves as the umbilical cord linking the contemplated listed entity and the domestic operating company, in that it involves using a series of agreements and arrangements to achieve actual control and financial consolidation between the contemplated listed entity and the operating company.
Although the series of agreements is comprehensive, the risk of breach of contract by the domestic operating company and its shareholders remains. Furthermore, due to the low cost involved in the restructuring of a VIE structure, and the speed with which it can be accomplished, there is a potential for abuse.
Out of consideration for protecting the investors of listed companies, HKEx issued Listing Decision HKEx-LD43-3 and Guidance Letter HKEx-GL77-14, which respectively apply to listing applicants that have business using a VIE structure, and issuers that use a VIE structure after listing. This column focuses on the requirements that Listing Decision HKEx-LD43-3 places on listing applicants. Since its issuance in 2005, Listing Decision HKEx-LD43-3 has been updated nine times, most recently in April this year.
Necessity of a VIE structure. Listing Decision HKEx-LD43-3 specifies that regardless of the materiality of the business in terms of revenue, profit or otherwise, the use of a VIE structure should be strictly limited to resolving the restrictions on foreign ownership. It additionally points out the possibility of a company partially using an equity linkage and partially achieving control through a VIE structure. In respect of the above-mentioned requirements, paragraphs 16B and 16C of the Listing Decision set out exceptions.
Paragraph 16B: If the operating company (OPCO), as a result of having foreign ownership, is required to obtain approval and fulfil additional eligibility standards, the listing applicant must fulfil these requirements. The listing applicant must seek and obtain such regulatory approval to directly hold the maximum interest in the OPCO prior to submitting its listing application, unless the approving regulatory authority confirms that it will not, or cannot, give approval, even if the listing applicant fulfilled the other requirements: (1) because no procedures or guidance for granting approval are available; or (2) for policy reasons.
Paragraph 16C: If clear procedures or guidance from the approving regulatory authority are not available, the listing applicant can directly hold less than the maximum permitted interest in the OPCO if it demonstrates to the satisfaction of the exchange that it has, as advised by its legal advisers, reasonably assessed the requirements under all applicable rules, committed financial and other resources, and implemented all the legal adviser’s recommendations prior to submitting its listing application.
Breaking down 16B and 16C. With respect to paragraphs 16B and 16C, different understandings exist depending on the industry, but certain points can be confirmed. First, when the listing applicant cannot directly hold the maximum permitted interest in the domestic operating company, talks with the approving regulatory authority are necessary because, when applying paragraph 16C, confirmation of the regulatory authority is require as to whether procedures or guidance for granting approval are available.
Second, the two reasons in paragraph 16B may be broadly understood as “do not know how to approve” and “do not approve”. A detailed analysis of the this logic reveals that regardless of whether procedures or guidance for granting approval are available, the result may be a “do not approve”. Accordingly, when a regulatory authority does not grant approval for policy reasons, inquiries should still be made as to whether procedures or guidance for granting approval are available. If they are available, the listing applicant is required to fulfil the other requirements. If they are unavailable or unclear, then paragraph 16C is applicable.
The presence of paragraph 16C clearly places more stringent requirements on Chinese legal advisers. It is likely that the sponsor will require the Chinese legal advisers to issue an opinion as to whether the listing applicant fulfils the requirements of paragraph 16C. At that time, how to comprehensively search for the applicable rules, put forward reasonable recommendations, and issue an opinion on the fulfillment by the listing applicant will be the difficult points of the work.
Where restrictions on access by foreign investors exist for only part of the business. In practice, it is very common for a domestic operating company to engage in a large mix of business, only some of which are subject to restrictions on access by foreign investors. In such a circumstance, can the domestic operating company directly erect a VIE structure, or is it required to spin off the business that is not subject to restrictions on access by foreign investors before erecting a VIE structure? The authors’ viewpoint leans toward the latter.
The description, “If there are no limits on foreign ownership, the listing applicant must not use contractual arrangements to carry on its business”, appears in paragraph 17 of Listing Decision HKEx-LD43-3. The authors argue that paragraph 17 is not a simple reiteration of the necessity principle, but rather emphasizes that the domestic operating entity controlling the VIE structure should not include business on which there are no limits on foreign ownership.
When based on the interconnectedness and inseparability of the business, or reasons specified in law, consideration can be given to attempting to convince HKEx to agree to not require the applicant to spin off such business. More specifically, reference can be made to the relevant disclosures in the section on contractual arrangements in the prospectus for Ping An Healthcare & Technology (HK 1833).