Why China’s Corporate Crackdown Isn’t What It Seems

China’s moves to rein in its ride-hailing giant Didi Global this past week, just days after the company went public in the U.S., seemed to signal a far-reaching shift in the government’s policy toward its tech giants. Not only is China hassling Didi over its data policy—it also appears to be rethinking its attitude toward the corporate structures Chinese tech firms have long used to evade foreign investment restrictions and to go public in the U.S.

Venture capitalists and public market investors fretted—Didi stock in particular tanked. In the end, though, this may not be as far-reaching a shift as some might think. It certainly isn’t a sign China doesn’t want Americans investing in its tech giants.

Let’s step back for a minute. The regulatory issue now under scrutiny didn’t start with the ride-hailing firm. It has been percolating for years and most recently boiled over during the disclosures last year of a massive accounting fraud at Luckin Coffee, the Chinese coffee-delivery startup that was delisted from the Nasdaq stock exchange after it was revealed to have grossly inflated its sales. The incident badly damaged China’s image and sparked calls from U.S. authorities for tougher scrutiny of Chinese companies listed in the U.S. The startup went from a symbol of China’s economic might to a poster child for endemic corruption.  

The event sparked a reckoning back home. China’s regulators didn’t have an easy way to deal with the fraud perpetrated by Luckin executives because the securities sold to the public in the U.S. were not sold by Luckin’s business in China. Instead, what was listed in the U.S. came from an offshore company based in the Cayman Islands with a contractual relationship to Luckin’s business in China. That’s the same kind of corporate structure used by most Chinese companies that go public in the U.S., including Didi and Alibaba. 

Such a structure is designed to get around foreign ownership restrictions imposed by the Chinese government in industries deemed sensitive, which include the internet and media. But the side effect is to put the public company outside the jurisdiction of China’s securities regulators. This has been a longstanding problem for the nation. In the late 2000s, hundreds of Chinese companies got into the U.S. capital markets through reverse mergers. Effectively taking over U.S. shell companies in a process that allowed them to avoid the scrutiny of an initial public offering, they also committed billions of dollars’ worth of fraudulent transactions, resulting in dozens of lawsuits. 

These frauds don’t directly affect Chinese investors, as most of them can’t invest in foreign equities because of China’s restrictions on the flow of capital out of its borders. But it’s not in China’s interest for its companies to become known as havens for illegal business practices. While China limits foreign investment, it needs the money and expertise of foreign investors such as Sequoia Capital who have a track record of backing winners.

In the case of Luckin, China’s government eventually fined the company—but for issues including unfair competition and misleading the public rather than securities fraud. As one senior Hong Kong–based lawyer who works on VC deals explained it, those fines were an “implicit acknowledgment” that the securities of Luckin were outside China’s jurisdiction. 

Extending China's Reach

The new policy, announced this week, is a way to extend the long arm of China’s law, the lawyer told me. Among other things, the government is considering giving itself new powers to regulate Chinese companies that want to list overseas, lawyers and investors say. If these regulations are implemented, companies that want to use the shell company structure to list in the U.S.—known as variable interest entities or VIEs—would need approval from the Chinese government to do so, according to Bloomberg. (Overnight, China issued new draft rules that any company collecting personal information of 1 million or more users must get approval from Beijing to IPO overseas.)

China’s review of VIE structures has alarmed U.S. investors, but VIEs are not necessarily going away. It’s unlikely that China wants to cut off the flow of foreign investment capital that has helped accelerate its economic growth. 

The government under President Xi Jinping is, however, determined to better control that flow. And that’s not necessarily a bad thing. As Didi and other Chinese companies that have listed in the U.S. have noted in securities filings, the VIE structure exists in a gray zone. While investors typically ignore the risks the companies have warned of, they’re real. Removing that regulatory uncertainty could benefit investors and companies alike, even if it raises the bar for who gets to go overseas. 

So where does this leave other Chinese companies, like TikTok owner ByteDance, that have raised billions of dollars from foreign investors? Many investors and entrepreneurs are saying it’s still too early to tell. At least for now, bankers are halting roadshows and putting discussions of deals on hold as everyone waits for the dust to settle. 

Others point out that Western investors have rushed back into Chinese companies even after previous screwups, as was the case when regulators late last year killed the huge IPO of Ant Group, the online financial services company of Alibaba founder Jack Ma. Before that, China had suddenly pulled the rug out from under a string of online peer-to-peer lending companies. But still, when Kuaishou, the short-video app that is ByteDance’s biggest domestic rival, listed in Hong Kong earlier this year, investors sent the share price soaring. 

For many, the potential upside of owning a piece of one of the fastest-growing economies in the world is still worth the risk.