A Destination for Asset Allocators
Like many emerging markets, China continues to monitor and restrict foreign ownership of companies that are listed publicly. To access the mainland China stock market and purchase "China A" shares, investors must either be qualified investors licensed by the government or trade via Stock Connect, which allows northbound orders from Hong Kong to the mainland stock markets in China. In both cases, investors are subject to trading quotas and ongoing monitoring resulting from China's capital controls.
In an effort to more easily access US capital markets, however, many Chinese companies leveraged another structure to allow their American Depository Receipts (ADRs) to invest directly into China A shares that has not been formally approved by the Chinese government. The structure is called a Variable Interest Entity (VIE), and it combines a Chinese agent who holds the shares locally and a shell company in a tax efficient location (mostly often the Cayman Islands) that reflects ownership through a series of controlling agreements. In other words, when investors buy a Chinese ADR, they are usually buying into a Cayman shell company with a legal agreement in place to reflect the shares owned by a local Chinese agent, who is the legally recognized holder of the China A shares.
This distinction is critical to understand if you invest or plan to invest in Chinese ADRs. If the ADR utilizes a VIE structure, the equity you are holding represents shares in a holding company that in turn owns A shares of the underlying company. The ADR does not represent a direct interest in the local shares.
Until February 2023, Chinese officials have never approved or formally supported the VIE structure. The access which VIEs provide to Chinese equities circumvents some of the foreign investment rules and requirements in China. And in fact, Chinese ADR filings have pointed out these risks. From the Tuniu (Ticker: TOUR) 20-F Registration filed with the SEC on April 29, 2022:
A series of contractual agreements, including powers of attorney, equity interest pledge agreements, cooperation agreements, purchase option agreements and shareholders’ voting rights agreements, have been entered into by and among our wholly owned PRC subsidiary, Beijing Tuniu Technology Co., Ltd., or Beijing Tuniu, the VIE and its shareholders. As a result of the contractual arrangements, we have effective control over and are considered the primary beneficiary of the VIE, and we have consolidated the financial results of the VIE in our consolidated financial statements…However, the contractual arrangements may not be as effective as direct ownership in providing us with control over the VIE and we may incur substantial costs to enforce the terms of the arrangements. There are substantial uncertainties regarding the interpretation and application of current and future PRC laws, regulations and rules regarding the status of our rights with respect to our contractual arrangements with the VIE and its shareholders. It is uncertain whether any new PRC laws or regulations relating to VIE structures will be adopted or if adopted, what they would provide. If we or the VIE is found to be in violation of any existing or future PRC laws or regulations, or fail to obtain or maintain any of the required permits or approvals, the relevant PRC authorities would have broad discretion to take action in dealing with such violations or failures. Our holding company, our PRC subsidiaries and VIE, and investors of our company face uncertainty about potential future actions by the PRC government that could affect the enforceability of the contractual arrangements with the VIE and, consequently, significantly affect the financial performance of the VIE and our company as a whole. In addition, these agreements have not been tested in China courts.
In response to sharply declining listings of Chinese companies in the US, regulatory changes are being introduced that would allow the Chinese Securities Regulatory Commission (CSRC) to oversee firms that utilize a VIE structure. These rules are intended to better regulate overseas IPOs by Chinese companies. The CSRC has publicly stated that VIE structures have been used to circumvent listing rules and regulations, and the new rules being introduced will allow the CSRC to remove or stop overseas listings with which they take issue.
The bottom line is that investors need to understand the unique nature of Chinese ADRs, specifically that the ownership interest is in a holding company and not directly into the listed company. And precisely how the rules will be enforced (or leveraged for political purposes) is still evolving. While Chinese ADRs may never be impaired by geopolitics, there are better means for institutional investors to access the Chinese stock market. The safer investment method is either directly as a qualified foreign institutional investor or by leveraging Stock Connect for northbound trading out of Hong Kong. Northern Trust can facilitate both custody and trading of China A shares via these methods.
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