2021-12-27 A Tale of Two Exchanges: Chinese ADRs and Delisting

A Tale of Two Exchanges: Chinese ADRs and Delisting


It was the best of times, it was the worst of times, it was the age of Biden, it was the age of Trump, it was the epoch of ARKK, it was the epoch of NFTs, it was the season of bull markets, it was the season of bear markets, it was the spring of Wyckoff, it was the winter of Crypto, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way. And somehow… we haven’t even scratched the surface of crazy market news. Let’s talk about China.

With seemingly catastrophic news around Evergrande finally defaulting on their $300 billion debt, market strategists are worried about contagion spreading and causing defaults for a deluge of Chinese property developers. Needless to say, this news has caused Chinese equities to be more volatile now than ever before. To fan the flames even further, there’s recent news that various Chinese stocks will delist from NYSE and settle down in HKSE instead. Bulls and bears alike have come out of the woodwork, furiously producing analyses to predict the extent of the fallout. But what does this mean to us, the average investor?

Before breaking down what equity delisting means to the layman, I want to educate everyone on how and why this is happening. The structural backbone instrumental to the Chinese investment ecosystem is a little different than your traditional stock listing. To set the stage, we’ll need to talk about American Depositary Receipts (ADRs) and Variable Interest Entities (VIEs).

This little island will be important in a bit… (hint: no corporate or income taxes on foreign income)

ADRs are certificates that trade on American stock exchanges and track the price of a foreign company’s domestic shares. Dating all the way back to 1927, the first American Depository Receipt was created by JPMorgan as one of the earliest efforts to globalize equity markets. In short, sponsored ADRs (the ones you see listed on the US stock exchange and the ones pertinent to this article) are formed by an agreement between the foreign company and a depository bank. There are three levels of sponsorship available, all with varying levels of privilege:

  • Level 1 ADRs are only allowed to trade directly between market participants, or over-the-counter (OTC). These companies do not need to report on a regular basis as other publicly traded companies are typically subject to.
  • Level 2 ADRs are allowed to trade directly on US exchanges. However, they are subject to more stringent requirements: regular Form-20-F (the international variant to Form-10-K) filings that must follow GAAP/IFRS principles, and a registration statement with the SEC.
  • Level 3 ADRs are even stricter than Level 2 ADRs. Companies must file a prospectus as well as annual reports, in accordance with GAAP/IFRS similar to Level 2 participants. Additionally, materials shared to shareholders must also be submitted to the SEC, where they are readily available to US investors.

The primary advantage offered by this instrument is the relative ease to how investors can transact stocks of foreign countries. Prior to the ADR, international investors would be at the mercy of foreign exchange and regulatory risks, which added significant hurdles to investing abroad. However, there are tradeoffs to investing in ADRs. ADRs represent the prices of foreign companies’ shares, but do not actually grant you ownership rights as shares of common stock typically do. This will cause some problems for us down the line.

What happens when an ADR is terminated? It happens quite frequently, although typically due to a lack of interest rather than a dramatic executive order in an effort to palliate worries of “the People’s Republic of China (PRC) exploiting United States capital”. First, all ADRs previously issued are cancelled and disallowed from trading in US exchanges. Much like a delisted stock, a delisted ADR loses the ability to transact freely on the open market, removing any previously available liquidity. So what happens with the remaining, existing  shares? There are two common scenarios available: share transfer and share buyback. The simplest and most beneficial for investors is the share transfer scenario where investors can simply convert shares of the defunct ADR into corresponding securities in a foreign exchange. Obviously, it’s not all sunshine and roses since now investors will be subjected to the rules of the foreign exchange, which may result in lesser protections than the US. The lack of liquidity also frequently leads to a decrease in share price. On the other hand, a buyback scenario is less beneficial to the original investor. Although US banks are not obligated to buy back the outlying shares when an ADR is terminated, the parent company can purchase its shares back at a previously agreed upon price (again, typically much lower due to the liquidity premium demanded). There is one last option: companies can simply disappear, refusing to report to the SEC entirely. In this scenario, an investor would typically lose all their money unless they were able to seek legal recourse from a court. Good luck trying to draw blood from a stone.

Enter the VIE, a business structure that allows a company to recognize variable interests without maintaining voting rights, obligations to absorb losses, and rights to receive residual returns. Originally called special purpose entities (SPE), this legal structure was used prominently during the Enron accounting scandal to conceal insurmountable losses ranging in the tens of billions of dollars. This should have been a warning not to pursue these types of structures again, but markets folks gotta market. Unsurprisingly, it left such a deep stain in the business and financial world that businesses needed to rebrand SPEs to the now immaculate and completely VIE-rtuous legal structure we know today as the variable interest entity. It’s almost crazy how history seems to be replaying itself, huh? If none of this is unfamiliar to you, don’t worry – it’s pretty unfamiliar to quite a bit of people, generating quite a bit of Google Search buzz over the last 5 years. How many of these are industry professionals trying to understand what they’re invested in themselves? Who knows!

Fast forward a decade later. VIEs are now most commonly and notably used by Chinese companies looking to tap into foreign markets while skirting Chinese law prohibiting non-Chinese ownership in a vast majority of Chinese companies. According to FTSE Russell’s Guide to Chinese Share Classes, very few securities are allowed to actually trade hands internationally. While the vast majority of Chinese investors buy and sell “A-shares”, only a select qualified foreign institutional investors (QFII) can actually participate in trading these A-shares. Hence the VIE workaround. By creating a VIE that houses foreign ownership, Chinese companies can legitimately say that they are owned entirely by Chinese nationals despite telling foreign shareholders that they own a piece of that same pie. However, this comes with a significant drawback: investors only have ownership on paper (the contractual obligations holding the VIE together) without any recognition of ownership in the underlying business.

Now let’s put the two together – ADRs based off of VIEs. On one hand, this allows non-Chinese investors to tap into emerging markets. On the other hand, it’s technically frowned upon by the Chinese government, although they’ve turned a blind eye to them for obviou$ rea$on$. In fact, there are over 100 Chinese companies with VIE structures set up across the world, incorporated primarily in the Cayman Islands. What’s dangerous about this setup is that if things go wrong, ADR-only stuff will be potentially compensated (based on the three options listed above), while ADR based on VIEs only have one scenario: straight bust. Basically, as an investor in a VIE-based ADR, you’re hoping that a bunch of potentially illegal legalese will keep things together when things go wrong.

What does this mean for everyone else, who probably has a tiny (or not so tiny) stake in Chinese equities? Long story short, a lot of things can happen. No one can say precisely, but it would be prudent to start derisking if you haven’t done so already. Worst comes to worst, we could see a repeat of 2011 where one of Yahoo’s top executives got yeeted after Jack Ma rug-pulled Alibaba by transferring the extremely lucrative Alipay (previously part of Alibaba) into his own company, without the knowledge of its then majority investor Yahoo. Despite months of court activity attempting to reclaim their stake in Alipay, Yahoo realized that they owned 43% of an Alibaba clone listed far off in the Cayman Islands instead of Alibaba proper… which could not enforce any of the contracts needed. Realistically, China would never magically disappear trillions of dollars worth of equity from ALL VIEs overnight – it would likely trigger global retaliation from very powerful financial institutions. But that’s not to say it hasn’t happened before. In the 2010s, US investors felt the collapse of Chinese cross-border listings and cumulatively lost quite a bit of money, estimated at tens of billions of dollars. However in today’s globally intertwined market, a more reasonable scenario would be China shutting down VIEs on certain companies, claiming that they are vital to domestic security.

Strangely enough, it was actually the US that took the first stab at closing the China-US loophole on November 12 2020: Executive Order 13959 was signed, prohibiting any new US investment in “Communist Chinese military companies.” Various companies were added throughout December, including Semiconductor Manufacturing International Corporation (SMIC) and China National Offshore Oil Corporation (CNOOC), culminating in 3 Chinese telecom companies delisting entirely from NYSE. To make matters even more severe, the House passed a bill to ban Chinese companies from listing in the US due to insufficiently regulated audits and financial reporting. How this ends is anyone’s guess, but one thing is for sure: the official Chinese response to this ban is absolutely scathing.

China opposes US abuse of national security and inclusion of Chinese companies on the so-called list of Communist Chinese military companies. We will take necessary measures to firmly defend the lawful rights of Chinese companies. At the same time, we hope the US will join China in creating a fair, stable and predictable business environment for companies and investors of the two countries and return bilateral economic and trade relationship [sic] to the right track at an early date.

I want to close out this article with a 2020-2021 timeline on all of the Chinese delisting events. Please shoot me a message on Twitter @breadcatbounce if you have suggestions for further research, or if you have any questions, comments, or corrections you’d like to suggest. I’d love to hear them!​​