The Blubber

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. And all hell broke loose when a recently released article stated that various Chinese stocks would 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, let’s talk about why this is all happening. In short, the structural backbone instrumental to the Chinese investment ecosystem is a little different than your traditional stock listing. First, we’ll need to talk about American Depositary Receipts (ADRs) and Variable Interest Entities (VIEs).

ADRs are certificates that trade on American stock exchanges and track the price of a foreign company's domestic shares. Dating back to 1927, the first American Depository Receipt was created by JPMorgan as one of the earliest efforts to globalize equity markets. In short, a sponsored ADR (the ones you see listed on the US stock exchange and the ones pertinent to this article) is 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). Therefore, these companies do not need to report regularly 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. For example, companies must file a prospectus and annual reports per GAAP/IFRS similar to Level 2 participants. Additionally, materials shared with shareholders must also be submitted to the SEC, 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. For instance, ADRs represent the prices of foreign companies’ shares but do not actually grant 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 occurs quite frequently, although typically due to a lack of interest rather than a dramatic executive order to palliate worries of “the People’s Republic of China (PRC) exploiting United States capital.” First, all previously-issued ADRs are canceled 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: share transfer and share buyback. The most straightforward and most beneficial for investors is the share transfer scenario, where investors can simply convert shares of the defunct ADR into corresponding securities in foreign exchanges. Obviously, it’s not all sunshine and roses since now investors will be subjected to the foreign exchange rules, resulting in lesser protections than the US. Specifically, the lack of US 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, investors would typically lose all their money unless they 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 companies 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 alien to quite a bit of people, generating quite a bit of Google Search buzz over the last five years. How many of these are industry professionals trying to understand what they are 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 can trade hands internationally. While the vast majority of Chinese investors buy and sell “A-shares”, only a select few qualified foreign institutional investors (QFII) can 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 recognizing any ownership in the underlying business.

Strangely enough, it was 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. In addition, the House passed a bill to ban Chinese companies from listing in the US due to insufficiently regulated audits and financial reporting to make matters even more severe. How this ends is anyone’s guess, but one thing is for sure: the official Chinese response to this ban is 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.

Let’s finally tie things back to price movement and options flow. For deep-dive commentary into Didi’s delisting, read @falcon_fintwit’s analysis: Was Didi’s delisting priced in?

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