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Poster by Rajan Mithra@VCBay

Days after ride-hailing giant- Didi Chuxing’s US$ 4.4 billion listing, China opened a cybersecurity probe into the company, which later culminated in Didi’s app and 25 other apps linked to it being removed from the app stores. Didi’s shares were down by 20% on Friday after reports surfaced that the Chinese government was contemplating “serious, perhaps unprecedented, penalties” for the company. In the past few months, China has gone full throttle, cracking down on domestic tech giants from suspending Ant’s US$ 37 billion IPO and imposing a US$ 2.8 billion antitrust fine on Alibaba to opening a cybersecurity review into another recently US-listed Chinese firm- Full Truck Alliance. The Chinese tech stocks have lost more than US$ 800 billion in combined value since February this year. Fearing the onslaught, five Chinese tech firms have shelved their US IPOs– worth a combined US$ 1.4 billion and even TikTok’s parent ByteDance—valued at around US$ 180 billion—has said that it’s pausing its IPO plans. So what has made the Chinese regulators go berserk? What are the implications of the crackdown? Is this the end of the golden era of Chinese tech giants?

The Party is Over

Over the past few decades, China has greatly benefitted from its relationship with the West. Venture capitalists from the US provided funding to the most talented entrepreneurs in China, offered them valuable expertise, and guided them on best governance practices which ultimately helped them reach millions of Chinese consumers in a short time span. Later, Wall Street banks guided Chinese firms through the legal and regulatory maze towards an eventual public offering on the NYSE or the NASDAQ. China’s Big Tech- Baidu, Tencent and Alibaba have all relied on foreign funding to fuel their growth. According to Refinitiv, in the first six months of this year, 34 Chinese companies got listed in the US, raising a total of US$ 12.5 billion, which represents a 561% jump from the same period in 2020. This is an astounding feat given the rising tensions between the two countries and the fact that most travel between the countries has been halted. If the trend had continued, this year would’ve been the best ever year for Chinese IPOs in the US, but the crackdown brought everything to a grinding halt. 

Beijing has become increasingly impatient with the profit-centric focus of the country’s tech giants, which has come at the expense of the public’s best interests, and no one has been spared. Chinese e-commerce platforms Pinduoduo and Taobao were taken to task over online vendors publishing fake product inspection reports; Meituan– China’s largest food delivery platform is facing an antitrust probe; social media platform Xiaohongshu has come under regulatory scrutiny for enabling “wealth-flaunting” behaviour. In order to rein in the tech giants, China has introduced a slew of regulations.

New Rules

The Chinese Cyberspace Administration (CAC), tasked with censoring China’s internet behind the Great Firewall, has taken on more responsibilities in the new regulatory landscape. The administrative body was created in 2011 and used to offer suggestions to businesses, and until now, rarely interfered with IPOs. Currently, China is in the process of implementing new regulations in three key areas: to govern fintech firms, restrain monopolies and protect data privacy. The Cyber Security Law, the Data Security Law, the Personal Information Protection Law and the increased scrutiny of Variable Interest Entities (VIE) are the result of this effort. 

Cyber Security Law: Enacted in 2017, the Cyber Security Law is a critical piece of legislation that requires stakeholders to “safeguard cybersecurity, protect cyberspace sovereignty and national security”.

Data Security Law: The Data Security Law, which is all set to take effect this September, aims to protect “core data” and “important data” but allows for less sensitive data to be used in boosting the digital economy. Under the law, companies that transfer core data overseas without proper regulatory approval will be fined up to 10 million yuan (~US$ 1.54 million) and could be forced to shut shop. 

Personal Information Protection Law: The law increases penalties for companies responsible for data breaches, proposing massive fines of up to 50 million yuan (~US$7.7 million) or 5% of annual revenue.

Variable Interest Entity: The CAC has come out with new rules for overseas listings. The variable interest entity (VIE) is a corporate structure through which firms set up offshore shell companies to attract foreign investors. VIEs are corporate bodies formed overseas, usually incorporated in the Cayman Islands. Under this structure, investors do not receive direct stakes in the company but instead use a series of complex contracts to retain nearly the same rights as shareholders. VIE was the result of China’s stringent laws surrounding foreign ownership of its most important companies; Alibaba, Weibo and Baidu have all used this structure. Though these setups were legally questionable, the Chinese government had until now looked the other way, though that might be changing.

The new rules would require any company with data from more than 1 million people—to undergo a formal government review before listing on foreign exchanges, though this might not be applicable to those listing in Hong Kong.

Taming the Tech Giants

While there are many reasons for the crackdown, the major ones can be roughly boiled down to the following: 

Holding Foreign Companies Accountable Act: In March this year, the US SEC adopted the Holding Foreign Companies Accountable Act, which was passed by the administration of former President Donald Trump. According to the law, certain companies identified by the SEC will require auditing by a US watchdog, and these companies will be required to submit documents to ascertain whether or not they are owned/controlled by a governmental entity in a foreign jurisdiction. Chinese firms will have to name each board member who is a Chinese Communist Party (CCP) official, and those who fail to comply could be delisted from the US exchanges. This has obviously rattled the Chinese government, forcing it to scrutinise US-listed Chinese firms to ensure they don’t pass on sensitive data.

Data: President Xi has emphasised the importance of data and has in the past stated that ‘there is no national security without data security’. In April last year, China released a policy document that listed data as a “factor of production alongside the traditional factors of production- land, labour, capital and technology. The increased importance attached to data is the result of the digital economy making up 38% of China’s GDP in 2020, and the proportion is expected to be around 55% by 2025. Since the traditional drivers of the Chinese economy have slowed down and now that the digital economy has taken precedence, it is crucial to have clear rules on how companies can gather, store and sell data. 

Social Good: Emphasis on social good is one of the lenses through which China’s tech crackdown can be understood. The Chinese government deeply believes that technology must never be harnessed solely for an individual or organization’s gain. The existing view is that tech firms may commercially profit from the exploitation of technology, but not at the expense of social good.

Not just China: China is not the only one reining in the tech giants-

  • The EU introduced its landmark General Data Protection Regulation (GDPR) in 2016, which sought to bring in rules around how user data was processed. In December last year, the EU introduced the Digital Markets Act and Digital Services Act which enforces stricter controls on the behaviour of tech giants in different areas. 
  • The US has trained its sights on Big Tech and recently released the Anti-trust report, which concluded that the tech giants are engaging in anti-competitive behaviour. 

Alibaba

Stock price of Alibaba tanking due to China's tech crackdown

Ant Group, in which Alibaba owns a 33% stake, was all set to raise a record US$ 34.5 billion in what would have been the world’s largest IPO if not for its abrupt suspension. In a statement in November last year, the Shanghai Stock Exchange stated “significant issues such as the changes in financial technology regulatory environment” as its reason for the suspension. The suspension coincided with the introduction of new draft rules on online micro-lending, a vital part of the company’s business. The de facto reason for the suspension is most likely due to Jack Ma’s scathing speech in October 2020, in which he criticized Chinese financial regulators for stifling innovation

In April, Chinese regulators hit Alibaba with an 18.23 billion yuan (US$ 2.8 billion) fine due to its abuse of market dominance. The State Administration for Market Regulation (SAMR) stated that Alibaba’s monopolistic practices stifled competition in China’s online retail market, infringed on the businesses of merchants and the legitimate rights and interests of consumers. In addition to the fine, Alibaba is required to file self-examination and compliance reports to the SAMR for three years.

Didi Chuxing

Stock price of Didi Chuxing tanking due to China's tech crackdown

Didi is the largest ride-hailing company in China, accounting for around 90% of car bookings in the country. The ride-hailing giant raked in a staggering US$ 21.6 billion in revenues last year with 156 million average monthly active users and 13 million annual active drivers. Days after Didi’s IPO which valued the company at US$ 68 billion, the CAC issued a statement that it has opened a cybersecurity probe into the company based on the country’s national security and cybersecurity laws. On July 4th, barely two days after the cybersecurity probe was initiated, the regulator found serious violations of laws in collecting and using personal information and ordered all app stores to remove Didi’s app. On July 9th, 25 apps linked to Didi were also removed from app stores. While existing users can still use Didi, the company cannot sign up any new users until the probe is completed. This serves as a massive opportunity for the 210 players that compete with Didi and its rivals have already made their move: 

  • Food delivery giant-Meituan has relaunched its standalone ride-hailing app, which was previously merged with its main app, amid increasing regulatory hurdles and rising costs.
  • Caocao Chuxing, which offers ride-hailing services, has been pushing discount coupons and various benefits to users while T3 Chuxing plans to expand to more cities.

According to sources, Didi seems to have forced its way onto the US markets despite the CAC’s security concerns regarding the company’s vast swathes of data, forcing the regulator to take action. Didi’s vast amount of data which may even include transportation records of people working for the government can be used to construct detailed travel logs of Chinese residents, which has obvious national security implications. 

What are the best and worst-case scenarios for Didi?

  • The cybersecurity review generally takes up to 45 working days to complete, but the period can be extended and doesn’t include the time that a company spends preparing documents for the investigation. So technically, the probe can take months.
  • The best-case scenario is if Didi is let off the hook since the review found no national security risks and its app is reinstated. 
  • The worst-case scenario involves Didi getting delisted from the US market, and its products and services are found to be problematic with national security implications. According to recent reports, the Chinese government is said to be weighing “serious, perhaps unprecedented, penalties” for the company.

Conclusion

China’s tech crackdown and its resulting regulations have different implications for key players. The outspoken founder of Alibaba, Jack Ma, who was seemingly untouchable, has realised that criticising the Chinese government has severe consequences. The Chinese tech companies have realised that they can no longer amass vast quantities of data and apply smart algorithms in the hopes of turning users into potential consumers as the cost of acquiring and managing data will rise steeply. Tech companies have been forced to up their game and invest more in innovation. 

The additional regulatory requirements could serve as a deterrent for companies aiming to list abroad and have instead increased the appeal of other listing venues such as the Hong Kong and mainland stock exchanges. While Didi’s data falling into the wrong hands could have national security implications, the problem could have been solved with minor regulatory tweaks. The situation did not merit radical rule changes and arbitrary restrictions. So the Chinese government’s actions can be interpreted as a show of force to re-establish control over the country’s biggest firms.Ultimately, the Chinese government has indicated that the days when it was willing to relax enforcement over its fast-growing tech companies are officially over. China has realised that in order to become a true superpower, it has to have a solid regulatory foundation and prioritise data protection and compliance.

For more extensive analysis and Market Intelligence reports feel free to approach us or visit our website: Venture Capital Market Intelligence Reports | VCBay.

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