The prospect for future Chinese IPOs in the US just grew even more dim on Friday when Chinese officials in Shanghai followed through on their promise to close a popular route for bringing domestic firms public on foreign exchanges.

Startups that have recently applied to Shanghai’s National Development and Reform Commission for permission to inject money into affiliated shell companies incorporated in places like the Cayman Islands are being turned away by Chinese regulators, Bloomberg reports, citing anonymous sources familiar with the issue. Injecting money into these entities is typically the first step toward setting up a Variable Interest Entity, which are used to facilitate IPOs of Chinese firms in the US, Hong Kong and elsewhere (since Chinese law forbids foreign ownership of any Chinese assets).

The shutdown isn't a complete surprise. Beijing has quietly chafed as the biggest and most successful Chinese firms have sought to list on foreign exchanges. And a few weeks ago we reported that Beijing was changing the rules, requiring firms to get permission from regulators before trying to form their own VIEs. It was all part of a broader crackdown that could mean the end of Chinese firms listing in the US. For now, at least, no Chinese firms are planning to go public in the US.

On the US side, the SEC has frozen applications for Chinese firms looking to list in the US over demands for more stringent auditing standards, which Beijing is loathe to agree with.

American analysts and investors have long been wary of the VIE structure, which received a lot of skeptical press coverage in the US back in 2014 ahead of Alibaba's historic public offering. As Globescan explains, almost every listed Chinese company trading outside of China is listed through a VIE structure. The structure ensures that investors - many of whom don't realize what's going on - don’t actually own any part of the underlying Chinese company. While that might sound ridiculous, sadly its true. Investors who buy shares in Chinese stocks such as JD.com, Alibaba, Tencent, etc do not technically have any ownership of the underlying business whatsoever.

Globescan continues:

The reason is that under Chinese law, foreign ownership in certain (most) Chinese industries is prohibited. As a result, it is illegal for Chinese companies like JD.com and Alibaba to have any non-Chinese shareholders. Back in the early 2000s, as the China growth engine was really beginning, Chinese companies growing quickly looked longingly at the huge amounts of capital available in the US and wanted to access it. At the same time, US investors and Wall Street firms looked longingly at the huge growth rates in China and wanted to access that. But Chinese law prevented them both from doing so. So, a structure was developed to circumvent Chinese law: the VIE (Variable Interest Entity). This is a structure that has been around for decades, first popularized here in the US by Enron to obfuscate assets and liabilities on its balance sheet (there is the first alarm bell…). The VIE structure achieves the dual purpose of giving Chinese companies access to Western capital, whilst simultaneously allowing Western investors access to Chinese stocks. It does so by effectively saying two different things to each side: the VIE says to the Chinese regulator that the company in question is wholly owned by Chinese nationals, while the same VIE simultaneously tells the Western shareholders that they legitimately own that Chinese company.

To explain exactly how the VIE structure works, Globescan offered Tencent as an example:

We will use Tencent as an example to explain the basic structure of a VIE. Tencent operates in a sector on the ‘restricted list’ issued by the government. This list outlines which sectors are prohibited from having any foreign ownership. It is a very broad list, with general wording such that in reality the majority of Chinese companies are barred from any outside ownership.

So as a result, Tencent cannot sell its shares to any non-Chinese investors. But it can circumvent this law using that VIE structure. Without getting into complex legalities, the VIE works as follows; Tencent creates a Cayman Islands listed shell company (no real business, no office, no employees), which it also calls Tencent. (For simplicity from here onwards we will refer to the actual Tencent as ‘Real Tencent’, and the Caymans shell company as ‘Fake Tencent’) Once Fake Tencent has been setup, Real Tencent then creates a complex web of legal agreements that serve to give Fake Tencent a claim on the profits and control of the assets that belong to Real Tencent.

(Note that there is no recognition of any actual ownership, just a claim on the profits and indication of an element of control)

Fake Tencent now owns as its only asset these contracts and agreements. Fake Tencent then lists itself as a company on the NYSE, selling shares to investors under the name ‘Tencent’. Wall Street banks take in millions of dollars in fees to list Fake Tencent, and hundreds of investment firms and investors invest billions of dollars into buying shares of Fake Tencent. Bear in mind, the whole time the Western investors are buying stock in a company called ‘Tencent’ that appears to simply be the Chinese company. Fake Tencent appears to have control over the assets and a right to the profits of the real Tencent in China, even though in reality it is just a shell company with no real assets or business.

Since Chinese first discovered the loophole, it has been technically illegal in China. But a loophole embraced by regulators allowed firms to continue to list in the US using the structure. Now, Beijing is looking to close that loophole after Chinese firms raised $76 billion via new offerings in the US over the last decade.