SEC Chair Gary Gensler said in a statement that he has directed staff to seek certain disclosures from offshore issuers associated with China-based operating companies before they get the green light from the commission to list on U.S. stock exchanges in light of recent developments in China and the risks inherent in variable interest entities (VIEs). He is worried that investors may not fully understand how certain Chinese companies are structured to sell shares.
This comes as the Chinese government recently strengthened supervision of China-based companies raising capital abroad, including through offshore shell companies. Notably, the new cybersecurity law includes government-led data security reviews of certain companies that raise capital via companies in other jurisdictions, such as the Cayman Islands.
Gensler said this is relevant to American investors because companies in certain sectors in China are not allowed to have foreign ownership and cannot directly list on exchanges outside of China. Thus, many China-based operating companies are structured as VIEs to raise funds on such exchanges.
Typically, a China-based operating company sets up an offshore shell company to sell stocks to the public. That shell company, which has service contracts with the operating company, issues the shares on a foreign exchange like the New York Stock Exchange.
The shell company has no equity ownership in the operating company, but the shell company can consolidate the operating company into its financial statements for accounting purposes. And this arrangement creates exposure to the Chinese operating company for U.S. investors through a series of service contracts.
“To be clear, though, neither the investors in the shell company’s stock, nor the offshore shell company itself, has stock ownership in the China-based operating company,” Gensler said in a July 30, 2021, statement. “I worry that average investors may not realize that they hold stock in a shell company rather than a China-based operating company.”
To better protect retail investors, Gensler said he has directed the staff to make sure that the issuers prominently disclose:
- That investors are not buying shares of an operating company but instead buying shares of a shell company issuer of the associated operating company. Thus, the business description of the issuer should clearly distinguish the description of the shell company’s management services from the description of the operating company;
- That the operating company, the shell company issuer, and investors face uncertainty about future actions by the government of China that could significantly affect the operating company’s financial performance and the enforceability of the contractual arrangements; and
- Detailed financial information so that investors can understand the financial relationship between the VIE and the issuer.
Moreover, Gensler said all China-based operating companies that want to register their securities with the SEC—directly or through a shell company—must clearly and prominently disclose:
- Whether the operating company and the issuer, when applicable, received or were denied permission from Chinese authorities to list on U.S. exchanges; the risks that such approval could be denied or rescinded; and a duty to disclose if approval was rescinded; and
- That the Holding Foreign Companies Accountable (HFCA) Act requires the SEC to delist companies if they fail to comply with the PCAOB’s audit firm inspections requirement for three consecutive years.
In addition, Gensler said he has asked staff to do targeted additional reviews of filings for companies that have significant operations in China.
“I believe these changes will enhance the overall quality of disclosure in registration statements of offshore issuers that have affiliations with China-based operating companies,” he said. “This work builds on the SEC’s Division of Corporation Finance’s previous guidance on disclosure considerations for companies based in or with significant operations in China.”
He was making a reference to CF Disclosure Guidance: Topic No. 10, “Disclosure Considerations for China-Based Issuers,” published in November last year.
The disclosure guidance addresses risks arising from the inability of U.S. regulators to inspect accounting firms that audit Chinese companies listed in the U.S. This has been a long-running problem as Chinese authorities prohibit accounting firms from sharing their audit work papers with U.S. regulators, which HFCA, passed last year, is trying to solve.
“I believe such disclosures are crucial to informed investment decision-making and are at the heart of the SEC’s mandate to protect investors in U.S. capital markets,” Gensler added.
However, some experts question whether the SEC’s move will be effective.
“The PRC position really clarifies what they have long been doing. I wonder if disclosure here is enough or do the exchange listing standards need to be changed?” said Thomas Gorman, a partner with Dorsey & Whitney LLP who was previously a former senior counsel in the SEC’s enforcement division. “Otherwise, we just continue to have ‘work arounds’ for what are effecting shell companies that can disappear in a whiff—pull a string and offshore investors have nothing while PRC investors continue to own the company.”
Chinese Law Implications
China’s Data Security Law covers usage, collection, and protection of data, including cross-border transmission. And companies can be fined or shut down for violations.
Paul Gillis, in his China Accounting Blog, wrote that some of the steps that China has taken may be a reaction to U.S. actions against Chinese companies.
“For example, the data security issues on DiDi seem remarkably similar to the since rescinded Trump order on TikTok,” Gillis wrote.
A month ago, China started a cybersecurity investigation into Didi Chuxing, the biggest ride-hailing company, which conducted listing on the New York Stock Exchange.
“I believe that China is disappointed that Biden has not softened the U.S. stance on bilateral relations,” Gillis wrote. “I think China may have sent a message to U.S. investors that decoupling would likely lead to huge losses for them and is hoping these investors put some political pressure on the U.S. government.”
Moreover, he believes that the Chinese government is making it clear to private companies that the state has primacy.
“While the private sector in China now dwarfs the state sector in the economy and job growth, recent actions against Ant and DiDi make it clear that the party remains in charge,” he wrote.
This article originally appeared in the August 2, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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