What is Behind the SEC's Pause in China-Based Listings?Posted on Oct 22, 2021
In 2020 alone, companies based in China raised approximately $12 billion to $19 billion on U.S. exchanges.However, by the end of July 2021, the SEC was no longer processing registrations for the issuance securities by China-based companies, as the agency is refining disclosure rules concerning the risks related to many Chinese companies’ use of offshore holding companies. Further, due to recent U.S. legislation, the SEC may be required to de-list hundreds of Chinese securities in 2024. This regulatory and legislative response ultimately stems from Chinese laws prohibiting foreign investment in Chinese companies and foreign oversight of Chinese auditors.
Regulatory Background in China
China restricts foreigners from investing in Chinese companies that operate in certain “sensitive” sectors. The country’s “Foreign Investment Law” spells out what restrictions apply to which sectors and completely bans any foreign equity ownership of Internet companies, such as Alibaba, JD.com, or Tencent.
However, these restrictions have not stopped Chinese companies from listing on U.S. and other foreign exchanges.Such Chinese companies take advantage of a variable interest entity (“VIE”) structure. This structure allows U.S. listings which have no actual equity stake in the underlying Chinese entity, but are merely an offshore holding company to which the Chinese company owes certain contractual obligations. Providing no equity stake, the structure had previously not required financial statement consolidation. Notably, Enron used the VIE structure to hide its liabilities offshore, and in response, the Financial Accounting Standards Board changed the accounting rules so that now the structure requires financial statement consolidation. Due to this change China-based issuers can now offer foreign investors “the rights and benefits normally associated with ownership of the VIE without holding actual equity ownership” and evade the country’s foreign investment restrictions.
The VIE structure is created through contractual arrangements pursuant where an offshore holding company (oftentimes incorporated in the Cayman Islands) “controls and receives the economic benefits of a Chinese onshore operating entity . . . whose shareholders would normally be [Chinese] nationals.” The onshore operating entity “holds the assets and licenses that cannot be legally owned by foreign investors” while the offshore holding company enters into service contracts that grant it control of the Chinese entity.
The structure is not without its risks to investors (and the China-based operating companies which employ it). Since the first Chinese companies used the VIE structure to list in the United States, Chinese regulators have oscillated between tacit approval of the structure to outright attack on it. We currently appear to be in a period of tacit approval—last year China’s State Administration for Market Regulation officially accepted a merger control filing for concentration of operators where one of the parties uses the VIE Structure. While Chinese officials certainly have incentives not to prohibit the mechanism, the VIE structure is clearly intended to circumvent the government’s foreign ownership restrictions.
Despite the structure’s legally dubious status in China, the structure has proliferated—“over 80% of all U.S.-listed Chinese companies operate VIEs that are material to their operations.” Further, “virtually every internet company from China that has gone public on American stock exchanges used VIE structures to circumvent Chinese restrictions on foreign investments in domestic businesses.”
Chinese regulatory risks extend beyond the VIE structure. In addition to changes to VIE accounting, the Enron scandal also led to the passage of the Sarbanes-Oxley Act. As part of the Act, the Public Company Accounting Oversight Board (PCAOB) was created. The PCAOB is “a nonprofit entity created by Congress to oversee audits of U.S.-listed firms”—essentially auditing the auditors. However, the Chinese government has prohibited the PCAOB from inspecting auditors based in China and Hong Kong. Because the PCAOB is unable “to confirm the financial health of U.S.-listed Chinese firms,” U.S. investors in those firms may be exposed to material risks.
U.S. Congressional and Regulatory Responses
As the SEC noted at the end of July, “average investors may not realize that they hold stock in a shell company rather than a China-based operating company.” In order to improve the quality of disclosure in VIE issuers’ registration statements, the SEC is updating their disclosure requirements. The SEC will require VIE issuers to disclose that “investors are not buying shares of a China-based operating company but instead are buying shares of a shell company” as well as the significant uncertainty risk related to potential regulation.
The SEC has “put a pause on new offerings from both Chinese operating companies who list directly and their shell-company affiliates,” working to ensure clear disclosure of all material and relevant risks. As these companies often already disclose their ownership structure and the legal uncertainty surrounding it, it is as yet unclear what the new disclosure rules will entail.
Additionally, Congress passed the Holding Foreign Companies Accountable Act last year, which prohibits trading in an issuer’s stock if a foreign jurisdiction prevents the PCAOB from “inspecting the company's audit firm for three consecutive years.” Because the clock began ticking in 2021, the SEC may be required to halt trading in approximately 270 China-based companies by early 2024 if the country makes no changes to its current PCAOB inspection prohibition. Further, the Senate recently passed the Accelerating Holding Foreign Companies Accountable Act, “which, if enacted, would wind the three-year clock down to two,” potentially accelerating the decoupling of U.S. and Chinese capital markets to early 2023.
Implications for U.S. Investors
With “248 Chinese firms listed on the three major U.S. stock exchanges . . . accounting for a market capitalization of $2.1 trillion,” the risks outlined above are especially salient for U.S. investors. It is important that investors understand they subject themselves to a number of risks when purchasing China-based securities—the risk that Chinese regulators determine VIEs violate Chinese law, as well as the reality that contract disputes may not be subject to U.S. jurisdiction, but to Chinese. In fact, “[a] dozen U.S.-listed Chinese internet companies haven't been remitting profits generated by the VIEs to the offshore holding companies like they are supposed to.” Further, the Holding Foreign Companies Accountable Act may lead to the de-listing of all securities from China-based issuers. While the growth potential of China-based securities may be attractive, investors would be wise to appraise themselves of their various inherent risks.
 Karen Sutter, U.S. Capital Markets and China: Issues for Congress, Cong. Rsch. Serv. (Sep. 2, 2021).
 Echo Wang, Scott Murdoch & Kane Wu, U.S. SEC Says Chinese IPO Hopefuls Must Provide Additional Risk Disclosures, Reuters (July 30, 2021).
 Gary Gensler, Statement on Investor Protection Related to Recent Developments in China, SEC (July 30, 2021).
 Gary Gensler, Opinion, SEC Chair: Chinese Firms Need to Open Their Books; China's companies must allow their audit firms to be audited or their shares won't trade in U.S. capital markets, Wall St. J. (Sep. 14, 2021).
 Jing Yang, U.S. and Chinese Regulators Are in a Bind Over a Three-Letter Acronym, Wall St. J. (Sep. 30 2021).
 China Further Opens its Market with New "Foreign Investment Law", Jones Day (Feb. 2020).
 China Considers Closing Loophole Used by Tech Giants for U.S. IPOs, Bloomberg News (July 7, 2021), https://www.bloomberg.com/news/articles/2021-07-07/china-mulls-closing-loophole-used-by-tech-giants-for-u-s-ipos.
 Marcia Ellis, Gordon Milner & Mark Hu, The VIE Structure: Past, Present And Future, Hong Kong Lawyer (June 2020), http://www.hk-lawyer.org/content/vie-structure-past-present-and-future-%E2%80%93-part-i.
 Id. (“We have seen the pendulum swing back and forth a number of times as the [Chinese] government vacillated between tacitly approving the VIE Structure and actively attacking it.”)
 Supra note 5 (“Chinese officials . . . [are] concerned about shutting down an avenue that let[s] Chinese companies—and by extension the Chinese economy benefit from foreign capital”).
 Supra note 1.
 Supra note 6.
 Supra note 4.
 Supra note 1.
 Supra note 3.
 See, e.g., Alibaba Tweaks a Controversial Legal Structure, The Economist (Aug. 11, 2018).
 Supra note 4.
 Supra note 1.
 Chris Prentice & Aurora Ellis, U.S. SEC warns investors of risks from certain Chinese business entities, Reuters (Sep. 20, 2020), https://www.reuters.com/business/us-sec-warns-investors-risks-certain-chinese-business-entities-2021-09-20/.
 Supra note 6.
 Supra note 4.