Investors in the world’s second-largest economy have seen their holdings battered by a Chinese government eager to exert its control over the private sector. Now, the latest threat could come from a U.S. government with a newfound skepticism of the investment vehicles Chinese entrepreneurs have used to raise money abroad for more than two decades.

Securities and Exchange Commission Chairman Gary Gensler outlined the emerging regulatory policy in stark terms last week in a video message, where he said the agency “is taking a pause for now” in approving new initial public offerings of Chinese companies on U.S. stock exchanges.

Gensler argued that American investors may not understand that most Chinese companies that list their shares on U.S. exchanges don’t do so directly. Because the Chinese government blocks foreign direct investment in key industries like technology, these companies form shell entities — called variable interest entities or VIEs — in foreign jurisdictions like the Cayman Islands, which are then listed on exchanges, including the New York Stock Exchange and Nasdaq. These shell companies have a contractual claim on the profits and assets of the parent company, though the enforceability of those claims is questionable.

“When American investors think we’re investing in a Chinese company, it’s actually more likely we’re investing in a company in the Cayman Islands,” Gensler said. “I’ve asked the SEC staff to ensure that companies provide full and fair disclosure that what we’re actually investing in is actually a shell company in the Caymans.”

The SEC chief added that such disclosures would include “what money is flowing between the Caymans and China” and “the political and regulatory risk that the government of China could, as they’ve done a number of times recently, significantly change the rules of the game” for Chinese companies and their U.S. investors.

The SEC has already begun giving more detailed instructions to Chinese companies applying to list on U.S. exchanges, Reuters reported on Monday, asking them to describe how the unusual corporate structure could impact a stock’s value and how these contractual agreements “may be less effective than direct ownership.”

The Nasdaq Golden Dragon China index
which tracks shares of U.S.-listed Chinese stocks, has declined more than 40% during the past six months, according to FactSet.

Flip-flopping on VIEs

Guy Davis, a portfolio manager at GCI Investors, is one of a minority of global investors who have long been skeptical of the VIE structure and argued in an interview with MarketWatch that the SEC’s newfound skepticism of the structure is just one more reason for American investors to avoid them.

“These structures are fundamentally illegal in China and were constructed to circumvent the foreign ownership laws that exist in China,” Davis said. “Somebody at some point came up with this wonderful structure that says two different things to two different people. It says to U.S. investors that you are investing in a Chinese company and it says to China that there are no foreign investors in this company.”

Though the VIE structure is technically illegal under Chinese law, the government there has looked the other way as it became an effective way for domestic companies in key industries to attract foreign capital to fuel their growth, while still denying foreigners control.

Davis pointed to the example of Yahoo’s investment in Chinese e-commerce giant Alibaba

in the mid 2000s. Because Alibaba was in a sector that was off-limits to foreign investors, Yahoo’s stake in the company was based on the VIE structure. That arrangement blew up in the faces of Yahoo investors in 2011, when Alibaba founder Jack Ma restructured the company to transfer ownership of the payments operation Alipay from Alibaba shareholders to another company he controlled. Here’s how Davis described the deal in a recent market commentary:

“Due to the VIE structure, Yahoo (and other shareholders alongside them) were powerless to do anything. They had no legal recourse. Yahoo owned 43% of the Alibaba VIE (Fake Alibaba), so it did not technically own any portion of Alipay at all. What Yahoo legally owned was 43% of a shell corporation listed in the Cayman Islands that had some (unfortunately illegal) contracts with Alibaba. And when it came time to enforce those contracts. they were unsurprisingly unenforceable. Let us be very clear about exactly what happened: Jack Ma took a company worth billions of dollars directly from under the nose of thousands of US and European investors in the VIE, and there was nothing anyone could do about it.

Davis remains skeptical that U.S. regulators will take drastic steps to protect U.S. investors in other Chinese VIEs, because of how popular these vehicles are. According to the U.S.-China Economic and Security Review Commission, there are nearly 250 Chinese companies listed on U.S. exchanges with a total market capitalization of $2.1 trillion.

Nicholas Howson, the Pao Li Tsiang Professor of Law at Michigan Law and former managing partner of the law firm Paul, Weiss’ Asia practice in Beijing, told MarketWatch in an interview that the SEC’s renewed interest in these structures, which have existed for more than two decades, is complicated by its long-running acceptance of the practice.

Howson argued however that future debuts of Chinese companies on public markets in the U.S. could be in danger because Gensler has directed SEC staff to ensure that companies disclose whether the Chinese government itself has given permission for them to list in the U.S.

“This is really important,” Howson said. “What the most protective thing for U.S. investors is this idea that these deals would not be able to go forward unless you can disclose that you have the approval of the Chinese government,” he said.

Whether or not the SEC will in fact start blocking such deals remains to be seen, but Howson argued such a move “would stop in its tracks any deal that is based on a VIE structure.”

Delisting Chinese stocks

At the same time the SEC scrutinizes the VIE structure, it is implementing the new Holding Foreign Companies Accountable act, passed during the final months of the Trump administration.

The new law is aimed directly at Chinese companies raising money in the U.S., which have historically not complied with U.S. laws requiring that public-company audits are overseen by a U.S. nonprofit called the Public Company Accountability Oversight Board.

The law was passed amid a wave of anti-China sentiment among American lawmakers of both parties who argued that Chinese companies should follow the same rules that any other company, foreign or domestic, must follow in order to raise money in the U.S. Most important, it came with the penalty that three years of non-compliance must result in a company getting kicked off U.S. exchanges.

Long called the “nuclear option” when investors feared that the Chinese government would force delisting because of its own distaste for the VIE structure, it appears increasingly likely that it will be U.S. policy that causes an abrupt split between U.S. cash and the hottest Chinese companies.

“We’re in a period where we’re moving toward delisting,” Paul Gillis, professor of accounting at Peking University, told MarketWatch in an interview, adding that the largest Chinese firms have begun doing secondary listings on the Hong Kong stock exchange, in part to prepare for a time when they are cut off from U.S. markets.

Gillis argued that the Luckin Coffee accounting scandal, which was the impetus for the HFCA legislation, would likely not have been avoided if the PCAOB were allowed similar oversight it has over other U.S.-listed companies, given that the fraud was uncovered by the auditing process already.

“The bigger problem is that the Chinese government has historically not prosecuted fraud,” he said. “If the Chinese got serious about enforcing fraud laws that would be more of a deterrent than PCAOB inspections.”

Protecting investors or shutting them out?

Some investors worry that these disputes over obscure regulatory matters threatens to do more harm than good for the average retail investor. Brendan Ahern, chief investment officer at Krane Investment Advisors, which offers a suite of China-based exchange traded funds, told MarketWatch that while Chinese companies can be riskier investments, the benefits for a portfolio are profound.

“Nobody talks about the rewards. Many of these companies have performed exceedingly well over the years,” he said. “U.S. investors need the kind of growth that exposure to China’s urban middle class these stocks provide. Everything is about the risk and nobody ever talks about the rewards.”

Ahern argued that if a mass delisting of China stocks from U.S. exchanges were to occur, large investors would likely be able to easily transfer their shares to foreign exchanges, whereas many retail traders would be unable to do the same if their brokers don’t support ownership of foreign stocks.

Gillis said that some smaller Chinese companies would likely decide to go private, with insiders benefitting from fire sale prices that would result from delisting. He remains hopeful that U.S. regulators can work out a deal with their Chinese counterparts that enables Chinese companies to comply with U.S. law while satisfying concerns the Chinese government has about protecting information it deems important to its national security.

“We’ve got a couple years, but I fear that at some point investors are going to panic, thinking we’re not going to see a settlement and Chinese stocks will sink even further,” Gillis said. “The stocks have already taken a beating because of Chinese regulators, something like this will really hammer them.”

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