SEC Responds to Chinese Crackdown with New Disclosure Requirements

Time to add a new term to your financial vocabulary: variable interest entities, also known VIEs. They’re playing a key role in an escalating economic tiff between the United States and China, and U.S. disclosure rules are changing as a result.

In fact, VIEs aren’t new – Alibaba and are among the Chinese companies that have used these heretofore-obscure corporate entities. It facilitates a convoluted process through which Chinese operating companies can effectively list their shares outside the country, even though the Chinese government prohibits them from actually doing that.

For those who care, the details go like this (feel free to skip to the next paragraph): The Chinese company creates an offshore shell company that can issue stock to shareholders. The shell company then sets up contracts with the operating company and puts its shares up on a foreign exchange. As a result, shareholders who purchase the stock on the foreign exchange gain exposure to the China-based company via the shell company’s contracts; the stockholders don’t have an equity interest in the original entity.

Do investors buying these stocks realize they’re not getting a piece of the actual operating company? Or do their eyes just “skip to the next paragraph” of their public disclosures when they start reading about the VIE structure? According to a statement issued last week, Securities and Exchange Commission Chair Gary Gensler is afraid they do just that.

Gensler’s transparency concerns are taking on greater urgency considering recent moves by China’s government to get tough on Chinese companies seeking equity capital abroad. In July, Beijing announced it intends to revise how China-based companies list on foreign exchanges. Additionally, Chinese authorities started implementing more rigorous oversight of companies’ cybersecurity defenses.

Although investors aren’t buying the stock of companies directly subject to China’s regulatory authority, cracking down on the operating companies can still affect the securities’ value. U.S. investors in the ride-sharing app Didi Global Inc. learned that the hard way last month. China announced a cybersecurity investigation of the company that led to the suspension of new user registrations. The stock price of Didi’s VIE subsequently fell 30%.

Given that there are approximately 250 China-based companies listed on U.S. stock exchanges with a total market capitalization of $2.1 trillion, such investigations could wipe out some serious shareholder wealth. Consequently, Gensler has directed the SEC to require new disclosures from “issuers associated with China-based operating companies.” The guidelines for the reporting rules call for issuers to distinguish between the shell companies and the operating companies in China. They must provide “detailed financial information” laying out the relationship between the two. Importantly, the issuers must also disclose “that the China-based 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.”

Meanwhile, Chinese companies hoping to register securities with the SEC will be required to tell investors if they were denied permission by Beijing to list on U.S. exchanges, as well as disclose the possibility that China’s government could rescind that permission. Moreover, the companies must disclose that they could face delisting if they don’t comply with the Public Company Accounting Oversight Board’s mandate to inspect their public accounting firms.

Gensler said the enhanced 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.” Unfortunately, for investors who didn’t understand the risks of Beijing’s interference, more disclosure won’t help them now.

Latest Articles

September SEC Enforcement Spike: Four Key Areas to Watch

Much like the cliché of a local police force ramping up patrols to meet its quarterly quota of speeding tickets, the Securities and Exchange Commission is yet again closing out its...

Read More

As Labor Strife Grows, So Do Complaints About CEO Pay

Elon Musk has apparently had enough of automotive companies showering their executives with lavish compensation packages. The Tesla CEO, himself under investigation by the Securiti...

Read More

New Disclosure Rules Prove Timely Amid Crippling Cyber Attacks

Here’s a case of what may be fortunate timing for both investors and gamblers. The Securities and Exchange Commission’s new cybersecurity disclosure rules went into effect this mon...

Read More