Wed. Dec 8th, 2021

SEC responds to Chinese crackdown with new disclosure requirements

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

In fact, VIEs are not new: Alibaba and are some of the Chinese companies that have used these hitherto obscure corporate entities. It facilitates a complicated process through which Chinese operating companies can effectively list their shares outside the country, even though the Chinese government actually prohibits them from doing so.

For those who care, the details are as follows (feel free to move on to the next paragraph): The Chinese company creates a foreign company that can issue shares to shareholders. The shell company then enters into contracts with the operating company and places its shares in a foreign currency. As a result, shareholders who buy foreign exchange shares gain exposure to the China-based company through shell company contracts; the shareholders have no shareholding in the original entity.

Do investors who buy these shares realize they are not getting a share of the actual operating company? Or do their eyes only “jump to the next paragraph” of their public disclosures when they start reading about the VIE structure? According to a statement released last week, the chairman of the Securities and Exchange Commission Gary Gensler fears they will do so.

Gensler’s transparency concerns are increasingly urgent given the recent moves by the Chinese government to take Chinese companies seeking capital abroad. In July, Beijing announced its intention to review the way China-based companies are listed on foreign stock exchanges. In addition, Chinese authorities began to implement more stringent oversight of companies ’cybersecurity defenses.

Even if investors do not buy shares of companies directly subject to China’s regulatory authority, repressing operating companies can still affect the value of the securities. US investors in the Didi Global Inc. app to share trips they learned it the hard way last month. China announced an investigation into the company’s cybersecurity that led to the suspension of new user registration. The share price of Didi’s VIE subsequently fell by 30%.

Given that there are approximately 250 Chinese companies listed on U.S. stock exchanges with a total market capitalization of $ 2.1 trillion, these investigations could end up with serious shareholder wealth. Accordingly, Gensler has ordered the SEC to require further disclosures of “issuers associated with operating companies based in China.” The guidelines for information rules require issuers to distinguish between shell companies and operating companies in China. They must provide “detailed financial information” that establishes the relationship between the two. It is important to note that issuers should also disclose that “the Chinese-based operating company, the parent company’s issuer and investors face uncertainties about future actions by the Chinese government that could significantly affect the financial performance of the operating company and the enforceability of the contractual agreements. ”

Meanwhile, Chinese companies hoping to register securities with the SEC will have to tell investors if Beijing denied them permission to trade on U.S. stock exchanges, as well as reveal the possibility that the Chinese government may terminate that permit. In addition, companies must disclose that they may suffer termination when they fail to comply with the mandate of the Public Company Accounting Oversight Committee to inspect their public accounting firms.

Gensler said the improved 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 did not understand the risks of Beijing’s interference, further disclosure will not help them now.

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