On September 20, 2021, the SEC published a warning to investors regarding U.S.-listed shell companies operating businesses in China through a VIE structure, which is employed in countless IPOs in the U.S., in light of strict restrictions on foreign equity ownership of Chinese companies in critical sectors such as education or telecommunications.
The VIE (variable interest entities) structure is a series of contractual arrangements which allows the U.S.-listed shell company to exercise its controlling financial interest in China-based companies and consolidate their financial statements to the shell companies. As a practical approach, it has been acceptable for years under U.S. GAAP for China-based companies to raise funds abroad. However, as the SEC warned, the contracts may not be enforceable in Chinese law since the structure has never been approved by China’s government, creating a risk for loss of control of the China-based company if there is a contractual breach subject to foreign jurisdiction.
This is not the first time that the SEC alerted U.S. investors about Chinese public companies. At the end of July, encouraged by Republicans, the SEC announced to halt approval of Chinese IPOs unless sufficient disclosure. On September 13, the SEC chair Gary Gensler again demanded to audit Chinese companies, noting the 3-year timeframe for delisting if the SEC has not been able to inspect for three consecutive years since 2021.
Of course, the SEC warns of VIE risks not only because of enforceability but also due to lack of reliable auditing work of such complex structures. Since 2002, the Sarbanes-Oxley Act has required inspection of public audit firms by the Public Company Accounting Oversight Board (“PCAOB” or the “Board”). While the authorized board has been conducting inspections for years over 50 jurisdictions, China is an exception. The first time that the China Securities Regulatory Commission (CSRC) provided the SEC with audit work papers was in July 2013 under the Memorandum of Understanding (“MOU”) with the PCAOB to reconcile an accounting fraudregarding Longtop Financial Technologies Limited, audited by Deloitte’s Chinese office. However, compared to 270 China-related companies listed in the U.S., the CSRC provided audit reports of only 14 companies to the PCAOB until 2021.
To reinforce implementation of Sarbanes-Oxley Act and tighten the disclosure standard, the Holding Foreign Companies Accountable Act(HFCAA) was enacted in December 2020. The SEC upgraded disclosure requirements to align with the HFCAA this April. Under the new requirements, if offshore issuers retain a public accounting firm which has a branch or office in a foreign jurisdiction, the issuer is required to disclose the ownership or controlling financial interest held by governmental entities. Along with that, the PCAOB will inspect the foreign accounting firm’s work for the concerns of accounting fraud, as seen with Luckin Coffee, Tal Education, and other cases.
How much this will deter fraud or obtain accurate financial information is still uncertain. After all, the SEC is unable to inspect and verify the filing information on site at the China-based companies as it does in the U.S. But delisting within three years might be a costly consideration.
Evidently, technology far outpaces regulations in China. Chinese domestic regulations changed significantly in terms of Cybersecurity Law and Personal Information Protection Law, causing Chinese companies to encounter more stringent scrutiny for U.S. listing. Chinese regulators obviously need more time to figure out a consistent scrutiny standard, taking into account national security concerns.
What are the alternative solutions? The environment is not promising for an updated MOU between the two regulatory counterparts given a series of the SEC warnings to issuers and investors after years of tension between the U.S. and China under former President Trump’s administration; pressure from Republicans to regulate Chinese companies continues to linger. Adopting an equivalent auditing standard like GAAP in China might be a plausible solution to the impasse to assure qualified audit work. However, it depends on Chinese regulators’ willingness to open offshore listings. The new Beijing Stock Exchange also offers an alternative to accommodate Chinese companies withdrawing from US listings. Considering the financial thresholds, pricing, valuation, market capacity, and monitoring of funds and other factors in different trading venues, issuers will make a preferable choice.
About the author:
Blair Wang is a licensed attorney in the U.S. with a focus on cross-border transactions, CFIUS and export control compliance, M&A, and venture capital. Please feel free to provide feedback on this article at email@example.com