[ad_1]
Investors in the world’s second-largest economy have seen their assets battered by a Chinese government eager to exercise control over the private sector. Now the latest threat could come from a US government with new skepticism about the investment vehicles Chinese entrepreneurs have used to raise funds abroad for more than two decades.
Securities and Exchange Commission Chairman Gary Gensler described emerging regulatory policy in strict terms last week in a video post, in which he said the agency is “taking a break for now” to approve the new initial public offerings of Chinese companies on the US stock exchanges.
Gensler argued that U.S. investors may not understand that most Chinese companies that list their shares on U.S. exchanges don’t do so directly. As the Chinese government blocks foreign direct investment in key sectors like technology, these companies form fictitious entities – called variable interest entities or VIEs – in foreign jurisdictions like the Cayman Islands, which are then listed on the stock exchange, notably the New York Stock Exchange and the Nasdaq. . These shell companies have a contractual claim over the profits and assets of the parent company, although the enforceability of these claims is questionable.
“When American investors think we are investing in a Chinese company, it is actually more likely that we are investing in a Cayman Islands company,” Gensler said. “I have asked SEC staff to ensure that companies fully and fairly disclose that what we are investing in is in fact a shell company to the Caymans.”
The SEC chief added that these disclosures would include “how much money is flowing between the Caymans and China” and “the political and regulatory risk that the Chinese government could, as it has done several times recently, significantly alter. the rules of the game ”for Chinese companies and their American investors.
The SEC has already started giving more detailed instructions to Chinese companies applying to be listed on the U.S. stock exchanges, Reuters reported on Monday, asking them to describe how the unusual business structure could impact the value of a company. action and how these contractual agreements “may be less effective than direct agreements”. ownership.”
The Nasdaq Golden Dragon China HXCK index,
which tracks shares of Chinese stocks listed in the United States, has fallen more than 40% in the past six months, according to FactSet.
Switching over to VIEs
Guy Davis, portfolio manager at GCI Investors, is among a minority of global investors who have long been skeptical about the structure of VIEs and argued in an interview with MarketWatch that the SEC’s new skepticism at the regard to structure is just one more reason for American investors. to avoid them.
“These structures are fundamentally illegal in China and were built to circumvent the foreign property laws that exist in China,” Davis said. “Someone at one point came up with this wonderful structure that says two different things to two different people. He tells American investors that you are investing in a Chinese company and he tells China there is no foreign investors in this business.
Although the VIE structure is technically illegal under Chinese law, the government has looked away as it has become an effective way for domestic companies in key sectors to attract foreign capital to fuel their growth, while denying the control to foreigners.
Davis cited the example of Yahoo’s investment in Chinese e-commerce giant Alibaba BABA,
in the mid-2000s. Because Alibaba was in an industry closed to foreign investors, Yahoo’s stake in the company was based on the VIE structure. This arrangement exploded in the eyes of Yahoo investors in 2011, when Alibaba founder Jack Ma restructured the company to transfer ownership of the Alipay payment transaction from Alibaba shareholders to another company he controlled. Here’s how Davis described the deal in a recent market commentary:
“Due to the structure of VIE, Yahoo (and the other shareholders alongside them) were powerless to do anything. They had no legal recourse. Yahoo owned 43% of Alibaba VIE (Fake Alibaba), so it technically did not own any part of Alipay. Yahoo legally owned 43% of a listed shell company in the Cayman Islands that had (sadly illegal) contracts with Alibaba. And when is the time to enforce these contracts? they were unsurprisingly inapplicable. Let’s be very clear on what exactly happened: Jack Ma took a billion dollar company right under the noses of thousands of US and European investors in VIE, and there was nothing there was to do about it.
Davis remains skeptical that U.S. regulators will take drastic action to protect U.S. investors in other Chinese VIEs, given the popularity of these vehicles. According to the US-China Economic and Security Review Commission, nearly 250 Chinese companies are listed on US stock exchanges with a total market capitalization of $ 2.1 trillion.
Nicholas Howson, Pao Li Tsiang professor of law at Michigan Law and former managing partner of the Paul law firm, Weiss’ Asia law firm in Beijing, told MarketWatch in an interview that the SEC’s renewed interest for these structures, which have existed for more than two decades, is complicated by its long-standing acceptance of the practice.
Howson, however, argued that the future debut of Chinese companies in public markets in the United States could be in jeopardy because Gensler has asked SEC staff to ensure that the companies disclose whether the Chinese government itself authorized their registration in the United States.
“It’s really important,” Howson said. “What is most protective for American investors is this idea that these deals could not go forward unless you can disclose that you have the approval of the Chinese government,” he said. he declares.
It remains to be seen whether or not the SEC will start blocking such transactions, but Howson argued that such a move “would put a stop to any transaction based on a VIE structure.”
Chinese stock delisting
At the same time as the SEC reviews the structure of VIEs, it is implementing the new Holding Foreign Companies Accountable law, passed in the final months of the Trump administration.
The new law directly targets Chinese companies that raise funds in the United States, which historically have not complied with US laws requiring audits of public companies to be overseen by a US nonprofit called Public Company Accountability. Oversight Board.
The law was passed amid a wave of anti-Chinese sentiment among US lawmakers on both sides who argued that Chinese companies should follow the same rules that any other company, foreign or domestic, must follow in order to collect. funds in the United States. it came with the penalty that three years of non-compliance must result in the expulsion of a company from the US stock exchanges.
Long referred to as the “nuclear option” when investors feared the Chinese government would force delisting due to its own distaste for the VIE structure, it increasingly seems likely that it was US policy causing a sharp split in US liquidity. and the hottest Chinese companies. .
“We are in a period where we are moving towards delisting,” Paul Gillis, professor of accounting at Peking University, told MarketWatch in an interview, adding that the biggest Chinese companies have started to make secondary listings. on the Hong Kong Stock Exchange, in part to prepare for a time when they will be cut off from the US markets.
Gillis argued that the Luckin Coffee accounting scandal, which sparked the HFCA legislation, likely would not have been avoided if the PCAOB had been allowed to exercise similar oversight to other companies listed in the United States. United States, as the fraud was discovered through the audit process. already.
“The biggest problem is that the Chinese government has historically not prosecuted fraud,” he said. “If the Chinese took enforcement of fraud laws seriously, it would be more of a deterrent than PCAOB inspections.”
Protect investors or exclude them?
Some investors fear that these disputes over obscure regulatory issues will do more harm than good to the average retail investor. Brendan Ahern, chief investment officer at Krane Investment Advisors, which offers a range of China-based exchange-traded funds, told MarketWatch that while Chinese companies can be riskier investments, the benefits for a portfolio are significant.
“Nobody talks about the rewards. A lot of these companies have done very well over the years, ”he said. “US investors need the kind of growth that comes from the exposure to China’s urban middle class that these stocks provide. It’s all about risk and no one ever talks about the rewards. “
Ahern argued that if a massive delisting of Chinese stocks from US stock exchanges were to occur, large investors would likely be able to easily move their stocks to foreign stock exchanges, while many retail traders would be unable to do the same if their brokers do not support foreign equity ownership.
Gillis said some small Chinese companies would likely decide to go private, with insiders benefiting from the discounted selling prices that would result from delisting. He hopes US regulators can strike a deal with their Chinese counterparts that will allow Chinese companies to comply with US law while addressing concerns of the Chinese government about protecting information it deems important to its national security.
“We have a few years, but I’m afraid that at some point investors will panic, thinking that we are not going to see a settlement and that Chinese stocks are going to sink even more,” said Gillis. “Stocks have already taken a hit because of Chinese regulators, something like that will really hammer them.”
[ad_2]
Source link