The US Securities and Exchange Commission (SEC) now requires further disclosures from Chinese companies about their legal structure and regulatory risks before listing in the US, as reported by Reuters on July 30. Specifically, in an official statement issued earlier that day, SEC Chair Gary Gensler demanded three additional disclosure items from pre-IPO companies with significant operations based in China. These clarifying items included that, if applicable, investors would only hold shares of a shell company instead of the underlying Chinese firm itself; investors would face risks of regulatory intervention from the Chinese government; the issuer should offer detailed financial information and quantified indicators to help investors understand the variable interest entity (VIE) listing structure.

The new disclosure rules came after Reuters reported on July 30 that SEC halted IPOs from Chinese companies due to transparency concerns. The concerns mainly revolved around the VIE structure that was popular among US IPOs of Chinese companies. In a VIE, the listed company, usually incorporated in a regulatory-friendly foreign jurisdiction such as the Cayman Islands, is a shell of the actual operating firm based in China. Since the shell company and the underlying firm formed convoluted contractual arrangements, investors are often unaware of the fact that they do not own the operating firm’s equity shares while exposed to unclear legal and regulatory risks. Currently, 69% of Chinese companies listed on the New York Stock Exchange (NYSE) and Nasdaq deployed the VIE structure, including Alibaba , NetEase , and Baidu .

The potential regulatory risks of US-listed China stocks alarmed SEC as the Chinese government recently tightened its grasp on technology and education companies. Within a week after Didi’s IPO on NYSE on June 30, China’s cyberspace authority launched a data security investigation on the country’s ride-hailing giant. The bureau ordered the firm to stop new user registration and remove its mobile apps from Chinese app stores, causing its opening stock price to fall 24% on July 6. Later, on July 23, Chinese authorities further restricted policies to crack down on the domestic private education sector. Shares of TAL Education and New Oriental Education and Technology , both listed on NYSE, respectively plunged 70.8% and 54.2% later that day as a result. While the S&P Index grew 18% this year by the end of July, the S&P/BNY Mellon China Select ADR Index, a measure of the performance of Chinese companies’ American depository shares, was down 22% during the same period.

Sources:

https://www.reuters.com/business/finance/exclusive-us-regulator-freezes-chinese-company-ipos-over-risk-disclosures-2021-07-30/

https://malaysia.news.yahoo.com/u-halts-ipos-chinese-based-173304731.html

https://finance.caixin.com/2021-07-30/101749036.html

https://markets.businessinsider.com/news/stocks/sec-china-ipo-freeze-didi-vie-regulatory-crackdown-2021-07

https://www.cii.org/files/publications/misc/12_07_17%20Chinese%20Companies%20and%20the%20VIE%20Structure.pdf

https://www.senecaesg.com/blog/cac-removes-didi-from-chinese-app-stores-amid-cybersecurity-investigation/ https://www.cnbc.com/2021/07/23/us-listed-china-education-stocks-plunge-as-beijing-regulators-crack-down.html