• SEC Chair Gary Gensler wants to make sure investors know that they don’t really own a part of that Chinese company they invested in
  • China prohibits foreigners from owning equity in domestic Chinese companies, so a workaround is created involving an offshore entity which holds a stake in the Chinese parent

SEC Chair Gary Gensler warned investors Friday of the risk of investing in US-listed Chinese companies because of their tenuous capital formation structure, and said that the regulator will require additional disclosures from listed Chinese companies. 

“In light of the recent developments in China and the overall risks with the China-based [variable interest entities] structure, I have asked staff to seek certain disclosures from offshore issuers associated with China-based operating companies before their registration statements will be declared effective,” Gensler said in a statement 

As foreign nationals are prohibited from investing in Chinese firms in a number of key sectors, listed companies set up something called a “variable interest entity” in an offshore jurisdiction. This entity in turn controls a type of domestic company within China called a “wholly foreign-owned enterprise”, which in turn has a management agreement with the domestic Chinese company that’s looking to raise capital on the US market. 

This complicated structure is a concern, according to Gensler. “I worry that average investors may not realize that they hold stock in a shell company rather than a China-based operating company,” he said in a statement.

Audit reports and ‘protecting user data’

The other reason why the SEC has taken significant interest in this is because of the Public Company Accounting Oversight Board’s (PCAOB) difficulty in obtaining comprehensive audit reports from China listed companies.

Post-Enron, US-listed companies have been required to submit their audits for review under the Sarbanes Oxley Act passed in 2002.

Beijing isn’t a fan of the arrangement and has proposed tightening the rules around “the overseas listing system for domestic enterprises” under the auspices of protecting user data.

Just today, New York-listed Didi, the Chinese equivalent of Uber, was caught in the crosshairs of the US data regulator for storing user data outside the country. Didi’s stock is down approximately 30% since the start of the year on news that regulators are looking into the company.  

“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,” Gensler said in his statement. 

Gensler also said that in the future the PCAOB will be required to inspect the issuer of any US-listed China stocks public accounting firm within three years, at the risk of a possible delisting if the PCAOB is unable to inspect the firm. 

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    Sam Reynolds is a Taipei-based reporter, covering digital assets and regulation throughout Asia. Before joining Blockworks he was an editor at Forkast News and an analyst with IDC.