SEC Orders Reviews and New Disclosures for Mainland Chinese Security Listings in the U.S.

U.S. Securities and Exchange Commission Chair Gary Gensler on 30 July announced heightened scrutiny of the security listings of mainland Chinese firms in U.S. exchanges. Gensler said the SEC will increase required disclosures by certain firms that establish shell companies to enter into contracts with mainland China-based firms and then list shares in the U.S.

In a “Variable Interest Entities” arrangement, a mainland China-based operating company establishes a shell company in another jurisdiction, such as the Cayman Islands, to issue stock to shareholders. This shell company enters into service and other contracts with the operating company and then issues shares on an exchange such as the New York Stock Exchange. Gensler wants the VIEs to disclose to investors that they are not actually buying direct shares in the mainland Chinese firm.

Gensler indicated that “neither the investors in the shell company’s stock, nor the offshore shell company itself, has stock ownership in the China-based operating company” and that “average investors may not realize that they hold stock in a shell company” rather than in the operating company. He asserted that “the business description of the issuer should clearly distinguish the description of the shell company’s management services from the description of the China-based operating company”, noting that “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 arrangement”. Gensler demanded that any such firm provide detailed financial information, including quantitative metrics, “so that investors can understand the financial relationship between the VIE and the issuer.” He also claimed that the mainland Chinese government has placed restrictions on companies raising funds offshore, including government-led cybersecurity reviews of those firms.

Even beyond VIEs, Gensler announced that all mainland China-based firms seeking to register securities with the SEC will be asked to “prominently and clearly disclose” whether the issuer had received permission from the authorities to list on U.S. exchanges and whether there could be any risk that this approval could be rescinded. He also reminded firms that under the Holding Foreign Companies Accountable Act the Public Company Accounting Oversight Board must be permitted to inspect the issuer's public accounting firm within three years. This requirement could potentially result in the delisting of a security if the PCAOB is unable to inspect the accounting firm.

In addition to the above, Gensler has asked staff to engage in targeted additional reviews of filings for companies with significant mainland Chinese operations. “I believe such 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,” he said in a statement.

These moves by Gensler mark a significant escalation in U.S. tensions with mainland China regarding capital markets. The announcement came one day after seven Republican senators demanded that the SEC investigate the practices of mainland Chinese companies along with the underwriters and index providers that do business with them. The lawmakers complained that U.S. investors had lost money when the shares of Beijing-based ride hailing company Didi Global fell after its initial public offering, after mainland Chinese regulators halted downloads of its app citing cybersecurity risks. According to the senators’ letter, Didi executives downplayed the domestic regulatory risk prior to their U.S. IPO, which highlights “the troubling trend of Chinese companies taking advantage of our capital markets while ignoring the transparency that is required under U.S. law to access U.S. markets.”

Gensler was chair of the U.S. Commodity Futures Trading Commission during the Obama administration and is credited with the reform of the US$400 trillion swaps market after the 2008 financial crisis. He was a senior advisor to Sen. Paul Sarbanes in writing the Sarbanes-Oxley Act, which instituted many changes to financial regulations in 2002, and served as undersecretary of the Treasury for Domestic Finance during the Clinton administration. Gensler has been a professor at the Massachusetts Institute of Technology and also worked at Goldman Sachs.