SEC Chairman Gensler tightens restrictions on Chinese companies after cybersecurity crackdown in China

Gary Gensler said the SEC will seek disclosures from Chinese companies that notify investors about shell companies and the potential government action.
Written by Jonathan Greig, Contributor

Securities and Exchange Commission Chair Gary Gensler released a statement on Friday announcing measures the SEC will take to protect investors from actions taken by the Chinese Government. 

An estimated $1 trillion has been lost from the value of overseas-listed Chinese tech stocks since the Chinese government began a widespread crackdown in February. The government is conducting cybersecurity and data privacy reviews of all the country's tech giants, spooking markets and forcing dozens of Chinese companies to shelve plans to list in New York

Gensler explained that the Chinese government was providing "new guidance" to Chinese companies as well as stringent restrictions to those raising capital offshore. In multiple sectors, Chinese companies are not allowed to have foreign ownership and cannot directly list on exchanges outside of China, Gensler explained. 

To get around these restrictions and raise money from exchanges, Chinese companies create Variable Interest Entities (VIEs) -- effectively offshore shell companies -- that allow them to issue stock to public shareholders. The shell companies are typically set up in places like the Cayman Islands and are able to enter into contracts with the Chinese company so they can "consolidate the operating company into its financial statements."

Gensler said this recent volatility in China prompted his desire to inform investors of the danger they face when investing in Chinese companies. 

"For US investors, this arrangement creates 'exposure' to the China-based operating company, though only through a series of service contracts and other contracts. To be clear, though, neither the investors in the shell company's stock, nor the offshore shell company itself, has stock ownership in the China-based operating company. I worry that average investors may not realize that they hold stock in a shell company rather than a China-based operating company," Gensler said. 

"In light of the recent developments in China and the overall risks with the China-based VIE 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."

The new disclosures demand Chinese companies and their offshore shell arms notify investors that they "are not buying shares of a China-based operating company but instead are buying shares of a shell company issuer that maintains service agreements with the associated operating company." 

Gensler explained 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."

He also wants investors to understand the "uncertainty" that may be caused by "future actions by the government of China that could significantly affect the operating company's financial performance and the enforceability of the contractual arrangements."

Chinese companies will also have to provide detailed financial information, including quantitative metrics, so that investors fully understand the financial relationship between the VIE and the issuer.

Gensler asked his staff to ensure that all Chinese companies looking to register securities with the SEC will also disclose whether the company received or were denied permission from Chinese authorities to list on US exchanges and risks that "such approval could be denied or rescinded."

The notice also covered the Holding Foreign Companies Accountable Act, which mandates that the Public Company Accounting Oversight Board (PCAOB) be allowed to inspect the issuer's public accounting firm within three years. Gensler said investors should know that companies may be delisted if the PCAOB is unable to review the firm. 

"Further, I also have asked staff to engage in targeted additional reviews of filings for companies with significant China-based operations. I believe these changes will enhance the overall quality of disclosure in registration statements of offshore issuers that have affiliations with China-based operating companies," Gensler said.  

"This work builds on the SEC's Division of Corporation Finance's previous guidance on disclosure considerations for companies based in or with significant operations in China. 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."

Multiple companies have been ensnared in the crackdown by the Cyberspace Administration of China, including rideshare giant Didi, Alibaba, Meituan and ByteDance -- the owner of popular social media giant TikTok.

According to the Wall Street Journal, Didi raised $4.4 billion after pushing ahead with an IPO, only to face significant backlash from the Chinese Government. All of Didi's apps and affiliated apps were removed from Chinese app stores days after the IPO.

Two weeks ago, ByteDance -- which is potentially worth around $300 billion -- scrapped plans for an offshore listing after Chinese government officials raised similar concerns about data security problems.

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