Message to Shareholders regarding SEC Chair Gensler’s statement about the use of VIEs by some Chinese companies listed in the U.S.
30 July 2021
Many Chinese companies listed in markets outside of mainland China use a business structure known as a variable interest entity, or VIE. Under the VIE structure, which have been in existence for over 20 years, Chinese companies use legal contracts to effectively allow foreigners to invest in a Chinese company without owning shares in the underlying businesses. This structure remains largely tolerated by the Chinese government, which could change, and remains untested in disputes over investor rights even though it has been used by a number of significant Chinese companies.
The VIE structure has been back in the spotlight recently, because many of the companies subject to increased regulatory requirements use that structure. In our view, this is coincidental: the regulators are focused on sectors dominated by relatively recently-listed companies, who often did not meet the stricter listing requirements for the mainland Chinese and Hong Kong markets, so they went to New York, using the VIE structure. We do not think that Chinese regulators have changed their historical decision to tolerate this structure, while not formally validating it.
Recently, a senior Chinese regulator commented that the VIE structure remains necessary and important to Chinese markets.
This is consistent with our view that while the regulators will continue to look at how the VIE structure is implemented, we do not believe that they are going to ban it.
In a July 30 statement, SEC Chair Gensler stated he had asked his staff to ensure that Chinese companies seeking to register securities with the SEC “prominently and clearly disclose” details regarding VIE structures and their risks, as well as whether the operating company and the issuer “received or were denied permission from Chinese authorities to list on U.S. exchanges,” as well as “the risks that such approval could be denied or rescinded.” We support this requirement for transparency, which is consistent with our approach of careful due diligence on behalf of our investors.
Comments on SEC Chair Gensler’s statement that the Holding Foreign Companies Accountable Act “may result in the delisting of the [Chinese] operating company in the future if the PCAOB is unable to inspect the firm”
By way of background, when Sarbanes-Oxley became law in 2002, one of the things that it did to try and avoid a repeat of Enron was to establish the PCAOB, the Public Company Accounting Oversight Board, which is under the SEC. This group is required by law to periodically check the workbooks of accounting firms that are auditing publicly listed companies in the United States, including foreign companies listed here. This required the U.S. government to sign agreements with the governments of some foreign countries whose companies are listed here in order to make it work due to differences in rules. While there has yet to be a formal agreement with China, Chinese companies listed in the U.S. have always had to comply with certain audit and financial disclosure requirements that apply to all companies listed on U.S. exchanges.
More recently, at the end of 2020, Congress passed another law, the Holding Foreign Companies Accountable Act, which states that if the PCAOB and a foreign regulator, like in China, cannot reach agreement on how to undertake these audits, then after three years companies from that country will be de-listed.
In our view, this is a dispute between the two governments. It is not that Chinese companies and the auditing firms want to avoid being reviewed or audited – this is a government to government issue. If they don't resolve this issue, then potentially by the summer of 2024, we could see forced de-listings.
Recently, however, Chinese regulators have submitted to the Biden administration an updated proposal for resolving this issue, and the Chinese regulators have said they are actively engaged with the PCOAB.
We are hopeful, because a deal to facilitate these audits of auditors is in the interest of both sides, especially for the U.S. Chinese IPOs choosing to list in the U.S. is good for our capital markets and it's also good for our investors because it puts these Chinese companies under the supervision of the SEC. So we are hopeful that this issue, which is relatively straightforward, can be resolved before we begin to see forced de-listings.
Should Chinese companies be forced to leave U.S. markets, many of them already have or would seek listings on exchanges in Hong Kong or mainland China, where investors such as Matthews Asia would continue to have access on behalf of the strategies we manage for our clients.