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A Regulatory Game Between Major Powers

Oct 18, 2021
  • Zhang Monan

    Deputy Director of Institute of American and European Studies, CCIEE

As games between China and the United States become more complicated, the listing of China concepts stock (CCS) in the U.S. is emerging as the next big risk. The adoption of the variable interest entity structure, or VIE, in particular, is storing up trouble in the form of potential regulatory conflicts.

A series of policies in the U.S. has made life much more difficult for CCS companies, as tensions between the two great powers increase. The Donald Trump administration restricted trade in the publicly traded securities of certain Chinese companies, purportedly identified as touching on national security. On March 24 this year, the U.S. Securities and Exchange Commission adopted interim final amendments to implement the congressionally mandated submission and disclosure requirements of the Holding Foreign Companies Accountable Act. Under the new law, companies that fail to satisfy the Public Company Accounting Oversight Board’s requirement to inspect their audit firms for three consecutive years will be delisted. On Aug. 17, SEC Chairman Gary Gensler said via his social media account that he had asked SEC personnel to stop processing Chinese companies’ registrations for U.S. IPOs through the VIE structure. CCS seem to be facing an emerging systemic risk.

The VIE structure is adopted by many CCS companies. It’s also known as agreement-based control. The structure includes domestic and foreign parts. The actual controller first creates a domestic enterprise in China and then sets up a company in the British Virgin Islands or Cayman Islands for future listing. The latter company subsequently establishes a wholly owned subsidiary outside of China, which then sets up a wholly foreign-owned enterprise in China. These are the four physical parts of the VIE structure.

According to incomplete data, at least 220 of the 285 CCS companies listed on the NASDAQ and New York Stock Exchange have VIE structures. In addition, all U.S.-listed CCS entities captured in the MSCI China All Shares Index use VIE structures and are mainly found in the internet and consumer industries.

In recent years, the VIE structure has become an important target for U.S. regulators. In their view, the legal status of the VIE structure in China is not clear and its legality is in doubt. The structure thus comes with a risk of regulatory prohibitions. This inherent defect has become a useful leverage for the U.S. to deliberately target and challenge China. In addition, inadequate disclosure by some Chinese companies and lax regulatory standards at places of registration have led to short sales, group litigation and indemnity claims in recent years.

The risks and disputes over the listing of VIE structures reflect regulatory conflicts and differences between China and U.S. On one hand, the American securities regulator argues for independent enforcement activities in China and inspection of Chinese accounting firms on the basis of U.S. laws. The Chinese side maintains — because of sovereignty and security considerations — that the U.S. needs to rely on the regulatory enforcement activities of its Chinese counterpart, or the two sides may engage in consultations and joint inspections. 

On the other hand, the U.S. SEC and the oversight board want direct access to the audit working papers of companies in China, while Chinese law contains strict rules limiting the release of audit working papers to overseas regulators. Some audit working papers may contain sensitive information. It is not in China’s national interest to submit such papers.

In the future, if such conflicts and disagreements are not effectively resolved, the U.S. is likely to use further regulatory tools to deter Chinese companies from financing in the U.S. In this situation, it will be necessary for China to clarify the legitimacy of the VIE structure, strengthen coordination between regulation and justice, actively expand diverse domestic financing channels and open the internet and other service sectors wider to fundamentally eliminate regulatory arbitrage.

Overseas listing is an important reflection of globalization. To protect the rights and interests of global investors, it is essential to engage all parties in making rules, solving problems and complying with laws. There is a need and a basis for China-U.S. cooperation in effectively safeguarding the rights and interests of investors. Chinese regulators and competent departments should actively assist the American side in improving the quality of financial audits of Chinese companies listed in the U.S. The China Securities Regulatory Commission also needs the support of American securities regulators and accounting firms in cross-border auditing and regulatory cooperation.

The service sector in China should also be more open to the outside world. One reason for VIE structure listing in the U.S. has been the inadequate openness of the service market. The level of openness in manufacturing is already fairly high, with almost all restrictions on market access and foreign shares removed. But there are still many restrictions on service sector access, especially in telecommunications, digital services, culture, education and healthcare. In this connection, the country should prioritize the opening of the service sector and thus fundamentally eliminate regulatory arbitrage.

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