SEC Letter to China-Based Issuers Reflects America’s “Rule” of Isolationist Policies

The Securities and Exchange Commission (“SEC”) released a vindicatory letter to China-based issuers demanding increased disclosures and financial reporting requirements. (U.S. Securities and Exchange Commission). The SEC’s letter took considerable jabs at the Chinese infrastructure that has stalled the Public Company Accounting Oversight Board (“PCAOB”) from auditing the Chinese issuers’ public accounting firms. (U.S. Securities and Exchange Commission). The letter demands that disclosures from China-based issuers include disparaging warnings indicating the lack of enforcement mechanisms and risks associated with a “less developed legal system.” (U.S. Securities and Exchange Commission). 

The letter comes on the tail of a strained decade between China and the United States (“U.S.”). Notably, China has shown stalwart resistance toward the influence of the U.S. dollar while pushing toward international finance since the 2008 G-8 summit. (Rush Doshi, The National Bureau of Asian Research). While China currently has a closed market system, the growth of technological progress within the country could cause China to open its system and create more competition with the U.S. for financial power. Id. 

To this end, the U.S. lags far behind China in terms of globalization. (Paulson, The Wall Street Journal). Although the U.S. has imposed trade tariffs and barriers, China has been welcoming negotiations and becoming a giant global trade partner. Id. China has signed partnerships and investment agreements while the U.S. has become increasingly isolated. Id. Henry Paulson Jr., former U.S. Secretary of the Treasury, insists that the solution is for the U.S. to invest further in technology and prevent isolation from global markets. Id. Paulson emphasizes the immediacy of the dilemma, stating “China isn’t going to give America the courtesy of waiting.” Id. 

Despite Paulson’s warnings to globalize, the U.S. has started trade wars and passed legislation to de-list foreign companies on domestic exchanges. Id. Following the 2018 Trump-era trade war with China, which decimated global value chains and stalled negotiations, spectators hoped for a mending of Chinese and U.S. relations. (Dollar, Brookings Institute). Instead, Chinese-based issuers are faced with a contentious letter from the SEC and the polarizing Holding Foreign Companies Accountable Act (“HFCAA”) legislation. (Maurer, The Wall Street Journal). The HFCAA applies to the auditors of foreign-based issuers, which have not been audited by the PCAOB in three most recent consecutive years. Id. Auditing firms that fail to comply with the HFCAA legislation face de-listing on U.S. exchanges. (Kristin Broughton, The Wall Street Journal) The harsh de-listing policy follows auditing scandals at Chinese companies that impacted U.S. investors. Id. Luckin paid $180 million to settle SEC claims of falsely reported sales and growth figures. (Michaels, The Wall Street Journal).

Security and risk concerns are the main emphasis of the SEC letter to China-based issuers. (U.S. Securities and Exchange Commission). SEC Chairman, Gary Gensler, emphasizes that “high-quality, reliable disclosure, including financial reporting” is the central mission of the SEC. Id. Gensler contends that these values are absent in China where investors face substantial risk of misleading disclosures without the avenues for recourse ordinarily available to U.S. investors. Id. Gensler further asserts that the changing laws and differences in corporate governance structures in China create risks that are unconscionable for U.S. investors to face. Id.

The SEC letter takes particular issue with variable interest entities (“VIE”). Id. When certain industries are prevented from listing on exchanges outside of China, the China-based operating company will create an offshore shell company (often in the Cayman Islands) which will then issue stock. (U.S. Securities and Exchange Commission). Since a VIE is designed to “mimic direct ownership,” a China-based issuer in the Caymans can consolidate the operating company into its issuer’s financial statements. (U.S. Securities and Exchange Commission). The issue with this arrangement, as emphasized in the SEC letter, is that the issuer can circumvent the Chinese laws that apply to the operating company. Id. The letter requires “clear and prominent” disclosures of the lack of oversight, enforcement, and regulatory risks on the registration statement of these issuers. (Anagnosti, et. al., JDSupra). Companies subject to the HFCAA are given 15 days to dispute the SEC requirement for enhanced disclosure. (Johnson, Reuters). Further, the letter requires disclosures of Special Purpose Acquisition Companies (“SPAC”) that are based in China, even if the SPAC has not acquired a target company. Id.

Does this letter mark a hardline position that the SEC will take moving forward? The position of the letter coincides with the SEC’s strong position of protecting U.S. investors. (Gensler, WSJ Op-Ed). Historically, the U.S. has prided itself on providing stable markets in the face of turbulent global events. (Meshulam, et.al., Law360). This stability is due to the rigorous adherence to transparent and accurate financial statements from market participants. Id. Chairman Gensler emphasizes that China will not be granted an exception to these reporting standards. (Gensler, The Wall Street Journal). Further, lawmakers are deeply concerned about the exploitation of U.S. investors following recent data security scandals. (Barbarino, Law360; Zanki, Law360).

Will China-based companies move away from U.S. markets following the letter and HFCA legislation? Reactions are mixed. (Barbarino, Law360). Yum China Holdings (“Yum China”), the China-based company behind Taco Bell and other popular franchises, warned that delisting will only cause “a large amount of our capital stock to move out of the U.S.” Id. Yum China was joined by other large China-based companies who raised the salient point that the harm of delisting is borne by the companies who are not in control of the actions of the Chinese government. Id. Yum China further asserted that as a company listed on multiple exchanges, it is already subject to high levels of disclosure standards. Id.

Although companies like Yum China are protesting de-listing in the U.S., other China-based issuers may be taking advantage of China’s increased financial globalization instead of using the U.S. markets to raise funds. (Paulson, The Wall Street Journal). China has been forging ahead with investment agreements in the E.U., Middle East, Africa, Japan, and South Korea, and issuers may not need the U.S. markets to raise funds in the future. Id.

While the letter from the SEC indicates a strong policy of investor protection, it also indicates a hardline isolationist policy in the face of China’s explosive globalization. (Kempe, CNBC). These actions by the SEC beg the question of where the SEC’s priorities lie: principled, transparent investor protections or working with foreign-issuers to remain a contender on the global stage. Moving forward, the SEC has the opportunity to maintain their unparalleled investor protections while working to find common ground on international financial disclosures. For example, moving toward universal acceptance of International Financial Reporting Standards (IFRS) could bridge the gap between standards. (SEC).