Gary Gensler, the U.S. Securities and Exchange Commission’s new chairman, has been quite vocal about the lack of accounting transparency and the warped corporate structures of many China-based and New York-listed companies
About time too..., even if bipartisan support hardened only in December ’20 with the Holding Foreign Companies Accountable Act, signed into law by President Trump
The Act allows the SEC and the Public Company Accounting Oversight Board (PCAOB) to require access to the audits of any company’s auditors and the ability to review “work papers” underpinning the accountants’ assessments
More than 50 countries have permitted these reviews but not China, on basis of national security
By auditing any company's auditors, with full access to financial data, and by requiring transparency of corporate structures, as well as political and regulatory risks, the PCAOB will be casting its net far afield
With close to 250 Chinese companies listed on New York exchanges (besides the over-the-counter listings which include a behemoth such as Tencent
Following a few egregious accounting scandals and ride hailing giant Didi Global's failed June '21 IPO Invalid tag asset following the firm's challenge of the Cyberspace Administration of China authority, resulting in a drop of more than 40% over the offering price as of late Augste '21, the defense of U.S. investor interests appears long overdue
With carefully tweaked announcements of the cavalry charge, Gary Gensler’s horse has taken the bit in his teeth
Hope the SEC's statements are grandstanding show pieces, and expectations in the financial community the issue will blow over, may turn out to be wishful thinking
It makes sense to take Gary Gensler's warning at face value... just in case
Incorporation in countries of convenience (the Cayman Islands are popular) and contorted ownership structures worsen already bad optics
Generously described by the SEC Chairman as ‘shell structures’, the preferred structure to work around the prohibition of foreign ownership in sectors deemed ‘strategic’ or ‘sensitive’ by China’s regulator is the VIE, which stands for Variable Interest Entity
The Chinese entity that is listed on the US or Hong Kong markets, and in which foreigners can buy shares, is an offshore holding company
By way of a ‘wholly foreign owned enterprise' (WFOE) subsidiary in China, this holding company has contracts with one, or more, VIEs, the entities which actually own some of the underlying assets, such as intellectual property, of the Chinese business and which are controled by the firm’s top management or founders
From the foreign (American) perspective, the ownership structure is covered by a specific FASB regulation FIN 46(R) to guide the consolidation of entities for which control is unclear
In fact, consolidation of the VIE is required when the listed holding company “absorbs a majority of the entity’s expected losses, or receives a majority of its expected residual returns…” which will (usually) - or may not - be the case on the basis of the contracts between the WFOE (controlled by the listed off-shore holding company) and the VIE in China
Compounding uncertainties for the foreign investor, the contracts, which may involve multiple VIEs for a single Chinese company, are the linchpins : both the percentage of assets controlled by the VIEs and of the revenues transiting through the structure actually vary over wide ranges, as discussed extensively in our VIE presentation
Obviously illegal under Chinese law, but tolerated for the time, VIEs had been the life-line of China tech and an integral part of their business models, securing valuable access to American capital markets
The SEC turning up the heat on corporate round-about structures is leaving Chinese regulators red-faced…, with just one line of defense, the protection of the American investor who, otherwise, could be left empty handed….
As for Wall Street investment banks, caught flat-footed, their reassurances in defense of Chinese IPO's sound hollow
Yes, human resources for in-depth inspections at the SEC and at PCAOB are limited, as bankers will argue in damage-control mode
But no, actual inspections are not all that urgent, it is Gary Gensler's announcements – and current delays in any additional IPOs – which tip the scale, darkening the outlook of already wary investors