The last couple of weeks have brought us numerous accounts of the U.S. government’s attempts to investigate certain U.S.-listed Chinese companies. The Americans say they need working materials from accounting firms to check out what these companies have been up to, while their Chinese counterparts say no, this information is protected under China’s state secrets laws. Stalemate.
Paul Gillis of the China Accounting Blog, a leading voice on this story, has distilled this whole thing down for us in a new post today. The underlying problem here, he says, is a regulatory vacuum that has allowed a number of Chinese companies to engage in fraudulent acts.
In my view, a major reason we have seen so much fraud is that the U.S. listed Chinese companies operate in a regulatory hole. They have structured themselves with offshore companies with variable interest entities to circumvent Chinese law. These efforts successfully (so far anyway) got them out from under Chinese regulation. One of the defenses the Chinese have used against U.S. complaints is that Chinese regulators have no authority over Cayman Islands companies. Yet China does not allow U.S. regulators to step in and fill the regulatory hole. It bans U.S. regulators from taking action on Chinese soil, where all the people and records reside.
In terms of specific jurisdiction, Paul is of course correct. The China Securities Regulatory Commission (CSRC) has authority over companies listed in China, so a typical Chinese company with an offshore special purpose listing vehicle (e.g., Cayman Islands, BVI) and a variable interest entity (VIE) would not fall within the purview of CSRC. The U.S. Securities and Exchange Commission (SEC) would have proper jurisdiction over these companies though, which brings us back to the current fight over access to audit materials.
While I agree with Paul’s description of the problem, I think there is one additional angle here that should be addressed, that of political will. It is true that CSRC is, from a legal standpoint, impotent when it comes to U.S.-listed Chinese companies. However, that does not mean that the government as a whole has no means to act.
Yes, the companies under scrutiny here are Chinese enterprises that have gone public, and it therefore makes sense to look at regulatory agencies like the CSRC and SEC when it comes to oversight responsibility. If neither agency has sufficient power, then we have a lot of bad actors running around with no cop on the beat.
Well, maybe. I’ll have to come down out of the ivory tower for this next bit. Keep in mind that many of these companies are utilizing a VIE structure and have the vast majority of their operations in China. That means that their onshore entities come under the regulatory authority of agencies like the Administration of Industry and Commerce (AIC) and the Ministry of Commerce (MOFCOM), and possibly the Ministry of Industry and Information Technology (MIIT), Ministry of Education (MOE) or other supervisory bodies. By withholding an operating license or threatening not to pass a company’s annual inspection, these agencies could put the fear of God into these firms.
While I admit that is makes little sense for an agency like MIIT or MOFCOM to get involved here in the regulation of an overseas listed company, it certainly would not be the first time that the regulatory apparatus in China has been used in such a way, particularly if there are overarching national economic issues at stake. Moreover, as the actions of Beijing in the accounting firm dispute make abundantly clear, the government certainly sees these as Chinese companies.
For me, the bottom line here is that even if there is no “natural” oversight authority here, Beijing has many regulatory levers to pull if it sincerely wished to solve the problem of these fraudsters. The fact that we are facing this problem at all suggests the absence of political will at some level.
Let me be clear, though, that I am certainly not advocating such a solution. It’s messy, complicated, and would be a non-transparent enforcement mechanism, the kind that I’ve been battling against during my 13-year stint as a foreign investment lawyer. I would much prefer a more straightforward regulatory fix.
Speaking of which, Paul’s solution is simple and makes sense: close the jurisdictional hole, and the problem goes away.
I argue that this regulatory hole needs to be closed from the Chinese side, with Chinese regulators stepping in to fill the gap. I think that involves getting rid of the Cayman Island holding companies and the VIE, allowing the Chinese operating company to list directly overseas. Getting rid of the VIE solves a pesky problem for both Chinese regulators and investors. Control of sensitive sectors should be done through dual share structures. Most importantly, I call for the CSRC to be designated sole gatekeeper and regulator for overseas listed Chinese companies. The CSRC needs to have the authority to work with foreign regulators to fulfill its mandate.
I am definitely on board with this. I have been saying for years now that the VIE structure is flawed and arguably illegal. If Chinese companies could simply list directly, that would obviate the need for many PRC firms to utilize the VIE, although I suspect there would still be some foreign investors out there that would insist on direct investment.
How feasible is this as a way out of this mess? Well, I’ll leave that for another post. At this point, I’ll just point out that many of these companies domestic operations fall under the regulatory jurisdiction of agencies like MIIT. If VIEs are abolished and these companies were allowed to list directly, that would cede a great deal of power to the new gatekeeper, CSRC. The mother of all turf battles?