Chinese Stock IPOs Halted

Dear Rich Lifer,

On Friday, the Securities and Exchange Commission (SEC) stopped processing initial public offerings (IPOs) from Chinese companies until they meet new disclosure requirements. 

The SEC’s move shines a light on continued concerns that Chinese companies are breaching U.S. rules, which require public companies to disclose potential risks to investors. 

Refinitiv data revealed 418 Chinese companies, which have already reached $12.8 billion this year, are listed on U.S. exchanges.

SEC Chair Gary Gensler explained in a statement that the SEC will begin requiring Chinese companies to disclose information about the structure of their IPOs and the risks of Chinese government intervention in order for companies to raise money in the U.S.

The “certain disclosures” were explained in detail by Reuters on Friday:

These should include that investors face “uncertainty about future actions by the government of China that could significantly affect the operating company’s financial performance” and the enforceability of certain contractual arrangements.

So how’d we get here and what’s next for investors gambling on Chinese stocks?

A Tense History

This move comes after Beijing increased oversight on overseas share issuances of newly listed firms — most notably ride-hailing company Didi Chuxing. Didi’s stock fell 30% this month after Beijing announced a cybersecurity investigation and suspended new users. 

China also recently told its for-profit education companies that they would have to become nonprofits, which sent shares of companies like New Oriental Education & Technology Group (EDU) and TAL Education Group (TAL) plummeting. 

As a result of the crackdowns, there have been massive selloffs in the shares of Chinese companies that are listed in the U.S. and Hong Kong. 

In fact, the Hang Seng Tech Index, which includes stocks such as Alibaba Group Holding Ltd., Tencent Holdings Ltd., and Meituan, dropped 14% in a week. 

Additionally, the S&P/BNY Mellon China Select ADR Index, which tracks the American depositary receipts of major U.S.-listed Chinese companies, has lost 22% of its value year-to-date. 

The U.S. and China have had tension over this issue for years, which has resulted in an increase in scrutiny of the SEC to be more firm with China. 

Last month, the SEC removed the chairman of the Public Company Accounting Oversight Board (PCAOB), William Duhnke, because of the inability of the board to ensure independent auditing of U.S.-listed Chinese companies. 

This week, a group of senators, including Republicans John Kennedy and Bill Hagerty wrote to Gensler urging “thorough investigations of U.S. listed Chinese companies’ concerning lack of transparency.”

Now that we understand more of the history behind disclosure tension, let’s explore the root of the problem: variable interest entities.

Variable Interest Entities 

You may remember, in his statement, Gesler mentioned variable interest entities structures, a structure unique to Chinese companies. 

Variable interest entities (VIEs) stemmed from the early-2000s period of China’s market liberalization. Since then, they have become the biggest way for U.S. capital to access exposure to public Chinese companies. 

According to GMT Research, 69% of NYSE- and Nasdaq-listed Chinese companies use VIEs.

These structures use a complicated combination of contracts, subsidiaries, and shell corporations, which basically allow investors to own mock shares in certain companies. In other words, they allow companies to sell shares of shell companies. 

Because of the complex nature of these structures, the SEC worries that many Americans are ignorant of the fact that they are not actually investing in ownership rights of VIE-listed Chinese companies. 

In his statement, Gensel explained that “average investors may not realize that they hold stock in a shell company rather than a China-based operating company.”

China Attempts Damage Control 

China attempted to ease investor anxiety by telling top, global financial firms that Beijing will consider market impact before enacting new crackdowns and urged foreign brokerages not to “overinterpret” its actions. 

Fang Xinghai, vice chairman of the China Securities Regulatory Commission, and Yi Huiman, the securities regulator’s chairman, reportedly talked with Goldman Sachs, UBS and other investment firms this past week. 

Mr. Fang apparently told these firms that the regulations targeted at for-profit education companies, such as tutoring services, were an attempt to address problems in the education sector. He also added that China has no intention of breaking off from global markets. 

One of the people who has knowledge of the meeting told Reuters the purpose was to “calm the market to isolate the education industry and not to overinterpret it,”

When foreign ministry spokesman Zhao Lijian was questioned about how confident investors should be in investing in Chinese companies after recent disclosure requirements, he commented, “We have been providing a fair, open and non-discriminatory environment for companies. What you mentioned is just not true.”

Whether or not foreign investors are buying these efforts, the Chinese markets certainly will. After the meetings, China stocks had their best day in two months — the blue-chip CSI300 Index (.CSI300) jumped 1.9%, and the Shanghai Composite Index (.SSEC) gained 1.5%.

Despite this, Qian Wang, Vanguard Group’s Asia-Pacific chief economist, urged investors to understand the risks of investing in China. 

She advises, “Although China is the world’s second-biggest economy, it remains an emerging market with economic, policy and regulatory uncertainty… you need to bear higher risks, which is natural” if you want higher returns. 

Further consequences of the SEC’s crackdown will likely play out in the weeks to come. Stay cautious in the meantime…

To a Richer Life,

The Rich Life Roadmap Team 

 

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