Investing in China: Unpacking the SEC’s concerns
Marie Pupecki 
Date published: Mar 11, 24
Ideagen has just completed our 20 year analysis of initial public offerings IPOs and the results show non-US based initial listings are almost half of the initial listings in 2023.
In a fairly quiet IPO market, there were 28 non-SPAC China based companies1 in those numbers. Why is this surprising? In 2021, transportation software company, DiDi Global, raised $4.4 billion with their IPO, with a valuation of $68 billion. Almost immediately, the Chinese government issued new rules on use of personal data and the Cyberspace Administration of China (CAC) opened an investigation into DiDi’s data practices. Soon after, the CAC prohibited Chinese customers from purchasing any of DiDi Global's 26 apps and then removed them from Chinese app stores. By the end of 2021 the Cyberspace Administration fined them $1 billion and DiDi Global delisted from the NYSE. They continue to trade over the counter, their market cap is now $16.8 billion and their ADS shares trade at $3.53 down from the initial IPO price of $14.2
DiDI Global Inc. American Depository Shares
The SEC highlights risks of investing in China
I frequently work on grading in our comment letters database and have read and classified hundreds of letters that the SEC has sent to China based companies about their disclosures. These letters make it clear that China is an area of SEC focus and investors should heed their warnings. The SEC’s letters focus on disclosure of the outsize risks and ensuring that the company’s ownership (or lack thereof) is absolutely clear in the filings.
One of the SEC’s primary points is that the structure of these companies does not provide ownership in the underlying operating companies and the structure hinges upon the ability to enforce contractual obligations in China. The SEC's sample letter to China-based companies includes the following suggested risk language:
“…the VIE [variable interest entity] structure often uses a series of contractual arrangements between a holding company domiciled outside of China and a Chinese operating company or companies, which may avoid PRC [People’s Republic of China] limitations or prohibitions on direct foreign ownership in certain industries. The contractual arrangements are intended to mimic direct ownership in the operating company, but in many cases have not been tested in court.”3
Perhaps more directly, SEC Chair, Gary Gensler, explained the specific risk:
“For US investors, this arrangement creates “exposure” to the China-based operating company, though only through a series of service contracts and other contracts. To be clear, though, neither the investors in the shell company’s stock, nor the offshore shell company itself, has stock ownership in the China-based operating company. I worry that average investors may not realize that they hold stock in a shell company rather than a China-based operating company.”4
Short background on consolidation and VIE’s
Before the travesties of Enron (the US energy, commodities and services company that collapsed due to accounting fraud and led to widespread changes in legislation), we did not consolidate entities (formerly known as Special Purpose Entities – SPEs) unless there were majority voting interests held. If you recall Enron had SPEs which were off-balance sheet entities (meaning they did not consolidate). This is referred to in the literature as the voting interest entity model. Part of the regulatory response to the scandal was to redefine what types of related entities need to be consolidated. Creating new consolidation rules for variable interest entities (akin to the SPEs from Enron) has given us the variable interest entity (VIE) model.
Entities consolidate these based upon:
- The power to direct the activities that most significantly impact the VIE’s economic performance
- The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.5
Nowadays, we have these highly structured variable interest entities that hold all the operations of the company in which the shareholders have no ownership and receive benefits through contractual obligations. Consequently, many China-based operating companies use this structure to obtain capital from foreign investors, due to restrictions upon direct foreign investment in China.
What are the risks?
The SEC’s comment letter disclosures also highlighted a few more risks:
Government regulations and the effect of changes
“For example, our PRC subsidiaries face risks associated with regulatory approvals of offshore offerings, anti-monopoly regulatory actions, oversight on cybersecurity and data privacy. Any change in foreign investment regulations, and other policies in China or related enforcement actions by the Chinese government could result in a material change in our operations and the value of our securities and could significantly limit or completely hinder our ability to offer, or continue to offer, securities to investors or cause the value of our common stock to significantly decline or be worthless.” 6
For another real-life example of what can happen, there is no need to look further than the Chinese 2021 regulations for the private education industry. These regulations required tutoring and education services firms to convert to nonprofit status, banned core-curriculum tutoring during weekends and vacations, and forbid foreign curricula or hiring foreigners outside of China to teach remotely.7
Look what happened to TAL Education Group (TAL) when the news leaked8:
Government control of currency
“Restrictions under Chinese law on PRC subsidiaries’ ability to make payments to us could materially and adversely affect our ability to grow, make investments or acquisitions that could benefit our business, pay dividends to investors and otherwise fund and conduct our businesses.” 9
Unreliable VIE shareholders
“In addition, we have designated individuals who are PRC nationals to be the shareholders of our VIEs. These individuals may have conflicts of interest with us. We cannot assure you that when conflicts arise, shareholders of our VIEs will act in the best interest of our company or that conflicts will be resolved in our favor.” 10
Legal recourse
Go ahead and try to enforce those contracts – we dare you
“However, since PRC judicial and administrative authorities have significant discretion in interpreting and implementing statutory and contractual terms, it may be more difficult to predict the outcome of a judicial or administrative proceeding than in more developed legal systems. These uncertainties may impede our ability to enforce the contracts we have entered into and could materially and adversely affect our business and results of operations.” 11
Conclusion
Adding to the risks previously noted, recent SEC comment letters ask if there is “communist party language” in articles of incorporation and/or communist party officials as employees, management, directors or shareholders. The risky areas where the SEC is focused are foundational tenets of functioning capital markets and include contract law, private property, liquidity, fiduciary duty of care and limited government intervention. The SEC has indicated loud and clear that there are exceptional risks in these companies, and that is without consideration of any potential geopolitical disturbance or general economic decline. Their message appears to be: “Let the buyer beware.”
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1 Includes the special administrative regions of Hong Kong and Macau with mainland China
2 https://www.auditanalytics.com/0002/company-browse-detail.php?cik=1764757
3 SEC.gov | Sample Letter to China-Based Companies[1]
4 SEC.gov | Statement on Investor Protection Related to Recent Developments in China
5 ASC 810-10-05-8A
6 https://www.sec.gov/Archives/edgar/data/1519472/000164033423002267/solarmax_s1a.htm
7 China's new private tutoring rules put billions of dollars at stake | Reuters
8 https://www.auditanalytics.com/0002/company-browse-detail.php?cik=1499620
9 https://www.sec.gov/Archives/edgar/data/1420529/000156459022016924/filename1.htm
10 https://www.sec.gov/Archives/edgar/data/1616291/000095017023052072/filename1.htm