On Friday, SEC Chair Gary Gensler issued a statement concerning investor protection related to recent developments in China. The statement summarizes risks to US investors as a result of recent government-led developments in China and outlines new requests to the SEC staff to seek certain disclosures with respect to these risks. The new directives to the SEC staff build on the November 2020 guidance issued by the Division of Corporation Finance – CF Disclosure Guidance: Topic No. 10, “Disclosure Considerations for China-Based Issuers” (Nov. 23, 2020).
Chair Gensler summarized that “the government of the People’s Republic of China provided new guidance to and placed restrictions on China-based companies raising capital offshore, including through associated offshore shell companies. These developments include government-led cybersecurity reviews of certain companies raising capital through offshore entities.” Most notably, Chair Gensler’s statement focuses on the risks related to the China-based Variable Interest Entity (VIE) structure, in which investors invest in the stock of a shell company that has “exposure” to the China-based operating company through a series of contractual arrangements that enable the shell company to consolidate the China-based operating company into its financial statements for accounting purposes. These structures are put into place in light of Chinese prohibitions against foreign ownership of certain sectors in China and prohibitions on listing Chinese companies on exchanges outside of China.
To ensure US investors are aware of these risks, Chair Gensler has instructed the SEC staff to “seek certain disclosures from offshore issuers associated with China-based operating companies before their registration statements will be declared effective,” including “prominent and clear” disclosure:
- That investors are not buying shares of a China-based operating company but instead are buying shares of a shell company issuer that maintains service agreements with the associated operating company. Thus, the business description of the issuer should clearly distinguish the description of the shell company’s management services from the description of the China-based operating company;
- That the China-based operating company, the shell company issuer, and 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 the contractual arrangements; and
- [Of] detailed financial information, including quantitative metrics, so that investors can understand the financial relationship between the VIE and the issuer.
The SEC staff has also been tasked with seeking the following “prominent and clear” disclosures from “all China-based operating companies seeking to register securities with the SEC, either directly or through a shell company,” which would capture de-SPAC activity with Chinese-based companies:
- Whether the operating company and the issuer, when applicable, received or were denied permission from Chinese authorities to list on U.S. exchanges; the risks that such approval could be denied or rescinded; and a duty to disclose if approval was rescinded; and
- That the Holding Foreign Companies Accountable Act, which requires that the Public Company Accounting Oversight Board (PCAOB) be permitted to inspect the issuer's public accounting firm within three years, may result in the delisting of the operating company in the future if the PCAOB is unable to inspect the firm.
Chair Gensler has also asked the SEC staff to engage in targeted additional reviews of filings for companies with significant China-based operations. Moreover, Chair Gensler made clear that the SEC “will continue to hold all companies to the securities laws’ high standards for complete and accurate disclosure.” As current public companies with operations or connections to China prepare upcoming periodic reports, or as companies engage in capital markets transactions, they will want to consider the applicability of Chair Gensler’s latest charge to the SEC staff and take a fresh look at their disclosures in light of this new guidance.