The SEC Division of Corporation Finance (the "Division") identified risks associated with China-based issuers and highlighted related disclosure considerations.
In newly modified disclosure guidance, the Division described the following risks:
- High-Quality and Reliable Financial Reporting: The Division stated that current restrictions on the Public Company Accounting and Oversight Board ("PCAOB") limit its ability to inspect audit work because China has not provided access to its accounting firms.
- Access to Information and Regulatory Oversight: According to Article 177 of the People's Republic of China ("PRC") Securities Law, U.S. securities regulators cannot directly conduct investigations within the PRC, meaning U.S. authorities, including the SEC, face substantial challenges in enforcing actions against China-based issuers.
- Corporate Organizational Structure: The Division stated that many China-based issuers enter into contractual agreements with Chinese operating companies to circumvent restrictions on foreign investments in certain industries. The Division explained that these variable interest entities ("VIEs") pose risks to U.S. investors because the issuer does not hold an equity interest in the operating company and can exert control only through contractual agreements, which may be less effective than direct equity ownership.
- Regulatory Environment: The Division stated that there is lack of certainty regarding the intent, effect, and enforcement of Chinese laws, including those which restrict the inflow and outflow of foreign capital and provide the Chinese government with the ability to exert influence over an issuer's business.
The Division emphasized that China-based issuers must fully disclose operational risks, and asked issuers to consider the following questions:
- Does the company clearly explain the limitations of PCAOB inspection;
- Does the company use VIEs in its organizational structure;
- Does the company disclose regulatory risks associated with the Chinese legal system; and
- Does the company disclose differing shareholder rights based on the company's country of organization?
Commentary Steven Lofchie
Although the guidance is purportedly directed to Chinese issuers, the real target is likely to be U.S. financial intermediaries (i.e., broker-dealers and advisers). It puts these firms on notice that there are additional risks in distributing, trading, or investing in Chinese issuers. In the event the price of one of these issuers plummets, a plaintiff will be able to point to the SEC's guidance and complain that a financial intermediary, who owed it some duty of care or prudence, failed to exercise proper care in the transaction.
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