Wait a SEC

The SEC letter on VIEs starts with a fallacy on how VIEs work, and proceeds to demand disclosures that mostly already exist.

The latest shots fired in the war of the US-listed Chinese companies has come from the SEC. In a letter from the Chairman, the agency lays out concerns about Chinese companies, and specifically about the ability of average investors to understand VIE risks.

Some see this as the agency laying down the gauntlet, as best they can. However, I’m more confused that anything else. While there are some things in here that could indeed help clarify the risks involved, I doubt these nuances would be of much use to your average investor.

They’re more likely to drown in the high seas of the existing risk disclosures.

Firstly, let’s note that the letter starts with the mistaken assumption I discussed in my first substack post. At several points in the letter it is clear that the implicit structure the letter is referring to has a Contractual Control Point (or CCP, for fun) between the Cayman entity and a “China-based operating company” where all of the business actually happens.

As we saw before, while that can be the case, it usually isn’t. Normally you do have ownership over parts of your China operations, the key question is which parts. It is possible to structure companies so that the VIE utilisation remains relatively low, and this really is where the focus should be from the US side. Improving VIE structuring, making it a key part of the required governance framework for Chinese companies listed in the US.

Demanding some more boiler-plate disclosure around VIE risks is unlikely to make much of a difference. This is probably best illustrated by the fact that most of the new disclosures that the letter asks for actually exists already.

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;

This is usually covered in a number of places in the risk disclosures of any US-listed Chinese company, often with a nice bullet-point list outlining the potential actions the Chinese government might take. There’s also the standard disclaimer that comes after the legal opinion saying the VIE contracts are all legal, basically stating that there’s no assurance that Chinese authorities will take the same view.

A quick search for “substantial uncertainties” on any annual filing from a Chinese company using a VIE will get you some examples.

Detailed financial information, including quantitative metrics, so that investors can understand the financial relationship between the VIE and the issuer.

This also already exists, although there is some difference in the level of detail we get. Sometimes we get condensed information, and others we get the entire balance sheet, coupled with revenue and cashflow information. It’s available in the footnotes to the financial statement.

Looking at this is a good way to see just how much of the company is actually in the VIE, so we can avoid assuming that all of it is. This is also one of the big issues with these companies switching over to a HK listing, as disclosures in HK has nowhere near this level of detail.

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.

This is also present for most companies that average investors will be likely to have shares in. It’s usually a standard part of the risk section for these companies, and searching for “Holding Foreign Companies Accountable Act” will get you to the right place.

Here’s an example from Netease as I had their annual filings open:

Our auditor, like other independent registered public accounting firms operating in China, is not permitted to be subject to inspection by the Public Company Accounting Oversight Board, and consequently you are deprived of the benefits of such inspection. Under the recently passed Holding Foreign Companies Accountable Act, our ADSs may be delisted from Nasdaq if the PCAOB continues to be unable to inspect our independent registered public accounting firm in the next three years. In addition, various legislative and regulatory developments related to U.S.-listed China-based companies due to lack of PCAOB inspection and other developments may have a material adverse impact on our listing and trading in the U.S. and the trading prices of our ADSs.

So that leaves two points that offer some new added disclosures.

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

Once again, this seems to assume that the Contractual Control Point is between the Cayman company and the China-based operating company, and for these companies this disclosure should be pretty easy. In fact many of them already have disclosures that cover this. They will clearly state that due to Chinese regulations the company’s operations are held in the VIE.

The new disclosures here would be for the better structured VIEs. Detailing exactly what parts of the company is in the WFOE as opposed to the VIE will be very interesting in identifying best-practices for how to structure companies to minimise VIE utilisation.

It’s not going to be easy though. I’m not entirely sure how you would write a disclosure that clearly distinguishes the parts of Alibaba’s business that is conducted in the WFOEs from the relatively limited parts that are handled in the many VIEs. I’m just very happy I don’t have to write it.

Finally, the disclosures around the new mechanism for approval of the foreign listing.

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

This is clearly a reasonable inclusion, and a risk that should be disclosed. However, given that there are already so many risk disclosures that professional investors don’t get through them all, I doubt the inclusion of this will have any measurable impact on how the average investor understands China risk exposure.

So, the SEC letter has me confused. It could be that the devil is in the enforcement here, and the Chairman wants to substantially increase the amount of detail in these disclosures. I would be a big fan of this, as it would let investors get deeper into their risk analysis, and potentially create the necessary information for a functioning VIE governance reform.

Maybe this is a first step, however, on it’s own the letter makes little sense from a VIE risk assessment point of view. I suspect the impact on how the average investor understands VIE risk is likely to be minimal.