The SEC Office of Investor Education and Advocacy, Office of the Chief Accountant and Division of Corporation Finance warned investors of the risks associated with investments in U.S.-listed companies with operations in China.

In an Investor Bulletin, the SEC explained that U.S.-listed companies with business operations in China are often holding companies structured as "variable interest entities" ("VIEs"). VIEs may be organized in the United States, but the principal assets may be located in China in a company that has entered into a contractual relationship with the issuer but is not actually an owned subsidiary of the issuer. The SEC stated that such arrangements are often set up as a result of the Chinese government's restrictions on non-Chinese ownership of companies in certain industries (e.g., education and telecommunications).

The Investor Bulletin outlined the following risks arising from investments in a U.S.-listed company with China-based operations under a VIE structure:

  • U.S. investors and the U.S.-listed company may be subject to severe financial losses with no guarantee of recourse if (i) the China-based operating company violates any terms of the contract or (ii) the Chinese government enacts a law that impacts the enforceability of the contract;

  • because the Chinese government has not formally approved China-based VIE structures, the Chinese government could conclude that such arrangements are in violation of Chinese law;

  • violations of the contract between the U.S.-listed company and the China-based VIE will probably fall under China's legal jurisdiction, raising questions as to the availability of recourse for the U.S.-listed company and its investors; and

  • conflicts of interest among the owners of a China-based VIE and the stockholders of the U.S.-listed company may impact investments into the U.S.-listed company.

The SEC stated that investors can find out if a U.S.-listed company with substantial Chinese operations uses a China-based VIE structure by examining the company's annual reports, which are publicly available on the SEC's EDGAR database.

Commentary

The SEC has warned investors of the risks of investments in China several times. Seee.g.SEC Chair Asks Staff to Ensure Offshore Issuers Accurately Disclose Relationship to China-Based Operating CompaniesSEC and PCAOB Officials Decry Inspection Limitations on China-Based Audit FirmsSEC Identifies Investment Risks Associated with China-Based IssuersPWG Addresses Chinese Non-Compliance with U.S. Audit Standards. Will a regulatory or enforcement action follow?