U.S. SEC Warns of Investment Risks Involving Variable Interest Entity Structure

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September 22, 2021

By: Ian Liao

The U.S. Securities and Exchange Commission (SEC) issued an alert to investors this week warning about potential risks in investing in U.S.-listed companies that have contracts with but no control over operating entities in China.  This arrangement is commonly known as a variable interest entity (VIE) structure under which the U.S.-listed company’s wholly owned subsidiary in China enters into contractual arrangements with a VIE owned by a “Chinese person,” who is often a nominee for the major shareholder of the Chinese company.  This structure is commonly used as a mean to bypass foreign ownership restrictions under Chinese law in order for a Chinese company to hold operating licenses in China while accessing the U.S. capital market.  The contractual arrangement can include powers of attorney, equity pledge agreements, and exclusive services or business cooperation agreements.

The SEC also warned that investors may be exposed to risk if China determines that these companies violated Chinese laws and thereby making the contracts with VIEs unenforceable, which results in a conflict of interest between the owner of the VIE and the U.S. shareholders.

This is the latest move by the U.S. agency to address concerns about Chinese companies accessing funds from the public market.  In July of this year, the SEC issued new disclosure requirement to Chinese companies seeking to undertake public offering in the U.S., including greater disclosures of their use of VIEs and risks that the Chinese government will interfere with their operations.   More specifically, the SEC asked that such companies provide disclosures on “how this type of corporate structure may affect investors and the value of their investment,” “how and why the contractual arrangements may be less effective than direct ownership,” and that “investors may never directly hold equity interest in the Chinese operating company.”

With about 150 Chinese ADRs trading in the U.S. markets, with a combined market capitalization of over 1.5 trillion dollars, such actions by the U.S. agency will likely to have a significant impact on these issuers, which includes many of China’s major technology, telco and media companies.

After the Trump administration’s executive order limiting U.S. investment in securities of certain Chinese companies and the SEC working to finalize rules on delisting Chinese companies that fails to comply with U.S. auditing requirements, the new disclosure requirements may further deter Chinese companies further from looking to the U.S. capital market.

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