SEC Chairman Gary Gensler spoke at the House Committee hearing in May. He introduced new restrictions on Chinese companies listed in the U.S. Image source: U.S. HOUSE COMMITTEE ON FINANCIAL SERVICES

U.S. regulators will require Chinese companies to disclose more information before listing in the U.S., following new restrictions imposed by the Chinese government on companies seeking overseas financing.

On July 30, SEC Chairman Gary Gensler stated: "Given the recent developments in China and the overall risks involved, I have instructed our staff to require certain disclosures from offshore issuers associated with companies operating in China before approving the effectiveness of their registration statements."

The new disclosure requirements will primarily focus on so-called Variable Interest Entities (VIEs)—a shell company structure used to circumvent China’s restrictions on foreign ownership and listings on overseas exchanges. Gensler said he’s concerned U.S. investors may not realize they’re buying shares in a shell company rather than a firm actually operating in China.

Companies seeking to sell shares in the U.S. must first submit a registration statement to the U.S. SEC. During this process, the company’s and the SEC’s legal teams will engage in multiple rounds of discussions regarding the disclosure details in the statement—only after which the statement can finally be declared effective, enabling the company to proceed with its initial public offering (IPO).

VIE allows U.S. investors to invest in Chinese companies by entering into service agreements and other contracts with the operating company.

The SEC's latest requirements signal that U.S.-China economic ties continue to cool under the Biden administration. For decades, the two countries have seen their financial and trade relationships grow increasingly intertwined, with U.S. investors particularly eager to invest in rapidly expanding Chinese enterprises.

Image source: SEC website (click to read the original article for public documents)

Gensler linked Friday's statement to China's recent tightening of restrictions on domestic companies' ability to raise capital overseas. In early July of this year, Chinese regulators launched a cybersecurity investigation into Didi Global Inc., shortly after the ride-hailing company went public in the U.S. By July, the company had lost over $10 billion in market value amid mounting regulatory pressure and growing investor concerns.

To list in the U.S., a company must file a registration statement with the SEC. This process typically involves back-and-forth negotiations between the company and SEC attorneys, continuing until the SEC officially declares the statement effective, thereby enabling the company to proceed with its initial public offering (IPO).

For companies using the VIE structure, the SEC will require their registration statements to clearly distinguish between the shell company and the China-based operating entity, along with providing detailed information about the relationship between the two entities. According to Gensler, the registration statements must also disclose "the uncertainty surrounding potential future actions by the Chinese government, which could significantly impact the operating company’s financial performance and the enforceability of its contractual arrangements."

Chinese companies listed on U.S. exchanges through the VIE structure have already been regularly disclosing these types of risks.

Gensler also stated that the SEC will require all Chinese companies seeking to list on U.S. exchanges to clarify whether they have obtained approval from relevant Chinese authorities, as well as disclose the risk that such approval could be revoked.

Take Didi as an example—this company gave its U.S. investors the impression that it had already secured approval for an IPO, and by late June, it raised approximately $4.4 billion through the New York Stock Exchange. However, just days later, Chinese regulators launched a cybersecurity review of the company and subsequently banned it from onboarding new users. In the following days, app stores were instructed to remove Didi’s apps, and the company announced stricter regulations targeting Chinese firms listed—or seeking to list—overseas.

Under a policy established by the U.S. last year, the SEC will also require Chinese companies to disclose that they could face delisting if U.S. auditing firms are not permitted to review their reports within three years.

Lawyers say that after years of negotiations between U.S. and Chinese regulators, the SEC has adopted a tougher stance, which could further chill the prospects for Chinese companies seeking to list in the U.S.

Some investors welcomed the SEC's move, even though they had already prepared for Chinese companies listed in the U.S. to face potential sell-offs due to the SEC's new scrutiny.

According to Xinhua News Agency, the Political Bureau of the CPC Central Committee held a meeting on July 30 to analyze and assess the current economic situation and outline economic tasks for the second half of the year. The meeting emphasized the need to proactively prevent and resolve risks in key areas, implement a fiscal and financial risk management mechanism led by local party and government leaders, and further refine regulations governing companies listing overseas.

Paul Kiernan

Updated July 31, 2021, 11:15 AM CST

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