Cross-country capital markets participation between China and the United States has been decidedly one-sided.
Over the past two decades, major Chinese companies have listed their shares in the U.S. markets and American investment capital has flowed into China by the billions. But the Chinese markets have not become more transparent, more open, or more stable.
Recent announcements of fraudulent accounting at U.S.-listed firms such as iQiyi and Luckin Coffee have underscored the dangers of investing in Chinese companies. And their participation in U.S. capital markets—an implicit seal of approval for most retail investors—conceals the fact that Chinese companies represent highly speculative, volatile investments.
Firstly, banks are profit-seeking companies. Absent legislation or sanctions, companies will generally act in a way that is most economically beneficial to its board and shareholders within the guardrails of an established regulatory framework. And that includes seeking out and taking on Chinese clients.
However, through China’s political and economic model, the Chinese Communist Party (CCP) directly or indirectly maintains de-facto influence over all Chinese companies—public or private, state-owned or not.
In addition, the opaque nature of these listings and complicated structure and ownership of Chinese companies render existing regulatory guardrails less effective. Further, the roles of Wall Street investment banks, law firms, and accounting firms as advisors to the issuers mean that most investors are at a severe disadvantage when owning stocks and bonds of Chinese companies.
In short, Chinese listed firms are not on a level playing field with their U.S. counterparts.
Underwriters Have No Duty to Investors
IPOs underwritten by multinational investment banks and advised by law firms that are focused in banking and finance should not be taken as sure things. And that’s especially the case with companies originating from China, where suspect representations occur on a more frequent basis.In an equity or debt sale, investment banks work with the issuer to create an offering and find investors from their client base to buy the securities. To be clear, the bank’s job is to provide sufficient information—usually using representations from the company and the company’s audited financials—in a fancy format allowing investors to make their own investment decisions. Caveat emptor applies.
The underwriting bank commits fraud when it misleads investors by withholding information from investors or if the bank knows the financial data presented is inaccurate or false. This is extremely hard to prove. Despite investor lawsuits during the last financial crisis with sales of mortgage-backed securities, and after the IPOs of prominent technology firms such as Facebook and Lyft, banks have largely avoided major controversy.
Investors Gain Financial Exposure, But Not Transparency
Almost all major Chinese firms list their stock in the United States by utilizing two innovative tactics: VIE structure and ADR shares.ADRs are not a recent innovation and not unique to Chinese companies. It was devised by Wall Street bank J.P. Morgan in 1927 as a way for American investors to invest in Selfridges, the U.K. department store chain.
ADR is a construct that allows non-U.S. companies to trade on U.S. exchanges. And ADR is not a share of the company, but is a negotiable security issued by a U.S. custodian bank that represents ownership in the company it references. An ADR share is theoretically redeemable for a share in the company and mirrors its value, allowing a U.S. investor to gain exposure to a foreign company otherwise unavailable to be traded by U.S. investors.
Theoretically, companies issuing ADRs in the United States are subject to the same Securities and Exchange Commission (SEC) reporting requirements as other U.S. companies.
But therein lies an issue. The ultimate operating company of the ADR stock still resides in China and is subject to Chinese laws, not U.S. ones. Beijing does not allow the SEC or U.S. regulators to examine audit work papers of Chinese companies. The Chinese Communist Party (CCP) claims that the books present “national secrets” which cannot be shared with outside parties.
In 2015, the SEC sanctioned four China-based accounting and audit firms—local affiliates of the “Big Four” accounting firms of KPMG, PwC, EY, and Deloitte & Touche—for failing to turn over documents to support an SEC investigation, thus violating Section 106 of the Sarbanes-Oxley Act.
Chinese companies also implicitly answer to local CCP bosses and Party cells. This is uncertainty for every Chinese company, no matter where its stock is traded and is a key reason why Huawei—a private company—poses a national security risk to the United States.
Many Chinese firms also have a high volume of related Party transactions whose terms are often not properly disclosed—a risk that a whistleblower report on Chinese coffeehouse chain Luckin Coffee laid bare.
The macro environment also makes it difficult to assess the financial health of Chinese companies, especially those listed in China (onshore stocks). The CCP is notorious for manipulating and massaging economic data such as official GDP figures, consumer spending, and manufacturing activity, making the tasks of economic forecasting and stock price discovery exceedingly difficult.
Risky Structure, With Wall Street Branding
The VIE (variable interest entity) structure is a more recent innovation specifically devised for Chinese companies listing in the United States.This dates back to 2000, when Sina.com became the first Chinese company to list in the United States. The VIE structure was reportedly created by Chinese lawyer Liu Gong, which Sina adopted to avoid Chinese regulations barring foreign ownership in industries such as telecom, media, technology, financial services, entertainment, and others.
A domestic Chinese entity is created as an operating company, and houses all the employees, databases, and equipment that enables the company to run its operations. This is the VIE, and for all intents and purposes, this is the real company.
Another company is created in China, typically referred to legally as the wholly foreign-owned enterprise (WFOE). This WFOE typically holds technology patents and certain intangible assets of the company.
Then an offshore entity is created, based in the British Virgin Islands, Cayman Islands, or another jurisdiction with high legal confidentiality. Through a series of intermediaries, the offshore entity owns the WFOE. This offshore WFOE issues ADR shares and is owned by U.S. investors.
How do U.S. investors gain “ownership” of the company? A series of financial contracts are executed between the VIE and the WFOE, where the WFOE (ultimately owned by foreign investors) effectively receives economic benefits of the operating company (the VIE) through legal contracts.
While novel, it’s certainly not an ideal way to own a company.
An inherent risk of this structure is that investors don’t hold ownership in the operating company. Local Chinese executives or the CCP could one day decide to abandon the offshore entity, leaving U.S. investors high and dry.
Wall Street’s Budding Relationship with Chinese Companies
Who was the lead underwriter on Sina.com? The New York-based Morgan Stanley, which also happens to be the first investment bank to enter China.Back in 1995, Morgan Stanley entered China and built up a 34.3 percent stake in China International Capital Corporation (CICC), the largest domestic investment bank. It was China’s first financial services joint venture with a foreign company. Morgan Stanley helped to build CICC’s investment banking know-how. By 2010, Morgan Stanley received regulatory approval to sell the stake to a consortium of other foreign investors. It made $700 million in profits on the sale.
Its 15-year relationship with CICC yielded results as Morgan Stanley won the offshore listings of several major Chinese companies including Sina.com in 2000, China Petroleum & Chemical Corp. in 2000, TAL Education Group in 2010, and 51job in 2004, to name a few examples.
In recent years, asset managers, ETFs, and pension funds have increased investments into Chinese onshore stocks as a result of global stock index providers such as MSCI and FTSE Russell adding Chinese stocks to their global and emerging markets indices.
Two years ago, MSCI—which operates the most widely tracked emerging markets index—added Chinese stocks, which enabled billions of dollars of fund flows into Chinese equities. MSCI is partially owned by Morgan Stanley.
Morgan Stanley isn’t the only investment bank to operate in China—most of its peers have a presence, although up until 2020, they were not able to have more than a 50 percent ownership in their Chinese joint ventures.
Swiss investment banks UBS and Credit Suisse both received Chinese regulatory approval to obtain a majority ownership of their Chinese joint ventures. U.S. bank JPMorgan Chase announced it would seek 100 percent ownership of its joint venture this year.
It has been 25 years since U.S. investment banks landed in China. Despite the banks’ initial intentions of transforming China’s markets, the CCP has barely opened its investments industry to outside ownership and its financial markets have not gained the free market mechanisms and stable regulatory oversight inherent in Western markets.
Investment banks are defined by mercantilism. Their influence has brought to U.S. markets Chinese companies that often cannot be held to the same standards as their American listed peers. In addition, Wall Street index firms have helped bring pension fund capital to Chinese onshore securities which have even less transparency and stability.
Investing bears risk and nothing is guaranteed. But such risk must be assessed within the framework of U.S. regulatory structure. And Chinese companies often operate outside of this framework.
The U.S. government should work to bar ADR listings from China that don’t adhere to the same regulatory standards, and prevent public pension funds from funneling their capital to fund opaque and risky Chinese companies.
