Resolving trade disagreements is not the only issue facing the Trump administration when it comes to dealing with China. What is the Securities and Exchange Commission to do about the approximately 300 China-based companies who have issued and listed their securities on our stock exchanges without any assurance that they have the proper accounting and disclosure regimes in place? This is the issue raised in the SEC’s recent “Concept Release on Foreign Private Issuer Eligibility.”
The SEC provides foreign companies who issue and list their securities in the U.S. (foreign private issuers or “FPI”) with specific accommodations such as allowing them to present their financial statements using accounting standards other than U.S. GAAP. This approach has allowed FPIs to gain significant access to our securities markets—the most important, comprehensive, and deepest securities markets in the world.
Such foreign access comes with many benefits. It has enhanced the world-wide dominance and liquidity of our securities markets, boosted the profitability of U.S. institutions who participate in them, allowed U.S. investors the opportunity to diversify their portfolios with FPI securities, provided funding for FPIs to make capital investments in the U.S., and increased the demand for services provided by the million plus people who work in our securities industry.
The SEC is allowed to provide FPIs with specific accommodations as long as they conform to what is required by the statutory language of the Securities Act of 1933 and the Exchange Act of 1934 and the discretionary disclosure authority provided by two statutorily undefined terms: “for the protection of investors” and “in the public interest.”
Under the first term’s authority, the SEC has made accommodations based on the understanding that while many FPIs may come from jurisdictions where the accounting, oversight and disclosure regimes differ from ours, such regimes still “provide full and fair disclosure of the character of securities sold in interstate and foreign commerce.” Under the second term’s authority, it has regulated based on the understanding that FPIs yield significant benefits, as described above, to all those who participate in our securities markets.
The SEC needs to make sure China-based issuers are providing adequate disclosures necessary “for the protection of investors.” As the SEC’s Corporate Finance Department said in its guidance on disclosures by China-based issuers:
Although China-based Issuers that access the U.S. public capital markets generally have the same disclosure obligations and legal responsibilities as other non-U.S. issuers, the Commission’s ability to promote and enforce high-quality disclosure standards for China-based Issuers may be materially limited. As a result, there is substantially greater risk that their disclosures may be incomplete or misleading.
This problem arose because China-based companies have figured out a way to get around the Chinese government’s restrictions on foreign investment in Chinese companies by utilizing holding companies incorporated in jurisdictions such as the Cayman Islands and British Virgin Islands. These holding companies enter into contractual arrangements with Chinese operating companies that imitate, but does not create direct ownership of the operating companies. This has led to an explosion of China-based companies issuing securities in the U.S.
The SEC cannot exceed its regulatory authority by allowing China-based issuers to provide inadequate disclosures. On the other hand, it is in the public interest for the SEC to make sure the benefits provided by FPIs are maximized. Therefore, the SEC’s regulatory changes must not be so overly broad as to discourage those high-quality FPIs who provide disclosures within a robust regulatory and oversight framework from participating in our markets. For example, FPIs who are both incorporated and have their headquarters in the State of Israel. Approximately 10% of FPIs come from this country.
The Concept Release presents a number of possible solutions. Several of them utilize bright-line rules that are necessarily over broad. For example, requiring FPIs to have a higher percentage of foreign ownership, have a minimum amount of foreign trading in their securities, or be listed on a major foreign exchange. These options would place needless burdens on high quality FPIs.
What these bright-line solutions lack is a targeted evaluation of the regulatory regime that a FPI will use in creating its disclosures. Doing so is the key to solving the issue of China-based issuers.
Coming closer to the mark, the Concept Release proposed an expansion of the Multijurisdictional Disclosure System (MJDS) that currently only exists between U.S and Canada. This agreement allows “eligible U.S. and Canadian issuers to conduct cross-border securities offerings and fulfill their reporting requirements primarily by complying with, and using disclosure documents prepared in accordance with, home country securities regulations.” While the MJDS allows for a thorough evaluation of a FPI’s regulatory regime, it would require an intense multi-year effort on the part of the SEC for each additional country participant and is therefore not a practical solution.
Fortunately, the Concept Release did propose one solution that hits the mark: “[R]equire that each FPI be (1) incorporated or headquartered in a jurisdiction that the Commission has determined to have a robust regulatory and oversight framework for issuers and (2) be subject to such securities regulations and oversight without modification or exemption.”
This solution requires significant work but is a much more practical solution than entering into a large number of MJDS agreements. Moreover, it minimizes the risk that we needlessly lose the securities issuance and trading business of high-quality FPIs. Once this solution is in place, it will then be up to China to establish a robust regulatory and oversight framework that will allow their companies to qualify as FPIs.
