Larry Fink, CEO of BlackRock, the world’s largest money management company, said: “Markets don’t like uncertainty. Market likes actually totalitarian governments where you have an understanding of what’s out there…”
So it’s no surprise that China’s best-known tech companies decided to list on American Exchanges, where investor demand always outstrips stock supply. As of May 2021, the U.S.-China Economic and Security Review Commission said there were 248 Chinese companies listed on U.S. Exchanges with a total market capitalization of $2.1 trillion.
In recent months, “certainty” under the undemocratic regime has begun to show its weakness and become like a giant gamble. Following China’s ride-hailing Didi Global crash in 2021, many other major Chinese companies have halted their Wall Street IPO plans.
And it is Beijing’s correcting mistakes policy that has marked a cold end to the era of Chinese companies flapping in a “foreign capital-raising paradise.”
Exploiting vulnerabilities to bypass domestic and overseas surveillance
Observers say China’s $2 trillion stock market is a sandcastle built on a foundation of unaudited bookkeeping and dubious shell companies. Over the years, by skillfully exploiting two regulatory loopholes—one in Beijing and the other in Washington—Chinese companies have evaded scrutiny domestically and abroad, leaving investors unaware of their actual financial status.
Soren Aandahl, a chief investment officer of the hedge fund Blue Orca Capital, said: “When you have a government that can very quickly and arbitrarily change their position on the validity and enforceability of these contracts, or even whether some of these companies should list abroad. That’s a massive risk to long-term stock ownership.”
To avoid domestic regulations, many Chinese companies sell their shares abroad through a legal structure known as a variable interest entity (VIE). VIEs are typically incorporated outside China, allowing Chinese corporations to set up shell companies in tax havens such as the Cayman Islands or the British Virgin Islands. Before listing on Wall Street, these shell companies will participate in a complex web of contracts that give them “ownership” over the parent group in China. When American investors think they are buying shares in a Chinese company, they give their money to a company with an empty shell in the Cayman Islands, which has established contractual arrangements with its parent company in China.
China imposes draconian restrictions on foreign ownership in Chinese companies operating in sensitive sectors such as technology, media, and telecommunications. But VIE’s loophole has made it possible for Chinese companies to become foreign entities exempt from the investment ban.
The loophole had existed since 2000 when Chinese media company Sina Corp created a VIE for listing on Nasdaq. At first, China stated that it would prevent this behavior. Anne Stevenson-Yang, co-founder and research director of J Capital Research, said: “I remember when Sina first listed, “the head of the Ministry of Post and Telecommunications held a press conference and said this is illegal—you can’t have foreign ownership of Chinese telecom assets.”
But in the end, Stevenson-Yang said, China’s appetite for economic growth trumped its concerns about foreign investments in sensitive industries. “Beijing was thinking, ‘If we can capture all this money, why not?'”
The VIE’s loophole has allowed the inflow of foreign money. In the past two decades, attracted by the vast international investment capital, prestige, and liquidity coming from listing on Wall Street, Chinese companies have rushed to the U.S. exchanges. The SCMP reported that about 100 VIE companies account for more than $4 trillion in capitalization in China’s MSCI Index—including $700 billion from U.S. investors.
However, these investments are now facing enormous risks. According to observers, the China Securities Regulatory Commission (CSRC) planned to fill the gap, preventing Chinese companies from listing overseas even if they sell stocks through VIE contracts.
“The contracts themselves effectively mean nothing because they are governed by the legal system of the People’s Republic of China,” Dan David, the founder of Wolfpack Research, said. “American investors must understand that any of these companies could pull the plug at any time, leaving them holding worthless shares in an empty Cayman shell.”
“They are not going to immediately say, ‘All VIEs are just illegal and foreigners don’t actually own anything,'” Stevenson-Yang said. “What they are going to do is require restructuring so that the VIEs are brought onshore. They will have some kind of restructuring and some kind of compensation. But eventually you are going to see the foreign interest kicked out of these companies.”
Chinese companies listed on the U.S. exchanges have also avoided financial supervision by regulators. Due to concerns over national security, the Chinese government has long refused to let the Mass Corporation Accounting Supervisory Board—organized by the U.S. Congress to protect investors—inspect the audits of Chinese companies listed on Wall Street.
The lack of transparency has created an overall distortion around Chinese companies trading on U.S. exchanges, a very attractive place to raise funds.
Barriers to regulatory oversight by Chinese companies used to cost investors dearly. Luckin Coffee, a competitor with Starbucks in China, which used to be a tech pet on the Nasdaq floor, was caught in an accounting scandal last year that led to its sudden collapse. After the company admitted to selling fabricated goods, its shares fell 75% only after a night. Luckin’s stock, worth $12 billion at its peak, was quickly delisted.
The U.S. regulators also failed to detect Didi’s apparent misconduct—China’s popular car call app. Three months before the expected IPO, cybersecurity authorities in China asked Didi to delay the listing, citing concerns about national security. But the company, facing listing pressure after raising billions of dollars from Masayoshi Son’s SoftBank and other venture capitalists, conducted an IPO despite the regime’s warnings.
The ride-hailing giant did not disclose that regulators “had already warned Didi to delay its IPO to conduct a self-examination of its network security,” one of three class-action lawsuits filed by shareholders said. As a result, the registration statement it filed was “materially false and misleading and omitted to state material adverse facts.” As a result, Didi is awaiting “serious, perhaps unprecedented penalties” from Chinese regulators.
Chinese companies have taken full advantage of both worlds. Domestically, they use fake overseas corporations to impersonate foreign entities; abroad, they consider themselves entirely Chinese, exploiting geopolitical tension to evade surveillance in the name of national security. But, after the perjury of dual citizenship, they face a double risk.
The era of investment at all costs for Chinese companies is over
“We realized that China had reached a point—and many of these mega-cap stocks and their leaders—had reached a point where the Chinese government was beginning to feel a challenge, something that they would not tolerate,” said Cathie Wood, CEO of ARK Invest.
Wood is not entirely ruling out China in her funds. But in her view, the era of China’s growth-at-all-costs approach to regulation is ending, as the regime focuses on protecting against leaks of sensitive data. “That point has been exacerbated by this surprise that the Biden administration is holding as tough a line on China as the Trump administration was,” she said. “Chinese companies are going to have to continue to look more inward for their growth.”
Life+ Liberty’s Tolle also pointed out that the data of iShares China Large-Cap ETF (FXI), which tracks China’s 50 largest companies, showed, “In the last 10 years, China has grown tremendously, but foreign investors did not take part in that.” Adding, “These American Wall Street storytellers are going to continue to spin their narratives and tell you to buy these stocks. But look at the numbers. The Chinese stock market has not put up the numbers to justify or to reflect these narratives.”