Recent events foreshadow the opportunities and challenges that Chinese companies and their investors will face in both the U.S. and People’s Republic of China as they seek to access the public capital markets. A speech by the head of the U.S. Securities and Exchange Commission (SEC) and a collaborative effort by three major PRC governmental and financial institutions to establish a 10 billion (RMB) investor protection fund send a strong and very positive message to the global investment community. The message is that securities regulatory agencies recognize that many Chinese companies are currently ill-prepared for the regulatory demands of the public capital markets and stand ready to rectify this situation. As securities regulators continue to shape the landscape of the capital markets, one message is clear—the critical element to an efficient marketplace for Chinese companies is the establishment and enhancement of investor confidence.
Directors and executive officers of Chinese companies should anticipate and prepare now for the demands of a new regulatory regime. Effective preparation will allow companies to advantageously position themselves for a long and successful foray into the public capital markets as well as ensure market stability for years to come.
Guidance Given by SEC Chairman Christopher Cox
During his October 18, 2005 speech to the Securities Industry Association at Tsinghua University, SEC Chairman Christopher Cox, announced that he and his counterpart at the Chinese Securities Regulatory Commission (CSRC), Chairman Shang Fulin, reached an accord on the parameters of their upcoming discussions to formalize an agreement on the regulatory schema that will apply to publicly-traded Chinese companies. Telegraphing what promise to be the SEC’s "hot button" issues in the upcoming discussions, Chairman Cox’s speech has presented Chinese companies with a real opportunity to prepare for the changing regulatory environment.
Chairman Cox indicated that the mutual goal of the U.S. and Chinese securities regulatory bodies should be to educate Chinese companies about operating in an evolved capital markets environment. With this mutual goal in mind, Chairman Cox shared his vision for achieving the goal and encouraged Chinese companies to embrace critical components of an evolved public traded securities market—high quality disclosure, fair operation of the capital markets and efficient capital formation. In the Chairman's estimation, all of these components present significant, but surmountable, challenges to Chinese companies in light of how their businesses currently are conducted. A general shift in the current Chinese business paradigm also is a critical element to the participation of Chinese companies in an evolved capital marketplace.
On a more concrete level, Chairman Cox outlined his view on the steps required for Chinese companies to become viable capital markets candidates and competitors. The first step requires Chinese companies to enhance their efforts toward increasing shareholder democracy. Drawing on lessons learned from the recent U.S. corporate scandals and the relatively negligible evaporation of investor confidence, Chairman Cox explained that Chinese companies that wish to list on U.S. exchanges must embrace shareholder driven accountability in order to foster investor confidence. Citing the inevitable tension between market-driven, economic decisions and geopolitically driven decisions, Chairman Cox emphasized that the privatization of Chinese state owned enterprises is a necessary predicate to ensuring that decisions by companies are motivated by economic objectives of the shareholders, not political objectives of the sovereign.
Highlighting another likely SEC pressure point, Chairman Cox expressed concerns with the limitations on access to information in the media. He noted that all market participants and constituencies in our capital market expect and will demand greater access to corporate information. According to Chairman Cox, a concerted, PRC-driven focus must be placed on removing obstructions to free information flow and financial transparency. Viewing the PRC’s restrictions on news and information as a serious impediment to the free exchange of accurate and complete information, Cox called for a significant abatement of such restrictions prior to the entry of Chinese companies to the U.S. exchanges.
Finally, Chairman Cox emphasized the need for tough and independent regulation, presumably of a caliber no less stringent than that imposed and enforced by the SEC. Chairman Cox encouraged directors of Chinese companies to recognize that strong regulation fosters investor confidence and assured Chinese companies that going through the rigorous listing process in the U.S. would help these companies improve their disclosure practices. Noting that the Chinese government controls the vast majority of over 1400 companies and the inherent conflict of interest when the regulated is also the regulator, Cox advocated of a regulatory schema which is arms-length and independent and predicated on privatization.
We can fairly assume that Chairman Cox will advocate the same positions and embrace the same regulatory construct in his upcoming discussions with the CSRC Chairman Fulin.
Organization of the Fund to Protect Securities Investors
In another important development, the CSRC, the China Ministry of Finance and the People’s Bank of China have established a 10 billion (RMB) investor protection fund designed to compensate clients of troubled brokerage firms. The fund, which is called the "Fund to Protect Securities Investors," is analogous to, and should offer a comparable level of, protection as that offered by the Securities Investor Protection Corporation (SIPC). Brokerages and other securities houses in China are required to finance the investor protection fund in varying amounts, depending on the level of risk that they present to the fund.
The fund will not be used to protect investors against normal market risks and fluctuations. Instead, when a brokerage house has been shut down by Chinese regulators due to financial difficulties and customer assets have been lost, the assets of the fund will be used to return customers’ cash, stock and other securities. We again can reasonably conclude that the establishment of this fund is a predicate to the agreement to be negotiated between Chairman Cox and Chairman Fulin.
Lessons for Deal Makers
The entry of Chinese companies into the U.S. capital markets has created an extraordinary economic opportunity for Chinese companies and investors alike. Such opportunities are counter-balanced by comparably large challenges. Chinese companies and their investors must heed the signals emanating from Chairman Cox’s speech and prepare for an evolved capital market with restored investor confidence as the paramount goal.
Given this environment, Chinese companies that intend to access U.S. capital markets should consider taking preparatory action now so that they are poised to move quickly when the opportunity to access the public capital markets presents itself. These recent developments demonstrate that both U.S. and Chinese regulators will take significant measures to improve investor confidence and we can reasonably anticipate that they will continue to do so in the future. While it is impossible to predict all of the measures that will result from the discussions between Chairman Cox and Chairman Fulin, several lessons from these recent events should be learned.
Movement Towards Privatization. One can fairly conclude from Chairman Cox’s remarks that he believes that PRC state ownership and control of Chinese companies is antithetical to an evolved capital marketplace. The PRC may hope to alleviate Chairman Cox’s concerns by adopting a more muffled voice over the business affairs of Chinese companies. This, however, may not adequately address Chairman Cox’s concerns. It is likely that Chinese companies will have to address the issue of privatization and the buy-out of the PRC’s state owned equity (i.e., SOE Privatizations). This process is complicated and time consuming. Any Chinese company expecting access to U.S. capital markets should commence the SOE privatization process well in advance of its anticipated entry into the market. After the buyout of the government’s ownership interest, Chairman Cox’s hope that the PRC will play a less influential role in determining the business direction of these companies is more likely to be realized as economics should replace politics as the driving force behind business decisions.
No Relief From Sarbanes-Oxley. Despite the market potential and magnitude of the business opportunity presented by the opening of the Chinese consumer market and capital market, there is little chance that the regulatory environment will be relaxed simply to capitalize on the opportunity. To the contrary, regulation of the public capital markets is likely to maintain its stringent nature, especially with respect to Chinese listed companies. Chairman Cox made clear that Chinese companies should expect to be Sarbanes-Oxley compliant and directors of those companies should prepare themselves for liability for failing to do so. As publicly-reporting U.S. companies have already learned, Sarbanes-Oxley imposes a high standard of financial reporting and disclosure of information about listed businesses. To the unfamiliar and unsuspecting Chinese company, the SEC’s disclosure and reporting requirements promise to be a rigorous, eye-opening experience. Chinese companies should consult with their advisors about these requirements ahead of time to gain a fuller understanding of the Sarbanes-Oxley regulatory demands.
Enhanced Information Flow. When alluding to the fact that the U.S. capital markets benefit from the free flow of information, Chairman Cox’s comments suggested that the flow of business and economic information, through both the traditional media and Internet resources, significantly enhances the annual and periodic reporting requirements under the Securities and Exchange Act of 1934 and promotes an efficient and evolved capital market. Chairman Cox also intimated that Chinese companies and their investor base would benefit from the abatement of restrictions on the free flow of information. While Chinese companies will certainly be expected to comply with the typical securities disclosure requirements, one can only wonder if Chairman Cox will advocate the loosening of restrictions on the free flow of information in mainstream media for purposes of the SEC/CSRC agreement.
Joint U.S./Chinese Regulation. In his speech, Chairman Cox did not extensively address the issue of joint regulation, although that topic should be thoroughly discussed and addressed in the agreement to be reached by Chairman Cox and Chairman Fulin. Joint regulation and the respective regulatory reach of the SEC and the CSRC will largely depend on progress made by China in readying itself and its companies for participation in a sophisticated capital market environment. With respect to significant Chinese investment in U.S. companies and other cross-boarder listings by Chinese companies where investor protection presents a significant concern, one should not expect the SEC to relinquish any of its regulatory oversight and control as investor protection will remain paramount to the SEC. To the extent that PRC companies make significant progress towards the goals outlined by Chairman Cox, we may see a willingness of the SEC to relax duplicative rules and eliminate contradictory regulations, but only if investor protection is not compromised and a significant burden is placed on a regulated company.
Implication for Chinese Investment in U.S. Listed Companies. Given China’s enormous trade surplus of more than $100 billion a year with the United States and its already significant investment in U.S. debt securities and bonds, it is fair to assume that the natural tendency of the PRC and its companies will be to diversify their investments by acquiring U.S. companies with global brand-name recognition. Any U.S. public company that is considering taking on a significant investment from the PRC or a Chinese investor should take a strong cue from Chairman Cox’s speech. In an era where information on a company’s largest investor is often as important as information on the company itself, U.S. companies cannot be careful enough to know their investors and to take steps that facilitate compliance with regulations.
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