U.S. Capital Markets and China: Issues for Congress

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Updated September 2, 2021
U.S. Capital Markets and China: Issues for Congress
Financial ties between the United States and China have
establish connectivity. Since 2014, the Aviation Industry
expanded significantly over the past few years. The
Corporation of China (AVIC) has tried to deny direct ties to
government of the People’s Republic of China (PRC or
its U.S. affiliates and assert immunity under the Foreign
China) has created limited openings in China’s debt and
Sovereign Immunities Act (P.L. 94-583) to thwart U.S.
equity markets, while China’s firms have sought access to
litigation despite China’s World Trade Organization
U.S. capital, debt, and private equity markets. The Rhodium
commitment that its state firms would operate on a
Group estimates that, as of December 2020, U.S. investors
commercial basis. The opacity of China’s system can make
held $100 billion of Chinese debt and $1.1 trillion in
it hard to secure evidence, prolong litigation, and impose
Chinese equities, while Chinese investors held $1.4 trillion
significant costs on U.S. investors asserting their rights.
in U.S. debt and $720 billion in U.S. equities . This data
may understate flows. The Financial Times estimates that,
Figure 1. Outline of the VIE Structure
based on Bloomberg data, foreign investment in Chinese
equities and bonds was $806 billion as of July 2021.
Some in Congress have raised concerns that U.S. investors
may fund Chinese state and military-tied firms. Congress
passed the Holding Foreign Companies Accountable Act
(P.L. 116-222) to address its concerns about the lack of
compliance by PRC firms with the U.S. Security and
Exchange Commission’s (SEC’s) statutory audit
requirements. Chinese firms appear to use complex
structures that may obscure risks, state ties, and other
corporate details, complicating the effectiveness of U.S.
government oversight and U.S. investors’ legal recourse.

China’s Presence on U.S. Exchanges
Source: CRS, with information from multiple sources.
U.S. exchanges offer China’s firms access to deep capital
Note: Example of a typical variable interest entity (VIE) structure.
markets and paths to earn hard currency, build brand
recognition, and expand overseas. As of May 2021, there
CRS estimates that two-thirds of all Chinese firms listed in
were 248 Chinese firms listed on the three major U.S. stock
the United States—including Alibaba, Baidu, and
exchanges—up from 217 in December 2020—accounting
Tencent—use a variable interest entity (VIE) structure,
for a market capitalization of $2.1 trillion, according to the
often to address China’s investment restrictions. A VIE
U.S.-China Economic and Security Review Commission.
structure involves the owners of a Chinese firm creating an
Initial public offerings (IPOs) in the United States have
offshore holding company to which foreign investors can
been popular for Chinese firms in emerging industries, such
purchase an equity claim. The holding company is tied to
as electric vehicles. PRC firms raised an estimated $12
the “parent” through a series of contracts and revenue
billion to $19 billion on U.S. exchanges in 2020.
sharing agreements that mimic ownership arrangements but
do not provide the same rights typically afforded to
In many instances, the stocks and core assets of parent
investors in U.S.-listed firms. The contracts underpinning
Chinese firms are not listed on U.S. exchanges. Many firms
the VIE allow the Chinese owner(s) to move funds across
use American Depositary Receipts (ADRs), a structure that
the business while creating a firewall between the listed
allows a U.S. financial institution to sponsor a secondary
entity and the core assets and licenses held by the Chinese
U.S. exchange listing of a foreign company. The overseas
owner (see Figure 1). VIE arrangements appear to have no
parent firm’s stocks are listed in the United States through a
definitive legal standing in China, which may leave U.S.
contractual arrangement that bundles the company’s stock
investors without recourse. SEC 20-F disclosures by some
certificates. Most listings of China’s large state-owned
firms acknowledge the risks of VIEs because they are
enterprises (SOEs) are ADRs. These ADRs include a small
incorporated offshore, conduct most operations in China,
number of the shares that SOEs list in China, and the
and have executives who reside outside the United States.
China-listed shares represent only a small portion of the
Some Chinese VIEs have reduced U.S. shareholder value,
overall firm, potentially shielding the parent and its assets
including for large corporate investors, by shifting business
from the exercise of shareholder rights and financial or
licenses and issuing off-the-books bonds. In 2010, for
litigation risk. The U.S. legal entity for Chinese SOEs is
example, Alibaba cut out Yahoo (a 43% stake investor) in
often a shell company with few assets of its own. Even
its spinoff of the online payment firm Alipay to a separate
when a U.S. entity is directed and controlled by an SOE
VIE, controlled by its chairman Jack Ma. In February 2021,
parent, it has proven difficult (but not impossible) to legally
global investors reportedly also had no alternative exit
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U.S. Capital Markets and China: Issues for Congress
strategy or legal rights for an estimated $10 billion invested
2021, the SEC enhanced scrutiny of Chinese firms after
in an offshore shell company after the Chinese government
China’s restrictions on U.S.-listed firms wiped out an
suspended Ant Financial’s $34.5 billion IPO in Shanghai
estimated $400 billion in value and China’s ride-hailing
and Hong Kong. In 2021, the PRC government enhanced
firm DiDi Global Inc. failed to disclose regulatory risks
controls over technology firms, including new restrictions
before listing on the New York Stock Exchange.
on Alibaba, shareholding and a board seat in ByteDance,
and new data security reviews for firms listing offshore.
Military-Tied Firms
In June 2021, the Biden Administration issued Executive
Disclosure and Auditing Requirements
Order (E.O.) 14032, which supersedes the Trump
While most Chinese firms are required to file an SEC 20-F
Administration’s E.O. 13959, prohibiting U.S. persons
annual report for foreign issuers, there are exemptions on
(including financial services firms) from investing in
specific disclosure requirements, particularly for ADRs.
Chinese firms identified as being tied to the military. The
The SEC relies on China’s reporting and disclosure rules,
U.S. financial sector had challenged the scope of E.O.
which are less extensive than U.S. requirements. Disclosure
13959, including corporate nomenclature and whether listed
of shareholders and operations may present a conflict of
firms are tied to their China parent. Some Chinese firms
interest for Chinese firms with government ties. The
challenged the earlier E.O. on due process and evidence
Chinese government prohibits the Public Company
issues. Morgan Stanley said it would launch parallel indices
Accounting Oversight Board (PCAOB)—a nonprofit entity
to retain stocks in question. As of June 2020, the U.S.
created by Congress to oversee audits of U.S.-listed firms—
Department of Defense (DOD) identified 44 PRC military
from inspecting the work of auditors based in China and
firms operating in the United States under reporting
Hong Kong. PCAOB’s inability to confirm the financial
requirements in the FY1999 National Defense
health of U.S.-listed Chinese firms may expose U.S.
Authorization Act (NDAA) (P.L. 105-261). The new
investors in these firms to substantial risk. In June 2020,
executive order and the June 2021 DOD list do not include
NASDAQ delisted Luckin Coffee after it was found to have
previously listed firms, such as China National Chemical
fabricated sales. The Holding Foreign Companies
Corporation, Xiaomi, Inc., and Advanced Micro-
Accountable Act (P.L. 116-222) requires firms to disclose
Fabrication Equipment. DOD’s list is not exhaustive and is
state and military ties and a delisting from U.S. exchanges
viewed by some experts as a first step in identifying
if the PCAOB cannot inspect a firm’s auditors for three
Chinese firms of concern. In the FY2021 NDAA, Congress
consecutive years.
reauthorized and bolstered requirements for DOD to report
on Chinese military firms.
Figure 2. Select U.S. Funds’ China Stock Holdings
(June 2020)
Issues for Congress
To address its concerns, Congress might consider the
potential costs and benefits of whether to do the following:
 Expand U.S. government identification of Chinese firms
with state and military ties and related restrictions.
 Examine China’s role in other areas—such as private
equity and debt financing—to assess the costs and
benefits of U.S. exposure and strategic implications.


Consider due diligence and liability requirements for
Sources: CRS, with data reported in Caixin, Citic Securities, and
U.S. actors that represent Chinese firms; potentially seek
Bloomberg.
for the SEC to further investigate and verify the
accuracy and completeness of the information provided
Mutual Funds and Indices that Include PRC Firms
and to issue regular alerts on China investments.
Five major index fund providers include PRC bonds and A-
 Strengthen disclosure requirements—including for
shares of firms listed on China’s exchanges; three major
investment risk and beneficial ownership—to account
funds include Chinese government debt. U.S. pension funds
for state ties, opacity in China’s system, complex
have China exposure through these indices and direct
corporate structures, and limited legal recourse.
holdings in Chinese firms. U.S. funds seek China exposure
Consider requiring that all firms, including ADRs , to (1)
with an eye to potential higher returns, but some in
file a 10K equivalent with full details about ownership,
Congress and the U.S. government are concerned about
shareholding, and corporate ties; (2) issue quarterly
potential risks (see Figure 2). The Chinese government has
reports and timely updates on major changes; and (3)
approved a few U.S. financial firms to increase joint
provide separate unconsolidated financial statements for
venture equity stakes and operate wholly owned funds.
VIE contracts and controllers.
Among these firms is BlackRock, the largest money

manager globally. It has $9.5 trillion under management as
Require Chinese firms to (1) establish a U.S. legal
of July 2021 but does not publicly disclose its China assets.
presence directly tied to its China parent; (2) hold
In May 2020, the U.S. government’s Thrift Savings Plan
ultimate beneficiaries in China legally accountable for
board deferred implementing a decision to tie its
listed firms; and (2) place a significant deposit with U.S.
international fund to an index that includes Chinese firms in
regulators in the event of litigation.
response to pressure from Congress and the Trump
Michael D. Sutherland, Analyst in International Trade and
Administration. In July 2020, the SEC issued an alert about
U.S. exposure to China’s financial markets
Finance
. In August
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U.S. Capital Markets and China: Issues for Congress

IF11803
Karen M. Sutter, Specialist in Asian Trade and Finance


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