U.S. Regulation of Chinese Stocks: Legal Background and Regulatory Options

Legal Sidebar
U.S. Regulation of Chinese Stocks:
Legal Background and Regulatory Options

September 21, 2020
Tensions between the United States and China have again moved to center stage. In recent weeks, the
Trump Administration has ordered China to close its Houston consulate over al egations of economic
espionage, imposed sanctions on Hong Kong officials accused of undermining the region’s autonomy,
and issued executive orders that may effectively ban the use of two Chinese apps—TikTok and WeChat—
in the United States. While commentators once noted the interdependence that characterized the U.S.-
China relationship, these developments and similar disputes now generate debate over whether the two
powers are on the verge of an economic “decoupling.
The regulation of U.S. investment in Chinese securities is another fissure in the bilateral relationship that
has attracted special attention from Congress, the Trump Administration, and the Securities and Exchange
Commission (SEC). In April, SEC officials released a statement warning investors of the risks of
emerging-market stocks after two U.S.-listed Chinese firms announced that their employees had
fraudulently inflated past sales figures. A month later, the Senate unanimously approved legislation that
would prohibit trading in the securities of companies whose auditors deny U.S. regulators access to their
work papers—a category that most prominently includes Chinese firms. And in July, the President’s
Working Group on Financial Markets (PWG) issued a report endorsing several proposals to strengthen
protections for American investors in Chinese securities.
Stricter regulation of Chinese stocks could have important implications for U.S. investors. Chinese
companies listed on U.S. exchanges boasted a combined market capitalization of $1.2 tril ion at the end of
2019. American investors have also taken on more exposure to firms listed on Chinese exchanges—
perhaps unwittingly—as major index providers have increased the weight of such companies in their
emerging-market indexes over the past year.
This Legal Sidebar discusses the current regulatory framework governing U.S. investment in Chinese
stocks, al eged inadequacies in that framework, and several proposals to strengthen the relevant laws and
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Legal Background
To protect investors and facilitate capital formation, federal law imposes a range of requirements on
companies that issue securities, accounting firms that audit their financial statements, funds that invest in
securities, firms that advise others about securities, and securities markets. This section of the Sidebar
reviews each set of regulations in turn.
Federal law requires certain companies that issue securities to abide by several disclosure requirements.
The Securities Exchange Act of 1934 (the Exchange Act) and associated regulations require reporting
companies—in brief, companies that are listed on a national securities exchange, exceed certain size
thresholds, or that offer securities to the public—to periodical y disclose audited financial statements to
investors. SEC regulations also require reporting companies to disclose qualitative risks associated with
their securities. Item 105 of SEC Regulation S-K requires reporting companies to annual y disclose their
most significant “risk factors.” And Item 303 of Regulation S-K requires a reporting company’s
management to describe any “known trends or uncertainties” that it reasonably expects to material y
impact the company’s revenues.
The Sarbanes-Oxley Act of 2002 (SOX) supplemented these requirements with an additional layer of
regulations on accounting firms that audit reporting companies’ financial statements. SOX created the
Public Company Accounting Oversight Board (PCAOB) to regulate these firms, subject to the SEC’s
oversight. The Act empowered the PCAOB to establish standards for regulated auditors, inspect regulated
auditors for compliance with those standards, and impose sanctions on firms that violate its rules. Foreign
auditors are general y subject to the same SOX requirements as domestic firms. Like U.S. auditors,
foreign accountants that audit reporting companies must register with the PCAOB and provide the Board
with audit work papers upon request.
The regulatory perimeter also encompasses certain funds that invest in securities and firms that advise
others about securities. The Investment Company Act of 1940 and associated regulations require certain
investment companies like mutual funds and exchange-traded funds to disclose their principal investment
strategies and risks to investors. The Supreme Court has also interpreted the Investment Advisers Act of
as imposing fiduciary duties on persons who advise others about securities. The SEC has explained
that these obligations include a duty of care that requires investment advisers to offer advice that is
suitable based on their clients’ objectives.
The SEC also has ultimate regulatory authority over national securities exchanges and broker-dealers that
operate in over-the-counter (OTC) securities markets. The Commission exercises this authority by
supervising “self-regulatory organizations” (SROs) that have front-line responsibility to develop certain
rules and enforce them against their members. National securities exchanges like the New York Stock
Exchange and NASDAQ are themselves SROs, while the Financial Industry Regulatory Authority
regulates broker-dealers that operate in OTC markets. The Exchange Act gives the SEC final authority
over SRO rules. Under Section 19 of the Act, SROs must submit proposed rules and proposed rule
changes to the SEC for approval. The Commission can also directly add to or amend an SRO’s rules
through notice-and-comment rulemaking.
The Risks of Investing in Chinese Stocks
The case for investing in Chinese stocks as part of a diversified portfolio is fairly straightforward. China
has sustained high levels of economic growth over the past forty years and is now the world’s largest
economy based on purchasing power parity. Unsurprisingly, China is also home to some of the world’s
largest and fastest-growing companies. And Chinese equities may offer diversification benefits when
added to a basket of developed-market securities.

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But Chinese stocks also carry significant risks. While foreign companies that issue securities in the United
States are general y subject to the same or comparable regulations as their American counterparts, the
practical efficacy of these regulations can be substantial y different when it comes to firms in developing
markets. U.S. regulators have explained that they are often significantly constrained in their ability to
oversee and obtain legal recourse against such companies, raising concerns about fraud and other forms of
Chinese companies traded in U.S. markets are particularly prominent examples of this general problem.
China has long refused to al ow its accounting firms to share their audit papers with overseas regulators
like the PCAOB, even though SOX requires foreign auditors to provide such papers upon request. As a
result, the PCAOB has been unable to fulfil its statutory mandate to monitor firms that audit Chinese
companies traded in U.S. markets. While the PCAOB has maintained dialogue with Chinese regulators to
obtain access to audit work papers, the Board has said that the relevant Chinese access proposals have
been insufficient for it to fulfil its statutory responsibilities.
The risks associated with Chinese stocks are not limited to these gaps in regulatory oversight. Many U.S.-
listed Chinese firms employ an ownership structure that some commentators have described as both
legal y dubious and unsafe for investors. Under this structure—the “variable interest entity” (VIE)—U.S.
investors do not purchase direct ownership interests in Chinese firms. Instead, they receive interests in
U.S.-listed shel companies, which then enter into contractual arrangements entitling them to the profits of
operating Chinese companies.
Some analysts have argued that the status of VIEs under Chinese law remains uncertain. These
commentators contend that the purpose of the VIE structure—to circumvent Chinese legal restrictions on
foreign investment in certain industries—exposes U.S. investors to the risk that Chinese authorities wil
ultimately condemn such arrangements. Besides these legal uncertainties, some commentators have
argued that VIEs present U.S. investors with other risks related to owner expropriation, taxation, and
corporate governance.
There is also active debate over the ethics of investing in certain Chinese companies. Several
commentators have argued that some Chinese firms included in major stock indexes are complicit in
human-rights violations, including abuses related to China’s treatment of its Muslim Uighur population.
Others have raised concerns that U.S. investors are harming national security by subsidizing firms that
work closely with the Chinese military.
Reform Proposals
Policymakers have developed several proposals to address the issues discussed above. Most significantly,
the Senate has passed legislation that would, after a three-year transition period, impose trading
prohibitions on companies whose auditors deny the PCAOB access to their work papers. Other
commentators have proposed more limited measures involving disclosure requirements, the fiduciary
duties of investment advisers, and the regulation of index providers. This section of the Sidebar reviews
each category of proposal in turn.
Trading Prohibitions
The Senate has unanimously approved legislation—S. 945, the Holding Foreign Companies Accountable
that would direct the SEC to prohibit trading in the securities of companies whose auditors deny the
PCAOB access to their work papers for three consecutive years. The bil ’s prohibition would apply to

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trading on national securities exchanges and OTC markets within the SEC’s jurisdiction. A companion
House bil (H.R. 7000) is also pending before the Financial Services Committee.
For its part, the Trump Administration appears to be broadly supportive of such measures. In a recent
report, the PWG endorsed a similar proposal that would al ow Chinese companies to comply with the
relevant requirements by submitting to a co-audit from a firm that provides the PCAOB with sufficient
access to its work papers.
Considerations for Congress
The debate over trading prohibitions for Chinese securities hinges largely on disagreement over the likely
Chinese response to such actions. Supporters of trading prohibitions contend that the attractiveness of
U.S. capital markets wil cause Chinese authorities to accede to U.S. demands for greater transparency
rather than lose valuable market access. But other commentators are skeptical that China wil capitulate in
the face of trading bans, meaning Chinese companies wil ultimately be kicked out of U.S. markets if S.
945 becomes law.
Skeptics of trading bans contend that eliminating Chinese firms from U.S. markets may harm U.S.
investors. For example, Harvard Law Professor Jesse Fried has argued that Chinese companies would
respond to trading bans with confiscatory “take-private” transactions in which they de-list their U.S.
shares at low buyout prices and then re-list on foreign exchanges at much higher valuations. To mitigate
this risk, Fried argues that any prohibitions should apply only prospectively to Chinese firms that are not
currently traded in U.S. markets.
Other commentators have identified broader problems with trading bans. According to several observers,
barring Chinese firms from U.S. markets would not seriously impede their ability to raise capital. These
analysts contend that Chinese companies that are banned from U.S. markets could stil raise money by
listing on foreign exchanges.
Moreover, U.S. investors could stil purchase Chinese securities on those
foreign exchanges, which are often subject to less rigorous oversight. In that case, Chinese firms would
retain access to U.S. capital, while American investors would potential y enjoy fewer protections than
they have in U.S. markets.
Enhanced Disclosure Requirements
Policymakers have also proposed more limited steps to reform the regulation of Chinese stocks. The
PWG has endorsed enhanced disclosure requirements for Chinese companies that issue securities and
funds that invest in Chinese securities. These measures would build upon the existing disclosure regime.
As discussed, Items 105 and 303 of SEC Regulation S-K already require reporting companies to disclose
certain qualitative risks associated with their securities. The Investment Company Act and related
regulations likewise require certain mutual funds and exchange-traded funds to disclose their risks to
These regulations reflect what the SEC has cal ed a “principles-based” approach to disclosure. Under this
approach, a company’s management must exercise judgment in evaluating whether a given piece of
information is sufficiently significant to meet the general standard articulated in the regulations. The SEC
has distinguished such “principles-based” regulations from “prescriptive” disclosure requirements that
employ bright-line tests triggering reporting obligations.
Enhanced disclosure rules for Chinese firms or funds that invest in Chinese firms could include
prescriptive requirements involving specific risk factors. For example, such rules could require Chinese
companies and funds that invest in them to disclose the PCAOB’s inability to supervise Chinese auditors

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and the precise risks associated with VIE structures. New disclosure requirements could also extend to
some of the ethical concerns discussed above, like the use of forced labor or involvement with the
Chinese military.
Short of adopting new prescriptive requirements, Congress could direct the SEC to issue guidance
clarifying the application of existing principles-based disclosure obligations to Chinese securities. The
Commission has issued similar guidance on its own initiative for emerging issues ranging from climate
change to COVID-19.
Considerations for Congress
Advocates of enhanced disclosure measures cite the need to provide investors with clear notice of the
financial risks associated with Chinese stocks. This is a familiar justification for securities disclosure
requirements, which aim to facilitate accurate stock prices and the efficient al ocation of capital. But new
qualitative disclosures regarding the financial risks of Chinese firms may only marginal y improve the
pricing of their stocks. Many sophisticated investors are likely already aware of the financial risks
associated with Chinese securities. And several studies have concluded that retail investors often do not
read securities disclosure documents. The efficacy of new qualitative disclosures focused on financial risk
may therefore be fairly limited.
However, reporting requirements are also viewed as a tool for shaping corporate conduct. Requirements
that companies disclose certain distasteful business practices—like the use of forced labor—may
incentivize companies to avoid those practices. These types of disclosure requirements may therefore
have more bite than new qualitative requirements focused on financial risk.
Fiduciary Duties of Investment Advisers
The PWG has also recommended that the SEC consider issuing guidance on investment advisers’
fiduciary obligations when recommending Chinese stocks to clients. As discussed, investment advisers
have a duty of care that requires them to offer advice that is in their clients’ best interest based on their
clients’ objectives. SEC guidance could clarify that investment advisers have a duty to fully disclose the
risks associated with Chinese securities when recommending them to clients. Congress could also
strengthen the existing regulatory framework—which is largely principles-based—with more prescriptive
requirements compel ing investment advisers to provide their clients with specific information about the
dangers and ethical concerns associated with Chinese stocks.
Considerations for Congress
The case for enhanced regulation of investment advisers largely draws on some of the considerations
discussed above. More robust disclosures can protect investors and facilitate more accurate pricing of
securities. Requiring investment advisers to fully inform their clients of the risks associated with Chinese
stocks could therefore further these core goals of securities regulation. But altering investment-adviser
regulation would remain a limited step toward addressing the regulatory gaps involving Chinese stocks.
As the PWG has noted, such tweaks may not ultimately limit investor choice or the ability of Chinese
firms to access U.S. capital.

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Index-Provider Regulation
The shift from active management to passive investing is among the most pronounced trends in equity
markets over the past twenty years. Rather than invest in funds run by stock pickers, many savers now
invest in vehicles that aim to replicate the performance of a broad index of securities like the S&P 500 or
the MSCI Al -Country World Index. This shift has dramatical y increased the power of companies like
MSCI, FTSE Russel , and S&P Dow Jones Indices that develop and license the most popular indexes.
However, unlike certain foreign regulators, the SEC lacks jurisdiction over these index providers, who are
free to develop their own criteria for index construction. In exercising this freedom, index providers have
included Chinese firms in several popular benchmarks. For example, Chinese companies represent over
40 percent of MSCI’s Emerging Markets Index and over 12 percent of its Al -Country World ex USA
Index as of the publication of this Sidebar.
Bringing index providers under the umbrel a of federal securities regulation may be a way to address
some of the issues with Chinese firms discussed above. This type of regulation could be either direct or
indirect. The PWG has endorsed an indirect approach, recommending that the SEC consider requiring
registered investment companies to “perform greater due diligence on an index and its index provider”
before selecting it to implement an investment strategy. Congress could also consider more direct
regulation of index providers.
For example, Congress could prohibit registered investment companies
from tracking indexes that have not been approved by the SEC. Alternatively, Congress could impose an
SRO regulatory structure on index providers and require them to obtain SEC approval for their index-
construction methodologies.
Considerations for Congress
Regulating index providers would tackle one of the main concerns that animates the policy discourse
surrounding Chinese stocks. Many commentators have focused their criticism of the existing regulatory
framework on the fact that U.S. investors may be unwittingly purchasing Chinese securities because of the
decisions of major index providers. Subjecting these firms’ methodologies to closer scrutiny may be a
straightforward way to address such worries.
Direct index-provider regulation may also offer the SEC a more nuanced means of confronting the risks
and ethical dilemmas associated with Chinese stocks. This type of approach could al ow the SEC to target
the business practices of specific companies rather than eliminating large swathes of Chinese firms from
U.S. markets. For example, if the Commission—potential y with the assistance of other federal
agencies—were to determine that some Chinese firms have links to the Chinese military, it could prohibit
registered investment companies from tracking indexes that include those firms. This type of regime may
offer regulators a more discriminating method of addressing problematic practices than categorical
trading bans.
However, direct index-provider regulation would also be uncharted territory. The framework outlined
above may prove overly complicated for the SEC to administer with its existing resources. And inserting
the Commission into the details of index construction may come uncomfortably close to the type of
“merit regulation” that the federal securities laws have traditional y avoided.

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Author Information

Jay B. Sykes

Legislative Attorney

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