China – Variable Interest Entities – What Should Chinese Companies Be Disclosing?

China-based companies continue to be in the spotlight this month, with the staff of the U.S. Securities and Exchange Commission (the “SEC”) issuing a “sample letter” that includes detailed comments the SEC staff may issue to companies regarding their disclosure of the risks of the variable interest entity (“VIE”) structure typically used by China-based companies listing on foreign exchanges.

The Division of Corporation Finance’s (the “Division”) current concern stems from recent Chinese government actions that place restrictions on China-based companies raising capital outside of China. The sample letter is the third set of guidance relating to the use of VIE structures that the SEC has issued in the last year or so. In November 2020, the Division issued CF Disclosure Guidance: Topic No. 10, Disclosure Considerations for China-Based Issuers, and in July 2021, SEC Chair Gary Gensler issued a Statement on Investor Protection Related to Recent Developments in China.

The Division also notes that recent developments with respect to the relationship between China and Hong Kong may raise similar risk considerations for companies based in, or with the majority of their operations in, Hong Kong, and the Division may issue similar comments to those companies.

The sample letter directs China-based companies to clearly and prominently disclose the structure of the company, including the relationship between the entity conducting the offering and the entities conducting the operating activities, risks associated with a company’s use of the VIE structure, and the potential impact on the company’s operations and investors’ interests if the structure were disallowed or the contracts were determined to be unenforceable. The Division’s comments also focus on additional legal, regulatory, and enforcement risks that may apply to investments in China-based companies, such as the potential impact of the Holding Foreign Companies Accountable Act (the “HFCA Act”) and any necessary Chinese government permissions a China-based company may need to operate its business or offer securities to foreign investors.

The comments are focused on disclosure in three main areas:

• Prospectus Cover Page – A China-based company should disclose in the prospectus cover page:
  • that it is not a Chinese operating company but a Cayman Islands holding company with operations conducted through a VIE structure and the risks of the structure, including that investors may never hold equity interests in the Chinese operating company;
  • an acknowledgement that Chinese regulatory authorities could disallow the VIE structure;
  • the legal and operational risks associated with being based in or having the majority of the company’s operations in China, including recent Chinese government actions related to the use of VIEs and data security or anti-monopoly concerns;
  • whether its auditor is subject to the determinations announced by the PCAOB on December 16, 2021 and whether and how the HFCA Act will affect the company (see our briefing for further details);
  • how it will refer to the holding company, subsidiaries, and VIEs when providing the disclosure throughout the document so that it is clear which entity the disclosure is referencing and which subsidiaries or entities are conducting the business operations (i.e., refrain from using terms such as “we” or “our” when describing a VIE’s activities or functions); and
  • how cash is transferred through its organization and the company’s intentions to distribute earnings or settle amounts owed under the VIE agreements.
• Prospectus Summary – In this section, a China-based company should:
  • disclose the company’s use of a structure that involves a VIE based in China and what that entails, and early in the summary, a diagram of the company’s corporate structure, identifying the person or entity that owns the equity in each depicted entity;
  • describe all contracts and arrangements through which the company claims to have economic rights and exercise control that results in consolidation of the VIE’s operations and financial results into its financial statements;
  • clearly identify the entity in which investors are purchasing their interest and the entity(ies) in which the company’s operations are conducted and describe the relevant contractual agreements between the entities and how this type of corporate structure may affect investors;
  • disclose the uncertainties regarding the status of the rights of the Cayman Islands holding company with respect to its contractual arrangements with the VIE, its founders and owners, and the challenges the company may face enforcing these contractual agreements due to legal uncertainties and jurisdictional limits;
  • refrain from implying that the contractual agreements between the VIE and the wholly foreign-owned enterprise are equivalent to equity ownership in the business of the VIE;
  • disclose the risks (in the risk factor summary) that the company’s corporate structure and being based in or having the majority of the company’s operations in China poses to investors;
  • acknowledge the risks that any actions by the Chinese government to exert more oversight and control over offerings that are conducted overseas and/or foreign investment in China-based issuers could significantly limit or completely hinder the company’s ability to offer or continue to offer securities to investors;
  • disclose each permission or approval that the company, its subsidiaries, or the VIEs are required to obtain from Chinese authorities to operate its business and to offer the securities being registered to foreign investors;
  • clearly describe how cash is transferred through the organization;
  • provide in tabular form a condensed consolidating schedule that disaggregates the operations and depicts the financial position, cash flows, and results of operations as of the same dates and for the same periods for which audited consolidated financial statements are required; and
  • disclose that trading in its securities may be prohibited under the HFCA Act if the PCAOB determines that it cannot inspect the company’s auditor, and that as a result the company’s securities may be delisted (see our briefing for further details).
• Risk Factors – The company should include risk factors:
  • acknowledging that if the Chinese government determines that the contractual arrangements constituting part of the VIE structure do not comply with Chinese regulations, or if these regulations change or are interpreted differently in the future, the company’s securities may decline in value or become worthless;
  • about the consequences of the HFCA Act, including that if Congress enacts the Accelerating Holding Foreign Companies Accountable Act, the number of “non-inspection years” before a delisting would decrease from three years to two years;
  • separately highlighting the risk that the Chinese government may intervene or influence the company’s operations at any time, and acknowledging the risk that Chinese government action could significantly limit or completely hinder the company’s ability to offer or continue to offer securities and cause the value of its securities to significantly decline or be worthless; and
  • explaining how greater oversight by the Cyberspace Administration of China (CAC) over data security, particularly for companies seeking to list on a foreign exchange, impacts the company’s business and its offering and to what extent it believes that it is compliant with the regulations or policies that have been issued by the CAC to date.

The sample letter notes that the disclosure consideration discussed above also applies to:

• a SPAC with sponsors based in China, executive offices in China, or a majority of its executive officers and/or directors are located in or have significant ties with China, or contemplating merging with a company incorporated in China; and
• registrants with ongoing periodic reporting obligations or that are engaged in capital raising transactions via takedowns from an effective shelf registration statement.

Additionally, a SPAC should also disclose:

• the risks associated with the SPAC’s operations, as well as the challenges that investors in the SPAC might face in enforcing their rights under the SPAC’s controlling agreements;
• any impact Chinese laws or regulations may have on the SPAC’s ability to complete a merger transaction with an operating company in China, or the cash flows associated with the business combination, including shareholder redemption rights; and
• the risks related to an investment in a China-based company after any subsequent business combination with an operating company, including any Chinse government regulation of that entity’s business or industry.

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