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From Securities Regulation Daily, September 19, 2014

Senator questions SEC efforts to monitor IPOs of Chinese companies

By Amy Leisinger, J.D.

Senator Robert P. Casey (D-Pa.) has written to SEC Chair Mary Jo White pressing the issue of whether the regulator is taking all appropriate steps to protect U.S. investors participating in initial public offerings (IPOs) of Chinese companies. In the letter, the senator questions regulators’ access to information about these companies and their complex corporate structures and whether the agencies have the resources they need to ensure the protection of American investors.

“I continue to be concerned that about the level of transparency from Chinese firms listing in our markets. The SEC has an obligation to step up its enforcement efforts and press these firms for additional information so that investors are protected,” Sen. Casey explains.

The correspondence came just ahead of today’s opening trades of Chinese e-commerce giant Alibaba Group on the New York Stock Exchange, following one of the largest IPOs in U.S. history. According to New York Times Dealbook, trading began at $92.70, a 36-percent increase over the IPO price of $68 a share.

Senator Casey’s concerns. Senator Casey notes that Alibaba is joining more than 200 other Chinese companies listed on major U.S. stock exchanges structured as variable interest entities (VIEs), organizations arranged in such a way as to help them avoid Chinese restrictions on foreign investments in certain industries, including technology. The “opaque” structure of VIEs has the potential to breed fraud and abuse, Casey notes, especially when coupled with potentially fraudulent accounting practices.

By way of example, Casey discusses the past trend of Chinese companies listing on American exchanges using “reverse merger” structures—that is, by acquiring a small publicly traded American company in order to get a stock listing without an IPO. This process led to abusive tactics, and American investors lost $18 billion in reverse merger companies between 2001 and 2011, he states.

“Like the reverse merger structure, the VIE structure is, by design, an opaque regulatory workaround,” Casey notes, and the risks, similar to those posed by reverse mergers, are “compounded by accounting irregularities [that] remain all too common at Chinese firms.” The Public Company Accounting Oversight Board (PCAOB) faces challenges in getting access to the audit work papers of Chinese companies, he says, and, according to the U.S.-China Economic and Security Review Commission, American investors face large-scale risks in relation to VIE structures.

Casey urges the SEC to look further into the potential risks posed by these entities and to ensure that companies structured as VIEs are complying with all applicable laws and regulations and making effective disclosures. He also requested Chair White to provide detailed information as to whether the Commission is actively engaged in investigative work in China and whether the SEC has enough resources to pursue violations by Chinese companies and to monitoring advisors and intermediaries facilitating VIE listings by Chinese firms.

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