Sample Letter to China-Based Companies[1]
Recent events have highlighted the risks associated with investing in companies that
are based in or that have the majority of their operations in the People’s Republic
of China (China-based companies). The Division of Corporation Finance believes that
more prominent, specific, and tailored disclosure about these risks, and companies’
use of the variable interest entity (VIE) structure specifically,[2] is warranted to provide investors with the information they need to make
informed investment decisions and for companies to comply with their disclosure
obligations under the federal securities laws. The Division previously provided its
views regarding certain disclosure considerations for China-based companies,[3] and, in July 2021, Chair Gensler issued a Statement on Investor Protection
Related to Recent Developments in China.[4] Among other things, the Chair’s statement noted that the People’s Republic of
China (PRC or China) has provided new guidance to, and placed restrictions on,
China-based companies raising capital outside of China.
In light of these concerns, the Division is issuing comments to China-based companies
seeking more specific and prominent disclosure about the legal and operational risks
associated with China-based companies. The Division’s comments focus on the need for
clear and prominent disclosure regarding 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 such 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 and related
rules and any necessary PRC permissions a China-based company may need to operate
its business or offer securities to foreign investors.[5]
The following illustrative letter contains sample comments that, depending on the
particular facts and circumstances, the Division may issue to China-based
companies.[6] These sample comments do not constitute an exhaustive list of the issues that
companies should consider.[7] The Division urges companies to consider these sample comments and additional
regulatory developments in this area as they prepare their disclosure documents. The
Division also encourages companies to consider the following depending on their
unique circumstances:
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If you are a Special Purpose Acquisition Company (SPAC) with sponsors based in China, executive offices in China, or a majority of your executive officers and/or directors are located in or have significant ties with China, or are contemplating merging with a company incorporated in China, the Division’s view is that specific disclosure about these circumstances is warranted to meet the company’s disclosure obligations. Specifically, your disclosure should address 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. Similarly, your disclosure should address any impact PRC law or regulation 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. Finally, the disclosure should cover the risks related to an investment in a China-based company after any subsequent business combination with an operating company, including any PRC government regulation of that entity’s business or industry.
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For China-based registrants with ongoing periodic reporting obligations or that are engaged in capital raising transactions via takedowns from an effective shelf registration statement, the Division expects your prospectus supplements or incorporated periodic or current reports, and future periodic reports, to disclose the information and risks discussed below.
The Division encourages companies to contact the industry office responsible for the
company’s filings with any questions regarding the company’s proposed
disclosure.
December 2021
Name
ABC Corporation
Address
Dear Issuer:
We have reviewed your filing and have the following comments.
Please revise or update your disclosure in response to our
comments.
Prospectus Cover Page
1. Please disclose prominently on the prospectus
cover page that you are not a Chinese operating
company but a Cayman Islands holding company with
operations conducted by your subsidiaries and
through contractual arrangements with a variable
interest entity (VIE) based in China and that this
structure involves unique risks to investors. If
true, disclose that these contracts have not been
tested in court. Explain whether the VIE structure
is used to provide investors with exposure to
foreign investment in China-based companies where
Chinese law prohibits direct foreign investment in
the operating companies, and disclose that investors
may never hold equity interests in the Chinese
operating company. Your disclosure should
acknowledge that Chinese regulatory authorities
could disallow this structure, which would likely
result in a material change in your operations
and/or a material change in the value of the
securities you are registering for sale, including
that it could cause the value of such securities to
significantly decline or become worthless. Provide a
cross-reference to your detailed discussion of risks
facing the company and the offering as a result of
this structure.
2. Provide prominent disclosure about the legal and
operational risks associated with being based in or
having the majority of the company’s operations in
China. Your disclosure should make clear whether
these risks could result in a material change in
your operations and/or the value of the securities
you are registering for sale or could significantly
limit or completely hinder your ability to offer or
continue to offer securities to investors and cause
the value of such securities to significantly
decline or be worthless. Your disclosure should
address how recent statements and regulatory actions
by China’s government, such as those related to the
use of variable interest entities and data security
or anti-monopoly concerns, have or may impact the
company’s ability to conduct its business, accept
foreign investments, or list on a U.S. or other
foreign exchange. Please disclose whether your
auditor is subject to the determinations announced
by the PCAOB on December 16, 2021 and whether and
how the Holding Foreign Companies Accountable Act
and related regulations will affect your company.
Your prospectus summary should address, but not
necessarily be limited to, the risks highlighted on
the prospectus cover page.
3. Clearly disclose how you will refer to the
holding company, subsidiaries, and VIEs when
providing the disclosure throughout the document so
that it is clear to investors which entity the
disclosure is referencing and which subsidiaries or
entities are conducting the business operations.
Refrain from using terms such as “we” or “our” when
describing activities or functions of a VIE. For
example, disclose, if true, that your subsidiaries
and/or the VIE conduct operations in China, that the
VIE is consolidated for accounting purposes but is
not an entity in which you own equity, and that the
holding company does not conduct operations.
Disclose clearly the entity (including the domicile)
in which investors are purchasing an interest.
4. Provide a description of how cash is transferred
through your organization and disclose your
intentions to distribute earnings or settle amounts
owed under the VIE agreements. State whether any
transfers, dividends, or distributions have been
made to date between the holding company, its
subsidiaries, and consolidated VIEs, or to
investors, and quantify the amounts where
applicable. Provide cross-references to the
condensed consolidating schedule and the
consolidated financial statements.
Prospectus Summary
5. Disclose clearly that the company uses a
structure that involves a VIE based in China and
what that entails, and provide 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 you claim
to have economic rights and exercise control that
results in consolidation of the VIE’s operations and
financial results into your financial statements.
Identify clearly the entity in which investors are
purchasing their interest and the entity(ies) in
which the company’s operations are conducted.
Describe the relevant contractual agreements between
the entities and how this type of corporate
structure may affect investors and the value of
their investment, including how and why the
contractual arrangements may be less effective than
direct ownership and that the company may incur
substantial costs to enforce the terms of the
arrangements. 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.
6. We note your disclosure that the Cayman Islands
holding company controls and receives the economic
benefits of the VIE’s business operations through
contractual agreements between the VIE and your
Wholly Foreign-Owned Enterprise (WFOE) and that
those agreements are designed to provide your WFOE
with the power, rights, and obligations equivalent
in all material respects to those it would possess
as the principal equity holder of the VIE. We also
note your disclosure that the Cayman Islands holding
company is the primary beneficiary of the VIE.
However, neither the investors in the holding
company nor the holding company itself have an
equity ownership in, direct foreign investment in,
or control of, through such ownership or investment,
the VIE. Accordingly, please refrain from implying
that the contractual agreements are equivalent to
equity ownership in the business of the VIE. Any
references to control or benefits that accrue to you
because of the VIE should be limited to a clear
description of the conditions you have satisfied for
consolidation of the VIE under U.S. GAAP.
Additionally, your disclosure should clarify that
you are the primary beneficiary of the VIE for
accounting purposes. Please also disclose, if true,
that the VIE agreements have not been tested in a
court of law.
7. In your summary of risk factors, disclose the
risks that your corporate structure and being based
in or having the majority of the company’s
operations in China poses to investors. In
particular, describe the significant regulatory,
liquidity, and enforcement risks with
cross-references to the more detailed discussion of
these risks in the prospectus. For example,
specifically discuss risks arising from the legal
system in China, including risks and uncertainties
regarding the enforcement of laws and that rules and
regulations in China can change quickly with little
advance notice; and the risk that the Chinese
government may intervene or influence your
operations at any time, or may exert more control
over offerings conducted overseas and/or foreign
investment in China-based issuers, which could
result in a material change in your operations
and/or the value of the securities you are
registering for sale. Acknowledge any 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 your ability to offer or continue
to offer securities to investors and cause the value
of such securities to significantly decline or be
worthless.
8. Disclose each permission or approval that you,
your subsidiaries, or the VIEs are required to
obtain from Chinese authorities to operate your
business and to offer the securities being
registered to foreign investors. State whether you,
your subsidiaries, or VIEs are covered by
permissions requirements from the China Securities
Regulatory Commission (CSRC), Cyberspace
Administration of China (CAC) or any other
governmental agency that is required to approve the
VIE’s operations, and state affirmatively whether
you have received all requisite permissions or
approvals and whether any permissions or approvals
have been denied. Please also describe the
consequences to you and your investors if you, your
subsidiaries, or the VIEs: (i) do not receive or
maintain such permissions or approvals, (ii)
inadvertently conclude that such permissions or
approvals are not required, or (iii) applicable
laws, regulations, or interpretations change and you
are required to obtain such permissions or approvals
in the future.
9. Provide a clear description of how cash is
transferred through your organization. Disclose your
intentions to distribute earnings or settle amounts
owed under the VIE agreements. Quantify any cash
flows and transfers of other assets by type that
have occurred between the holding company, its
subsidiaries, and the consolidated VIEs, and
direction of transfer. Quantify any dividends or
distributions that a subsidiary or consolidated VIE
have made to the holding company and which entity
made such transfer, and their tax consequences.
Similarly quantify dividends or distributions made
to U.S. investors, the source, and their tax
consequences. Your disclosure should make clear if
no transfers, dividends, or distributions have been
made to date. Describe any restrictions on foreign
exchange and your ability to transfer cash between
entities, across borders, and to U.S. investors.
Describe any restrictions and limitations on your
ability to distribute earnings from the company,
including your subsidiaries and/or the consolidated
VIEs, to the parent company and U.S. investors as
well as the ability to settle amounts owed under the
VIE agreements.
10. We note that the consolidated VIEs constitute a
material part of your consolidated financial
statements. Please 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. The
schedule should present major line items, such as
revenue and cost of goods/services, and subtotals
and disaggregated intercompany amounts, such as
separate line items for intercompany receivables and
investment in subsidiary. The schedule should also
disaggregate the parent company, the VIEs and its
consolidated subsidiaries, the WFOEs that are the
primary beneficiary of the VIEs, and an aggregation
of other entities that are consolidated. The
objective of this disclosure is to allow an investor
to evaluate the nature of assets held by, and the
operations of, entities apart from the VIE, as well
as the nature and amounts associated with
intercompany transactions. Any intercompany amounts
should be presented on a gross basis and when
necessary, additional disclosure about such amounts
should be included in order to make the information
presented not misleading.
11. Disclose that trading in your securities may be
prohibited under the Holding Foreign Companies
Accountable Act if the PCAOB determines that it
cannot inspect or investigate completely your
auditor, and that as a result an exchange may
determine to delist your securities. Disclose
whether your auditor is subject to the
determinations announced by the PCAOB on December
16, 2021.
Risk Factors
12. Revise your risk factors to acknowledge that if
the PRC government determines that the contractual
arrangements constituting part of the VIE structure
do not comply with PRC regulations, or if these
regulations change or are interpreted differently in
the future, the securities you are registering may
decline in value or become worthless if the
determinations, changes, or interpretations result
in your inability to assert contractual control over
the assets of your PRC subsidiaries or the VIEs that
conduct all or substantially all of your
operations.
13. We note your disclosure about the Holding
Foreign Companies Accountable Act. Please expand
your risk factors to disclose that the United States
Senate has passed the Accelerating Holding Foreign
Companies Accountable Act, which, if enacted, would
decrease the number of “non-inspection years” from
three years to two years, and thus, would reduce the
time before your securities may be prohibited from
trading or delisted. Update your disclosure to
reflect that the Commission adopted rules to
implement the HFCAA and that, pursuant to the HFCAA,
the PCAOB has issued its report notifying the
Commission of its determination that it is unable to
inspect or investigate completely accounting firms
headquartered in mainland China or Hong Kong.
14. Given the Chinese government’s significant
oversight and discretion over the conduct of your
business, please revise to highlight separately the
risk that the Chinese government may intervene or
influence your operations at any time, which could
result in a material change in your operations
and/or the value of the securities you are
registering. Also, given recent statements by the
Chinese government indicating an intent to exert
more oversight and control over offerings that are
conducted overseas and/or foreign investment in
China-based issuers, acknowledge the risk that any
such action could significantly limit or completely
hinder your ability to offer or continue to offer
securities to investors and cause the value of such
securities to significantly decline or be
worthless.
15. In light of recent events indicating greater
oversight by the Cyberspace Administration of China
(CAC) over data security, particularly for companies
seeking to list on a foreign exchange, please revise
your disclosure to explain how this oversight
impacts your business and your offering and to what
extent you believe that you are compliant with the
regulations or policies that have been issued by the
CAC to date.
We remind you that the company and its management are
responsible for the accuracy and adequacy of their
disclosures, notwithstanding any review, comments, action or
absence of action by the staff.
Sincerely,
Division of Corporation Finance
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Footnotes
[1]
The statements in this guidance represent the views of the staff of the Division
of Corporation Finance. This guidance is not a rule, regulation, or statement of
the Securities and Exchange Commission (“Commission”). The Commission has
neither approved nor disapproved its content. This guidance, like all staff
guidance, has no legal force or effect: it does not alter or amend applicable
law, and it creates no new or additional obligations for any person.
[2]
In this context, the VIE structure often uses a series of contractual
arrangements between a holding company domiciled outside of China and a
Chinese operating company or companies, which may avoid PRC limitations or
prohibitions on direct foreign ownership in certain industries. The
contractual arrangements are intended to mimic direct ownership in the
operating company, but in many cases have not been tested in court.
[3]
Division of Corporation Finance, CF Disclosure Guidance: Topic No. 10
Disclosure Considerations for China-Based Issuers (Nov. 23, 2020), available
at https://www.sec.gov/corpfin/disclosure-considerations-china-based-issuers.
[4]
Chair Gary Gensler, Statements on Investor Protection Related to Recent
Developments in China (July 30, 2021), available at https://www.sec.gov/news/public-statement/gensler-2021-07-30.
[5]
See Holding Foreign Companies Accountable Act, Pub. L. 116-222, 134
Stat. 1063 (Dec. 18, 2020), Holding Foreign Companies Accountable Act
Disclosure, Release No. 34-93701 (Dec. 2, 2021).
[6]
The Division 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 therefore the Division also may issue similar comments to those
companies.
[7]
While the comments partly focus on VIE structures, China-based companies that
do not use such a structure also should consider the comments with a view to
providing the disclosure that is applicable to their company.