5.3 China-Based Operating Companies | DART – Deloitte Accounting Research Tool

Examples of SEC Comments

To the extent the Division of Corporation Finance’s Sample Letter to China-Based Companies, issued by the Staff in December 2021, requests disclosure on the prospectus cover page or in the prospectus summary, please provide such disclosure in a separate section at the beginning of Item 3 of Form 20-F; in addition, please include a discussion of the transfer of cash within the company in Item 5 of Form 20-F.
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 stockholders hold an interest.
We note that your definition of China and the PRC appears to exclude Hong Kong, Macau and Taiwan. Please revise to include the definition of China at the beginning of Item 3, and to clarify that the legal and operational risks associated with operating in China also apply to operations in Hong Kong and Macau. Additionally, please clarify whether you have any locations, operations or directors/executive officers in Hong Kong; in this regard it is unclear what you mean when you say that [Company X] has been “deregistered.”
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 [wholly foreign-owned entities] 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.
Please disclose prominently here that you are not a Chinese operating company but a British Virgin 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 your securities, 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 its investors as a result of this structure.
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.
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.
You state that many of your suppliers are located outside of the U.S. Please tell us whether you import any supplies from the Xinjiang region in China. If so, please revise your next Form 10-Q filing to include a discussion regarding any material impact of the recently enacted Uyghur Forced Labor Prevention Act (UFLPA) on your ability to obtain supplies and fulfill customer orders. Also, if applicable, discuss any efforts taken to mitigate such impact and where possible quantify the impact to your business.
In order to clarify the scope of your review, please supplementally describe the steps you have taken to confirm that none of the members of your board or the boards of your consolidated foreign operating entities are officials of the Chinese Communist Party. For instance, please tell us how the board members’ current or prior memberships on, or affiliations with, committees of the Chinese Communist Party factored into your determination. In addition, please tell us whether you have relied upon third party certifications such as affidavits as the basis for your disclosure.
With respect to your disclosure pursuant to Item 16I(b)(5), we note that you have included language that such disclosure is “to our best knowledge.” Please supplementally confirm without qualification, if true, that your articles and the articles of your consolidated foreign operating entities do not contain wording from any charter of the Chinese Communist Party.

In a July 2021 public statement, SEC Chair Gary Gensler provided an update on investments in China-based operating companies. In his statement, he noted that the Chinese government “provided new guidance to and placed restrictions on China-based companies raising capital offshore, including through associated offshore shell companies.” Since companies in a number of industry sectors in China are restricted from having foreign ownership and cannot directly list on exchanges outside of China, many China-based operating companies structure themselves as VIEs to raise money on such exchanges.

Chair Gensler further noted:

In such an arrangement, a China-based operating company typically establishes an offshore shell company in another jurisdiction, such as the Cayman Islands, to issue stock to public shareholders. That shell company enters into service and other contracts with the China-based operating company, then issues shares on a foreign exchange, like the New York Stock Exchange. While the shell company has no equity ownership in the China-based operating company, for accounting purposes the shell company is able to consolidate the operating company into its financial statements.

For U.S. investors, this arrangement creates “exposure” to the China-based operating company, though only through a series of service contracts and other contracts. To be clear, though, neither the investors in the shell company’s stock, nor the offshore shell company itself, has stock ownership in the China-based operating company. I worry that average investors may not realize that they hold stock in a shell company rather than a China-based operating company.

As a result of such exposure, the SEC staff has recently issued comments requesting FPIs to make disclosures that Chair Gensler described in his public statement as follows:

That investors are not buying shares of a China-based operating company but instead are buying shares of a shell company issuer that maintains service [and other] agreements with the associated operating company. Thus, the business description of the issuer should clearly distinguish the description of the shell company’s management services from the description of the China-based operating [company’s services];
That the China-based operating company, the shell company issuer, and investors face uncertainty about future actions by the government of China that could significantly affect the operating company’s financial performance and the enforceability of the contractual arrangements; and
Detailed financial information, including quantitative metrics, so that investors can understand the financial relationship between the VIE and the issuer.

The SEC staff has also issued comments requesting the following disclosures, as described by Chair Gensler in his public statement, related to China-based operating companies that seek to register securities with the SEC either directly or through a shell company:

Whether the operating company and the issuer, when applicable, received or were denied permission from Chinese authorities to list on U.S. exchanges; the risks that such approval could be denied or rescinded; and a duty to disclose if approval was rescinded; and
That the Holding Foreign Companies Accountable Act, which requires that the [PCAOB] be permitted to inspect the issuer’s public accounting firm within three years, may result in the delisting of the operating company in the future if the PCAOB is unable to inspect the firm.

On the basis of the comments that we have seen, it is clear that the SEC staff expects registrants to expand on these disclosures. The staff began issuing comments on these matters during the third quarter of 2021 as part of its review of in-process registration statements and then as part of its review of annual reports on Form 20-F. In December 2021, the Division issued a sample letter highlighting the comments it is issuing to registrants based in China. More recently, in July 2023, the Division issued another sample letter regarding China-specific disclosures. The sample letter reminds companies of their disclosure obligations under the federal securities laws and to “provide more prominent, specific, and tailored disclosures about China-specific matters.” Over the past several years, the SEC staff has issued a substantial number of comments that are consistent with the sample letters. We expect the staff to continue focusing on these disclosures in its reviews of Form 20-F and other registration statements.