Back to General Resources

HFSC “Taking Stock of China, Inc.” Hearing

House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets

Taking Stock of ‘China, Inc.’: Examining Risks to Investors and the U.S. Posed by Foreign Issuers in U.S. Markets

Tuesday, October 26, 2021

Witnesses

  • Karen Sutter, Specialist in Asian Trade and Finance, Congressional Research Service
  • Samantha Ross, Founder, AssuranceMark, The Investors’ Consortium for Assurance
  • Claire Chu, Senior Analyst, RWR Advisory Group
  • Eric Lorber, Senior Director of the Center on Economic and Financial Power, Foundation for Defense of Democracies

Opening Statements
Chairman Brad Sherman (D-Calif.)
In his opening statement, Sherman discussed the intertwining of America and China’s economies and some witnesses’ decisions to pull out of the hearing. He also pushed back against criticism of capital flowing out of the U.S. to China, arguing that the reverse is also true.

Ranking Member Bill Huizenga (R-Mich.)
In his opening statement, Huizenga expressed concern with his office not being notified of the bills discussed in the hearing ahead of time and asked for clarification on which witnesses decided not to show up. Sherman said he wanted to protect the identities of the witnesses. Huizenga discussed Chinese economic competition with the U.S., adding that the U.S. should focus on sanctioning certain Chinese firms and fostering entrepreneurship to combat the threat of China.

Full Committee Chairwoman Maxine Waters (D-Calif.)
In her opening statement, Waters discussed how playing by the rules ensures the success of our capital markets. She then discussed how China has created obstacles to effective securities regulatory oversight.

Testimony
Karen Sutter, Specialist in Asian Trade and Finance, Congressional Research Service
In her testimony, Sutter emphasized six points: (1) China is selectively opening its financial markets in limited ways to certain U.S. investors, and the Chinese government has recently granted licenses or expanded the terms of licenses to allow a few U.S. investment firms to expand offerings in China. (2) The limited and targeted nature of China’s financial investment openings to date appears designed in part to attract U.S. capital to areas of China’s economy where the government may seek to compensate for weaknesses, such as bad assets and debt. (3) The Chinese government appears to be seeking U.S. capital to fund its strategic and emerging industries, strengthen China’s capital markets, and position Chinese firms as global leaders and competitors. (4) The growing role of the state in China’s economy and business ecosystem has increased dramatically since 2014 and intensifies the potential challenges and risks for U.S. companies. (5) The corporate structures Chinese firms are using to invest in U.S. capital markets, such as the variable interest entity (VIE) structure, are complex and make it difficult for U.S. investors to assess potential risks. (6) There is a lack of transparency on deals and an absence of publicly-available data on the main and growing pathways for two-way investment including private equity, venture capital, and private placements.

Samantha Ross, Founder, AssuranceMark, The Investors’ Consortium for Assurance
In her testimony, Ross said our markets are being tested by a string of frauds by China-based companies that obtained capital from our markets but failed to comply with our investor protection rules. She quoted a New York University Professor who said “the basic problem is that they do not have the same auditing standards that we do here. And, compounding that problem is that the Public Company Accounting Oversight Board (PCAOB) generally cannot get access to audit the Chinese auditing firms. A lot of firms go public from China into Western capital markets that do not meet the same disclosure and auditing standards that we would here.” Ross concluded that based on the heightened risks evident from a string of frauds, it will be important to ensure that China-based companies that are prohibited from trading on our public markets do not turn to other ways to access U.S. capital, and he commended continued vigilance as well as the SEC’s work to ensure these companies provide full, fair, and transparent disclosure of their risks and corporate structure.

Claire Chu, Senior Analyst, RWR Advisory Group
In her testimony, Chu listed many China-related risks. (1) China’s opaque bureaucratic and corporate structures prevent high-quality disclosure and transparency, preventing U.S. investors from making informed investment decisions. (2) The U.S. financial industry is not equipped to identify, understand, and act in response to the market and reputational risks posed by China’s rapid integration into global capital markets. (3) U.S. investors are inadvertently subsidizing Chinese companies involved in activities contrary to the national security and foreign policy interests of the United States. She concluded in support of unanimous passage of the Holding Foreign Companies Accountable Act (HFCAA) introduced by Sherman.

Eric Lorber, Senior Director of the Center on Economic and Financial Power, Foundation for Defense of Democracies
In his testimony, Lorber said protecting U.S. investors from Chinese issuers who refuse to abide by U.S. standards is an important objective but that Congress must be cautious to ensure we do not inadvertently raise reporting and disclosure obligations too high and chill the attractiveness of the financial markets we aim to protect and foster. He said narrowly targeted sanctions on certain Chinese companies or Chinese industries that the U.S. determines pose national security threats can be a way to protect both U.S. investors and national security. Lorber added that Congress and the Administration should clearly understand the limits of such sanctions, because while they can prevent malign actors from accessing our financial markets, they may be less effective at protecting U.S. investors from non-U.S. issuers who do not provide sufficient material information.

Question & Answer
CCP Tightening Control and Fleeing U.S. Markets
Huizenga asked how serious the Communist Part of China’s (CCP) crackdown has been on their entrepreneurs and innovators, and what the U.S. can do to ensure we stay competitive and improve the market situation. Lorber confirmed there has been a tightening of control over certain companies within China led in-part or in-full by the government. Lorber added that ensuring capital markets remain strong helps increase innovation, ensures the cost of borrowing in the U.S. is low, and incentivizes non U.S.-companies to come work in the states.

Rep. Anthony Gonzalez (R-Ohio) asked about the CCPs crackdown on Didi, and if it is the sign of a new trend by China. Chu said these are not new trends, the government has always cracked down on companies posing threats to state control. She said the only difference now is that U.S. investors are increasingly exposed to these risks and crackdowns.

Gonzalez asked what steps China might take to replicate U.S. markets and keep Chinese companies from listing in the U.S. Chu discussed Chinese companies fleeing U.S. markets after entity list designations and recommended enforcing capital markets sanctions and restrictions on investments to satisfy U.S. foreign policy objectives.

Entity Lists
Rep. Van Taylor (R-Texas) asked if there are other entities that should have been sanctioned that the Trump Administration might have missed. Chu said the lists under Executive Order 13949, Executive Order 14032, and Section 1260H combined include 80 individual companies designated as Chinese Companies Military Companies (CCMCs), but that she has identified hundreds more that include subsidiaries and direct parents of these companies. She expressed frustration that these lists were supposed to be regularly updated but have not been and, as a result, contain many gaps.

Holding Foreign Companies Accountable Act (HFCA)
Rep. Juan Vargas (D-Calif.) asked Ross what the U.S. should do about China not playing by PCAOB rules. Ross said the HFCA is critical to addressing the issue.

Sanctions Approach
Reps. Ann Wagner (R-Mo.) and Huizenga asked how targeted sanctions and export controls better ensure our rules will be followed by the CCP. Ross and Lorber said they can be very effective tools. Lorber added that sanctions have been used successfully both by the Trump and Biden Administrations and noted that the guidance has been good in warning of sanctions and elicit activity risk.

Rep. Bryan Steil (R-Wisc.) asked Lorber about targeting sanctions and how to draw the line between benign companies and those actually involved in activities against U.S. interests. Lorber said it can be a challenging line to draw but that for companies that do not provide sufficient financial information may not be the best target for sanctions. He said other companies are working to bolster the Chinese military, and sanctions may be more appropriate there. Lorber did not recommend specific tweaks or changes to the sanctions regime but questioned whether there may be more entities posing national security threats that may justify targeting.

Rep. Andy Barr (R-Ky.) asked why leveraging U.S. sanctions regimes is preferrable to a ban on public equity investment or enhanced disclosures. Lorber said that sanctions involve a wider scope and allow for more rigorous oversight. Barr asked about the mechanics of the Office of Foreign Assets Control (OFAC) designations. Chu discussed how sanctions in addition to restrictions on capital investments would align national security objections with sanctions programs. Barr asked Lorber to discuss the force multiplier of sanctions versus disclosures in preventing a circumvention and rerouting of capital to foreign exchanges. Lorber discussed how U.S. jurisdiction requires foreign companies to follow U.S. regulations resulting in non-U.S. companies in foreign jurisdictions not touching those securities because they would be blocked properties.

Sanctioning Individual People
Gonzalez asked about the effectiveness of targeted blocking sanctions against specific individuals. Lorber said it depends on the target, but there have been many situations where they have been very successful and have major impacts on the entity.

Dual Class Share Structure
Waters asked Sutter how the dual class share structure creates risk for U.S. investors and how China uses the structure. Sutter highlighted how even if the dual class share structure were to be changed, that underlying this structure are inherent asymmetries and that the Chinese government is often also a controlling shareholder. Waters asked if dual class share structures are good for the U.S. Sutter said she does not have a specific opinion on the structure itself.

Variable Interest Entities (VIE)
Sherman asked Sutter about including VIEs in indexes and if we should allow issuers to use phony names. Sutter opined on the nature of VIEs but was cut off by Sherman before directly answering in a substantive way.

American Depository Receipts (ADR)
Rep. French Hill (R-Ark.) asked how to improve disclosures for the use of a VIE or ADR structure. Sutter said there are many challenges the U.S. faces in looking at greater transparency but mentioned (1) requiring SEC 20-F or 10-K equivalent for all firms, not just those that list but also those who have secondary listings, (2) more detail on the corporate structure, beneficial owners, and ties across all owners, and (3) quarterly versus annual reports on a company’s financial situation. Huizenga asked if this would make America’s market less effective for ADRs, since companies want access to U.S. retail investors. Sutter said the issues she raised are the same for what U.S. listers would have to do.

Increased Disclosures
Huizenga asked about the materiality of disclosures. Lorber said that increased non-material SEC disclosures will create some degree of deterrence for companies to finance on U.S. markets. Ross said we do not need new disclosures because China-based companies are not even complying with existing rules. Rather, she said to focus on better enforcing the current rules. Rep. Ann Wagner (R-Mo.) asked how increasing U.S. investment disclosures rules would compromise the strength of America’s capital markets. Lorber said it would reduce companies’ willingness to list on U.S. financial markets or seek access in our markets and that it could directly impact U.S. competitiveness. Wagner asked Lorber to explain how the strength of the U.S. economy is key to our effectiveness abroad. He said U.S. capital markets are a crown jewel and allow for low cost capital to be accessed.

Rep. Jim Himes (D-Conn.) asked if the Chinese are getting special treatment for bad behavior that is not leading to delisting. Ross responded that there is a uniquely Chinese issue that China is blocking U.S. investor protection efforts. She also discussed how the HFCAA is moving the needle on Chinese company and government behavior. Rep. Bill Foster (D-Ill.) asked if there is any discussion on multilateral agreements on minimum transparency standards for listed companies and what the venues are for which these discussions are taking place. Ross said the Chinese government is pulling their companies home, and that the SEC, the International Organization of Securities Commissions (IOSCO), and the European Union have been forums for these discussions.

Index Provider and ETF Disclosures
Hill asked Chu about Commissioner Pierce’s speech in which she was open to additional disclosures for index providers and ETFs and asked what would be appropriate there. Chu said the criteria that is used by index providers, who exert overwhelming power over where U.S. investors are able to invest in China, are based on market factors instead of reputational risks or national security.

OFAC versus SEC
Rep. Warren Davidson (R-Ohio) asked how effective OFAC has been in identifying national security risks and if it is a more effective way to deal with human rights issues than going through the SEC. Lorber said OFAC has been effective with human rights related sanctions, and said OFAC has expertise that allows them to identify and successfully target human rights abusers.

Access to Capital
Rep. Sean Casten (D-Ill.) asked about Chinese companies using exempt offerings as a back door to U.S. securities markets. Ross confirmed Casten’s concerns. Rep. Alex Mooney (R-W.V.) asked Sutter if passive investors give Americans the same control as a typical shareholder. Sutter discussed how China is highly restrictive and closed in certain sectors and trying to access capital without allowing U.S. companies access to Chinese markets. Mooney asked Sutter to explain her remarks concerning how China seeks U.S. capital to fund its strategic interests. Sutter explained how U.S. capital going into Chinese companies may support made-in-China policies.

IP Theft
Rep. Trey Hollingsworth (R-Ind.) asked Lorber to speak about the deprivation of technological transfer from U.S. firms to Chinese firms and the mechanisms we have in place to stop it. Lorber said when it comes to technology theft, the Department of Justice can pursue lawsuits and added that the Committee on Foreign Investment in the United States (CFIUS) might also have jurisdiction. Lorber added that targeted sanctions could help as well. Hollingsworth emphasized that these problems should be solved with laws and real penalties in the event those laws are broken, rather than attempting to go about this through the financial system.

Risk of Chinese Collapse
Reps. David Scott (D-Ga.) and Casten asked Sutter to explain the impact for not just the U.S., but for all global markets, if a Chinese economic collapse were to occur. Sutter discussed the debt of Evergrande as a case study for system risk to the U.S. from China, the role of the Chinese government when Chinese companies are in trouble, and the creditor priority upon default. Scott asked how the slowdown of Chinese construction and manufacturing related to the growing warning signs of a possible shock to global financial markets. Sutter discussed how the Chinese government is trying to avoid moral hazard and is dependent on big Chinese companies like Evergrande.

Trump Administration Sanctions
Taylor asked Lorber to explain what the Trump Administration did to address China-related risks. Lorber said in terms of securities, they issued Executive Order 13969 to prohibit U.S. persons from trading in securities of companies identified as CCMCs. He added that many other sanctions were imposed relating to Hong Kong and certain activities in Xinjiang. Lorber also noted that the Administration put out guidance to warn U.S. companies of the sanctions and illicit finance-related risks that were emanating from China.

For more information on this hearing, please click here.