By Pam Martens and Russ Martens: October 28, 2021 ~

Congressman Brad Sherman (D-CA) knows a thing or two about accounting and law. He has a law degree from Harvard, where he graduated Magna Cum Laude. He has previously worked as a CPA and Certified Tax Law Specialist.

Sherman chairs the House Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets. At a Tuesday hearing on China’s myriad forms of market abuses, he made it crystal clear that investors are being hoodwinked when it comes to buying Chinese stocks.

In his opening statement for the hearing, Sherman said this:

“We see that China is able to pressure index funds to include Chinese companies but it’s not Chinese companies that are in the index funds. An index fund may choose to put the thousand biggest companies in the world in the index. But you can’t buy Alibaba. You buy Alibaba of the Cayman Islands.

“Now Alibaba is one of the biggest companies in the world, but Alibaba Cayman Islands – the Cayman Islands isn’t even one of the biggest islands in the world. You’re investing in a shell company that invests in another shell company that has a contractual relationship with Alibaba. Does that belong in an index?

“But we do see that China is able to pressure Morgan Stanley and others to include these questionable entities in indexes.”

The IPO of the online Chinese retail marketplace, Alibaba, began trading on the New York Stock Exchange on September 19, 2014. It closed its first day of trading with an increase of 38 percent, giving it a market value greater than Disney or Boeing. Alibaba was the second largest IPO in U.S. stock exchange history. The SEC filing for the Alibaba offering included the following information on the Variable Interest Entity (VIE) structure:

“Specifically, our material variable interest entities are majority-owned by Jack Ma, our lead founder, executive chairman and one of our principal shareholders, and minority-owned by Simon Xie, one of our founders and a vice president on our China investment team where he works on projects related to our China acquisition and investment activities. These contractual arrangements collectively enable us to exercise effective control over, and realize substantially all of the economic risks and benefits arising from, the variable interest entities. See ‘Our History and Corporate Structure — Contractual Arrangements among Our Wholly-foreign Owned Enterprises, Variable Interest Entities and the Variable Interest Entity Equity Holders.’ The contractual arrangements may not be as effective in providing operational control as direct ownership. See ‘Risk Factors — Risks Related to Our Corporate Structure.’ ”

Under “Risks Related to Our Corporate Structure,” there was this sentence:

“If the PRC [People’s Republic of China] government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations.”

China is currently engaged in a regulatory crackdown of Alibaba. Its share price has lost 44 percent since the beginning of the year.

Sherman had called witnesses from Wall Street to testify at the hearing but they had all backed out. Sherman said their absence “speaks strongly to China’s strong economic power over politics and economics here in the United States.”

When Sherman was asked by Congressman Bill Huizenga (R-MI) to clarify who it was that didn’t show for the hearing, Sherman said this:

“I’m not here to end any careers on Wall Street by explicitly identifying names. There are those whom we were in discussions with – some who had actually agreed to come testify – then notified us that it was in the interest of their careers that they not appear before us.”

Later in the hearing, Sherman explained that his constituents include movie studios that want to get their movies into China. But they know that if they do a movie about Tibet, that movie isn’t getting into China and none of their movies are getting into China. Sherman then explained how this same pressure from China is impacting Wall Street:

“If you’re Morgan Stanley and you want to do banking in China, you know that you may be one of the banks that gets into China – if your global index includes Chinese companies to a sufficient degree and if you officially notify all your customers that they should include China to the 15 percent level, or whatever level, in their portfolios.

“You know that you’ll be allowed to do business in China if your lobbyist is here on the hill lobbying for China. China doesn’t need to hire a lobbyist. They have all of them through this selective access system.”

One of the witnesses called to testify was Claire Chu, a senior analyst at RWR Advisory Group, a research and risk assessment firm based in Washington, D.C.

Chu’s written testimony expanded on the shell company structure of Chinese companies being listed on U.S. exchanges and added to index funds by U.S. financial firms such as Morgan Stanley. Chu wrote:

“Variable interest entities (VIEs) are legally and functionally ambiguous corporate structures frequently employed by Chinese companies to list on U.S. exchanges, through which overseas listed entities control domestic Chinese business entities through agreements. A 2017 report by the Council of Institutional Investors (CII) found that VIE corporate structures are used by 62% of Chinese companies currently listed on U.S. exchanges, and by over 80% of Chinese companies that went public on U.S. exchanges between 2015-2017.

“Domestically, VIEs can circumvent China’s foreign investment prohibitions on certain industries, and restrictions on ‘round-trip investments’ by domestic entities via offshore special purpose vehicles (SPVs). Internationally, VIEs are able to meet the requirements of listing on U.S. and other foreign securities exchanges, allowing Chinese companies to raise funds overseas. Chinese analysts have suggested that the strength and speed of the Chinese Internet industry’s development can be partly attributed to the VIE model…

“U.S. investors have very shaky legal rights to the underlying assets of VIE-structured companies because in reality, they are holding shares of a shell company with no intrinsic value or operations, that only mirrors the performance and value of a domestic Chinese company. In the event of a delisting or an undervalued take-private deal, it is unclear what recourse is available to U.S. shareholders of Chinese companies with VIE structures. This past July, SEC Chair Gary Gensler introduced new guidance seeking VIE-related disclosures from all China-based operating companies seeking to issue securities, and to conduct targeted additional filing reviews for companies with significant China-based operations. These enhanced disclosure requirements have not yet, but should be, codified as an amendment to the Securities Act.”

Read Chu’s complete written testimony on the far-reaching threats posed by China’s rapid expansion into international stock markets here.

Despite the fact that China has not been complying with accounting laws in the U.S. for almost two decades, Wall Street has continued to underwrite its questionable shell companies.

According to the Subcommittee’s Memorandum released as part of the hearing, during the first half of this year, initial public offerings (IPOs) by Chinese companies represented “nearly 15 percent of total IPO proceeds raised in the U.S.” As of October of last year, there were 248 China-based firms listed on U.S. stock exchanges, representing a total market value of $2.2 trillion.

One of the questions raised at the hearing was what type of fallout would financial firms in the U.S. experience if there was a major financial upheaval in China. While there was no definitive answer, it might be wise to recall that China’s stock market ruptured in July 2015 and China suspended trading in more than a thousand stocks. During that same week, on July 8, 2015, the New York Stock Exchange suspended trading for almost four hours. See our report: China Stocks and the New York Stock Exchange Shutdown: The Untold Story.