Congress, the media, and independent regulators like the Securities and Exchange Commission (SEC) have recently focused on the risks posed to U.S. investors from Chinese companies directly listed on U.S. stock exchanges. While CPA welcomes this focus, it does not address the bulk of “bad actor” Chinese companies that are still present in U.S. capital markets and investment portfolios of tens of millions of American retail investors, pensioners, and retirees. This explainer describes in detail how Americans are exposed to thousands of mainland Chinese companies and what actions must be taken to protect U.S. investors.
Key Points
- U.S. investors are inadvertently subsidizing Chinese companies involved in activities that are contrary to the national security, economic security, and foreign policy interests of the United States.
- The bulk of U.S. investor exposure to these “bad actor” Chinese companies is through A-shares, or Chinese companies listed on mainland exchanges that Americans can only invest in via certain financial products, such as Exchange Traded Funds (ETFs) . This is because A-shares are not directly listed on U.S. exchanges due to Chinese laws that restrict foreign access.
- A new U.S. law, the Holding Foreign Companies Accountable Act (HFCAA), seeks to bring Chinese companies that are listed directly on U.S. exchanges, or N-shares, into compliance with U.S. securities laws.
- While HFCAA addresses China N-shares directly listed on U.S. exchanges like the NYSE or NASDAQ, it fails to address thousands of A-shares that U.S. investors are still unwittingly exposed to.
- S. law currently does nothing to protect American retail and institutional investors from asymmetric information when investing in Chinese A-share companies.
- Congress must pass legislation that requires index providers and asset managers to address the risks posed by A-share companies.
- The U.S. Government – either through legislative or executive action – must harmonize U.S. sanctions policy against Chinese companies in order to close current gaps that exist between different sanctions lists.
- The U.S. government – either through legislative or executive action – should establish a new standard for placing capital markets sanctions on Chinese corporate human rights abusers.
- The SEC must require further disclosures and issue new rules for index providers as it pertains to oversight of quality control and minimizing conflicts of interest.
- Index providers must reevaluate their index inclusion criteria, which currently expose U.S. investors to material and reputational China-specific risks.
How a loophole allows the CCP — with Wall Street’s help — to raise capital for bad-actor Chinese companies that most Americans do not know are even in their investment portfolios, and why the U.S. Government refuses to stop it.
A-shares vs. N-shares: What is the difference and why does it matter for the law?
Over the last nearly two decades, basic investor protection measures required by U.S. law for inspecting the audits of publicly traded companies have been evaded by Chinese companies listed on major U.S. stock exchanges like the NYSE or the NASDAQ. The Chinese government is the only foreign government that does not comply with the required third-party financial audits conducted by the Public Company Accounting Oversight Board (PCAOB), of companies listed on U.S. exchanges and has sought special waivers for non-compliance with U.S. law. Due to a Memorandum of Understanding signed in 2013 between the U.S. government and the Chinese Communist Party, Chinese companies listed in the United States have a free pass to ignore these important investor protections and transparency measures.
Last year, Congress sought to address this serious deficiency by passing the Holding Foreign Companies Accountable Act (HFCAA), which was signed into law in December 2020. Now, the Securities and Exchange Commission (SEC) is working with the PCAOB to implement the law and finally bring Chinese companies into compliance with U.S. securities laws.
This is welcome progress, but the new law only covers N-shares, Chinese companies listed on a U.S. exchange. That means thousands of Chinese companies that don’t comply with U.S. securities laws are still making their way into the portfolios of millions of U.S. investors, retirees, and pensioners.
The HFCAA neglects to address A-shares, which are securities listed on mainland Chinese exchanges (Beijing, Shenzhen, and Shanghai) and only accessible to American and foreign investors via inclusion in indices and associated index funds. The law also fails to address H-shares (Hong Kong-listed securities). Currently, there are over 4,000 A-share companies in American passive investment products that have never been subject to U.S. laws and regulations for transparency and investor protection. The vast majority of American investors are unaware that their Exchange-Traded Funds (ETF) or mutual fund portfolios include exposure to China A-share companies that are not compliant with U.S. securities laws and, in some cases, have been sanctioned by the U.S. government for egregious human rights and national security abuses. Americans should not be unwittingly financing the rise of the CCP and their abuse of power throughout the world.
The scope of the HFCAA is limited to approximately 270 U.S.-listed N-shares, and approximately 900 securities listed on the Over-the-Counter (OTC) market. However, it does not cover the thousands of Chinese A-shares present in indexes and the ETFs tracking them. That means that there are more than 4,200 Chinese companies not covered by the same laws that protect American investors and apply to U.S. companies publicly listed on U.S. exchanges. In other words, HFCAA only covers about 22 percent of Chinese companies, leaving 78 percent of the problem unresolved. Exposure to these indices through ETFs amounts to hundreds of billions of dollars or more in U.S. investment.
CPA compiled research on just how massive American investor exposure is to these unaccountable Chinese companies, the risks this poses, and policy solutions we recommend be adopted immediately.
A-Shares in US Index Funds
In May 2018, after three years of deliberation and negotiations with Chinese regulatory authorities (and considerable arm-twisting from Beijing), major index provider MSCI released a list of large-cap China A-shares to be included in the MSCI China Index, Emerging Markets (EM) Index, and All Country World Index (ACWI) beginning in June. The MSCI EM Index previously only included shares of Chinese companies listed in Hong Kong or the United States. As of June 2018, MSCI had over $1.8 trillion in assets benchmarked globally to its Emerging Markets Index suite, 30.99% of which was comprised of China-based securities.
By November 2019, MSCI had increased and expanded its index exposure to mainland Chinese companies significantly by including mid-cap China A-shares and quadrupling the inclusion ratio of China A-shares in the MSCI EM Index from 5% to 20%. The total index weighting of China A-shares jumped from 0.7% to 3.3%, drawing in an estimated $80 billion in foreign inflows to the Chinese market.37 As of August 2020, the overall weight of China A-shares in the MSCI EM Index had risen to 5.1%, where it currently remains.
FTSE Russell followed in MSCI’s footsteps and was the second major index provider to include China A-shares in its indices. In June 2019, FTSE added 1,097 China A-shares into its FTSE Global Equity Index Series (GEIS, which covers the FTSE Emerging and All-World Indices) in the first stage of inclusion (20%), drawing an expected $10 billion from U.S. passive investors. As of June 2020, China A-shares represented approximately 6% of the FTSE Emerging Index. Over 4,200 China A-shares are available to U.S. investors at this point through their inclusion in indices.
Undisclosed Risks to Investors
Index providers neglect to consider the full range of China-specific material risks to investors when determining index constituents and weighting. These include considerations of reputational risks relating to national security, export controls and sanctions regimes, human rights violations, political factors, or even full consideration of traditional environmental, social, and governance (ESG) factors.
Retail and institutional investors are exposed to a wide range of publicly traded Chinese companies involved in developing weapons systems, new technologies, and building infrastructure in support of China’s military modernization goals; and companies involved in facilitating the ongoing genocide of Uyghurs and other Turkic Muslims in Xinjiang, the systematic intimidation and coercive assimilation of Tibetans, and the mass surveillance and government interference in people’s lives in Hong Kong. Beyond these, additional risk factors to consider include U.S. sanctions designations and any other blacklists that may signify a material reputational and financial risk to investors.
Recommendations:
Problem: U.S. investors are inadvertently funding Chinese companies involved in activities contrary to the national security, economic security, and foreign policy interests of the United States. While index providers exercise virtually unchecked authority over how, where, and when U.S. investors deploy their funds – which companies, countries, sectors, and industries – they also operate outside of SEC regulation, without industry-wide rules on transparency or accountability.
Solution: It is critical for index providers to reevaluate their index inclusion criteria, which currently expose U.S. investors and index providers to material reputational and China-specific risks. The SEC must enhance its disclosure requirements for index providers and / or mandate exclusion of non-compliant and risky Chinese companies from indexes and passive investment products.
Problem: U.S. investors holding China A-shares are also exposed to material financial risk due to the lack of access by the PCAOB to these companies’ audited financials. The HFCAA passed by Congress attempted to close this gap, but only regulates Chinese companies listed directly on U.S. exchanges, therefore neglecting to address the more than 4,200 A-shares U.S. investors are holding via passive investment products. This legislation, while a positive step in the right direction, must be amended and expanded to rectify this major shortfall.
Solution: HFCAA should be expanded to cover Chinese companies traded in the United States via passive investment products, despite not being directly listed on U.S. exchanges. Or other laws must be passed to exclude A-shares from indexes so they are not then tracked into ETFs and other investment products.
Problem: Little information is required to be disclosed by issuers, fund managers, or made available to fiduciaries for decision-making in investment stewardship.
Solution: The SEC and other U.S. Government agencies must provide and require more information to be made known to investors and fiduciaries in regard to the geographic location of companies, their industries or sectors, their linkages to foreign governments or foreign actors, the presence of companies on U.S. sanctions lists, or other national security, human rights, or governmental and political risk factors.
