The theory of holes | China Accounting Blog | Paul Gillis

The theory of holes

I have written editorials this week for both the Wall Street Journal and the Financial Times.

I am trying to focus attention on the underlying problem that audit inspections and SEC access to documents need to solve. That problem is the high incidence of fraud among U.S. listed Chinese companies.

In my view, a major reason we have seen so much fraud is that the U.S. listed Chinese companies operate in a regulatory hole. They have structured themselves with offshore companies with variable interest entities to circumvent Chinese law. These efforts successfully (so far anyway) got them out from under Chinese regulation. One of the defenses the Chinese have used against U.S. complaints is that Chinese regulators have no authority over Cayman Islands companies. Yet China does not allow U.S. regulators to step in and fill the regulatory hole. It bans U.S. regulators from taking action on Chinese soil, where all the people and records reside.

In academia there is actually a theory of holes. Structural holes are gaps between parties with complementary information. Structural holes in markets can be exploited by entrepreneurs who step in to fill them and connect the separated parties. Regulatory holes work similarly, but instead of entrepreneurs stepping in to fill them, fraudsters step in to exploit them. Regulatory holes are the perfect environment to pull off a scam.

I argue that this regulatory hole needs to be closed from the Chinese side, with Chinese regulators stepping in to fill the gap. I think that involves getting rid of the Cayman Island holding companies and the VIE, allowing the Chinese operating company to list directly overseas. Getting rid of the VIE solves a pesky problem for both Chinese regulators and investors. Control of sensitive sectors should be done through dual share structures. Most importantly, I call for the CSRC to be designated sole gatekeeper and regulator for overseas listed Chinese companies. The CSRC needs to have the authority to work with foreign regulators to fulfill its mandate.

Copyright 2015 Paul L. Gillis all rights reserved