$2 Trillion Invested in Chinese Companies, but US Investors Have No Control over Them: Keith Krach

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Keith Krach:

Every listed Chinese company on U.S. Exchanges that we can buy, uh it goes through that VIE structure. And through this structure investors don't actually own a part of the underlying Chinese company. And you know, that might sound ridiculous, but it's true.

Simone Gao:

Hello everyone, and welcome to Zooming In China. I'm Simone Gao. How will U.S. Capital markets react to the recent disastrous IPO of Didi, China's version of Uber? I had these discussions with former Under Secretary of State Keith Krach. Take a listen. Let's talk about another big thing that happened in the last week. So, Secretary Krach, you have always championed U.S. Investors and highlighted the risks associated with Chinese stocks and how they are the only stocks that are allowed not to follow U.S. Accounting standards. So, China's Uber, Didi, recently had a disastrous IPO in, in America because the central government of China basically killed Didi by ordering all Didi's 25 apps to be removed from the app store two days after the IPO. So, what kind of impact would this have on the U.S. Investment in the Chinese stocks? Could this have a long-term impact on the U.S. Investment in China?

Keith Krach:

By the way, the impact I believe is gonna be big and it will be long-term and, you know, what it shows is China's growing willingness to upend things with little notice as exemplified by this Didi, uh, fiasco, pulling Ant's $34 billion IPO with two days to go, and then also with recent announcements by Chinese financial regulators. And I really think this should really be one of the biggest stories in finance. And here's why here's the thing that a lot of people don't talk about. It's called a variable interest entity, or VIE, and it goes like this: almost every listed Chinese company on U.S. Exchanges that we can buy uh goes through that VIE structure. And it's through this structure investors don't actually own a part of the underlying Chinese company. And you know, that might sound ridiculous, but it's true. So, investors who buy shares in Chinese stocks, such as Didi, Alibaba, Tencent, et cetera they don't have any ownership of the underlying business whatsoever. And in reality, they're actually buying exposure to a Cayman Island-registered shell company called a VIE. And that is many steps remove technically, legally and economically from the real company in China.

Simone Gao:

Okay. So this is mind-boggling. Do you mean that U.S. Investors simply have no clue what they are buying, uh you know, when they invest in Chinese stocks and when they buy, you know, Tencent, Alibaba stocks that they own a percentage of the company, as they doing like U.S. And European stock markets, but that's actually not the case. How can that be?

Keith Krach:

Well, the reason behind it, Simone, is that under Chinese law, foreign ownership in most Chinese industries is prohibited. And as a result, it's illegal for Chinese companies like Tencent and Alibaba to have any non-Chinese shareholders. And back in the early 2000s, as the China growth engine was really beginning Chinese companies needed huge amounts of U.S. Capital. And at the same time, Wall Street firms looked at the huge growth rates in China and wanted to be able to access that and take advantage of that, uh but Chinese law prevented them from doing both. And that's when it came up with this structure.

Simone Gao:

Hmm. Okay. How big is this problem? Can you put this problem into perspective?

Keith Krach:

Yeah, so right now there are currently 240 Chinese VIE companies listed on U.S. Exchanges with a total market cap of more than $2 trillion. So, think about that for a minute. Investors are ascribing in $2 trillion worth of value to a bunch of unenforceable contracts held in shell companies in the Cayman Islands and where there's been a history of underlying company assets being stolen without warning, compensation or recourse. And it is honestly slightly staggering. I think that we've even gotten to this point, and the risk of that has increased with Didi and Alibaba.

Simone Gao:

So, can you give me an example? Has this happened before?

Keith Krach:

As a matter of fact, yes, it has. So, let's take Ant Financial you know. Ant, which grew up within Alibaba, used to be called Alipay, and it became China's largest payment processing company. It's the perfect example of risk of VIEs, and that is that what you think you own can be taken away from you at any time. So, in 2011, Alibaba was literally stolen from U.S. Investors in Alibaba's VIE structure. And this is when Founder and CEO, Jack Ma unilaterally transfered 100% of the ownership of Alipay into a different company controlled solely by himself.

Simone Gao:

Wow. Then what happened?

Keith Krach:

Well, one of their biggest investors was Yahoo. They were an early investor early on in the Alibaba VIE, and they matched like a 43% stake. And when this happened, Yahoo didn't even find out about the transaction until months later. And they, of course, were absolutely outraged and launched into legal proceedings. However, due to the VIE structure, Yahoo, along with other shareholders, were powerless to do anything. They literally had no legal recourse, because they legally, you know, the only thing they owned was 43% of the Cayman Island shell corporation. They had illegal contracts with Alibaba unenforceable by Chinese law. So, here's what happened. Jack Ma took a company worth billions of dollars directly from under the nose of thousands of U.S. Investors in the VIE, and there was nothing that anyone could do about it. You know Yahoo, Yahoo eventually got a pitiful settlement from from Ma on the VIE. Shareholders got about $6 billion out of what ended up to be a $300 billion asset. And it goes without saying that the Yahoo shareholders were furious and this, you know, this is, yeah, this is something that there's just no way to prevent. And, and it could happen again very clearly. And I think the risk has gone up recently,

Simone Gao:

Right. I mean, this is absolutely incredible. So where does, where did our financial system fail? How could things like that happen?

Keith Krach:

Yeah. You know any American investor that sees a U.S.-listed Chinese company, I think, just automatically assumes investing is like investing in any other company. After all, you know, it's fair to assume it must have the stamp of approval from regulators, investment bankers, the stock exchanges and the large, well-known asset managers that already hold those shares. And each of these entities the way I look at it, failed to do their job in protecting those American investors, in educating them, uh on this substantial risk. And I think they let their commercial interests and conflict of interest get in the way of protecting U.S. Investors. It's really a shame. Something's really gotta be done about it, especially now.

Simone Gao:

Right. Tell me about your plan how to fix this financial system in the future programs.

Keith Krach:

So Simone, as far as my personal plans, you know, I'm gonna continue this mission especially in terms of educating U.S. Investors. You know, at uh one of the press conferences that I held, I made a plea to the press to educate the average American investor, all American investors, on the huge risk in terms of investing in Chinese companies. And, and I went over with them you know, Chinese companies have broken especially the Chinese military companies and surveillance companies, into an unnatural amount of subsidiaries for the purpose of disclosure and deception. Then what they do is they bury those subs in the MSCI index fund, the FTSE index fund, Bloomberg index fund. And then those go in the big asset management funds, like from BlackRock, Vanguard, State Street. Those are the big three. For example, BlackRock has 431 emerging fund products, either ETFs or mutual funds chock-full of Chinese companies.

Keith Krach:

And then those go in the $11.7 trillion pension funds. So, you know, one of the things that I'm really hoping for is that our Secretary of Labor what he's able to do is to, is to send out a business advisory to these pension funds, because the Secretary has two-thirds of the authority for this issue. He runs the Employee Benefits Security Administration, which is responsible for administering and enforcing the provisions of URISA, which cover all pension funds, and URISA provides protections for participants and beneficiaries in these plans such as access to information. And the fund managers, the pension managers, have discretion in managing those plans and their plan's assets. And they've got to meet certain standards of conduct under the fiduciary responsibilities specified by law. You know, an example is the prudent man rule. And so the Secretary of Labor's job is to educate them.

Keith Krach:

So, I'm hoping that he issues a business advisory just like we did where we issued it to all companies regarding the utilizing forced labor from Xinjiang in their supply chains. That will go a long way. Secretary of Labor is also responsible for the Pension Benefit Guaranty Corporation. So, this is the insurance company that holds funds that back up pension funds in case they go defunct or bankrupt, and they're holding a significant amount of Chinese companies. And a lot of those are listed on the Chinese exchanges from the MSCI index fund. And just like the TSP, which is the federal federal employees' pension funds, divested of their MSCI index funds. I'm hoping the Benefit Pension Benefit Guaranty program will as well. So stay tuned on that one. And I really believe transparency on this issue is the best disinfectant. You know, as, as a former CEO of public companies and a chairman of Purdue, I wrote a letter about this issue.

Keith Krach:

I wrote three letters. One was to all the CEOs of U.S. Companies on this issue. The other was to all the Board of Governors of universities and their foundations, because those are also chock-full of the MSCI index fund and consequently, Chinese index funds. It was interesting to learn as most of these guys in who are on the Board of Governors, these foundations, they have no idea. I also wrote a letter to the civil society leaders, those organizations, particularly ESG because that is like a standards body for clean investing. So environment, social governance, and in social, that's what covers human rights and genocide. And so to be financing companies, for example, that use slave labor or enabling genocide I'm really waiting for that community to call them out. And that's key to educating them. You know, the last thing is that we just sit announced the Purdue tech tag, it's the center for technology diplomacy at Purdue, my old alma mater where I was chairman of the Board of Trustees.

Keith Krach:

And I'm the chairman of that, so I'm really looking forward to working a lot in those areas. And one of those issues there is clean technology and advancing that. And and solar energy is going to be industry experts predict it's going to be 50% to 70% of the world's energy by 2050. We all want to take action on climate change, um you know, but if we do nothing we'll be getting our solar energy not only from China, but the vast majority is in Xinjiang where they have the big open-pit coal mines. And because it's a very energy intensive manufacturing process so that you have the world's two biggest coal-fired plants there making solar panels. It also uses utilizes slave labor. It's also a national security issue, because energy security is national security. We don't want to depend on the Chinese for our energy.

Simone Gao:

Yeah. And also just what actually happens to those Chinese stocks like Didi? After Didi do you think the appetite for U.S. Investment in Chinese market could shrink?

Keith Krach:

Yes, Simone, I do think this is big. And I do think the market for Chinese companies is, is going to shrink. You know, it was interesting with the with the Ali with Ant Financial where the IPO got pulled you know, with two days before it was set to go, the bankers got hurt. But with Didi this is a whole new thing. You know, the Chinese Communist Party knowingly let it go public at a high valuation so they could extract the U.S. Investors' money, and a couple days later, they tagged the thing. And this hurt the investors. You know, I think one of the questions that needs to be asked is that did the regulators in China know about this? I have to think, yes. And did they disclose this? And then, mostly the investment bankers, why didn't they do a big job of disclosing it, or, as a matter of fact, pulling it? Uh you know, I've taken three companies public, and that's a really tight community.

Keith Krach:

And when you've got something that is glaring you right in the face, that's as big as this, you pull the, you pull the IPO. That's their fiduciary duty. So, I think that's that's going to be out there and questioned. You know, the other big thing is to eliminate these VIEs. This is something nobody talks about. And now with Xi at his discretion, and regulators at their discretion, not afraid to do, to, to not only hurt their own companies, but U.S. Shareholders on a whim, they have all the leverage with the VIEs, because anybody who's made an investment in Chinese stocks on American exchanges actually doesn't have the ownership and has no legal recourse economically or legally. So, I think that's going to come into play. I think one of the other things that's big is, you know, the Chinese don't follow they're the only companies, the Chinese companies are the only companies that don't follow universal and gap accounting standards.

Keith Krach:

And and we gave them three years to fix it. I think it's way too long, as you could see in what just happened to Didi. And you know, this could be changed within a 30-day notice, because in 2013 an MOU got signed between China regulators and the PCAOB, which is the accounting board that has responsibility for this. So, I think there's some pressure on the chairman of the PCAOB to give that 30-day notice and say, you guys gotta get your accounting straight right now. I'm also sure, uh Secretary of the Treasury Yellen has the authority to do that as well.

Simone Gao:

Right. Right. I mean, maybe in the short-term, they hate, they hurt the U.S. Investors, but in the long run, this would definitely prevent them from investing in China anymore, I think. But anyway thank you so much, Secretary Krach. Do you have anything else to add?

Keith Krach:

Well, I guess one last thing Simone. You know, the free world has not only looked the other way from the Communist China crimes for way too long, but we finance them by providing them access to our capital markets. And we not only sent over a treasure trove of our best investment bankers, lawyers, money managers, private equity investors, and venture capitalists, but we funded China, Inc. Through our pension funds, university, endowments, foundations, mutual funds, bond portfolios. And most these Chinese companies are tied to the CCP. Practically all of them. And especially with military-civil fusion and with their national intelligence law. I can tell you as a former CEO of public companies and the chairman of the board of Purdue these boards in various institutions, have a moral obligation and a fiduciary duty to disclose Chinese holdings and divest from companies enabling human rights violations.

Keith Krach:

As Under Secretary of State I directed this communication with three separate letters. And I think that was really important. One to the CEOs of American companies, the other, the university governing boards and the third, civil society organizations. And so at a minimum, they should disclose the Chinese stocks they're invested in. And I think the Didi debacle is the latest sign that investing in China stocks is not worth the risk. Many investors who were hot about Didi got burned just like they got burned with Luckin Coffee, but even in a bigger way. Simone, my hats off to President Biden for institutionalizing capital markets sanctions, and really picking up in a lot of the areas where we left off. It's just so important, because we've been funding this Chinese military machine, as well as their surveillance state that has enabled genocide.

Keith Krach:

I think in three important companies. I would add to that OFAC list, that capital market sanction list. And that would be the big three: Alibaba, Tencent and Baidu. Because these three companies are the most strategic companies to the Chinese military's AI programs. They're also the backbone of this surveillance state, along with Huawei. And I think we've got to, we've got to do something there with those. And finally, I think it's really important that we have continuity of policy, so that companies that are on the commerce entity list, that means we cannot export technology to them, that those go on the capital market sanctions list. It just doesn't make sense. And we did a comparison of those two lists you know, just a few months ago, back in January, and of the 500 Chinese companies that are on the entity list that we couldn't export to, only seven of those are on the OFAC list. So, I think we need continuity of policy there, and particularly these companies that just got put on the commerce entity list that are enabling the genocide and human rights abuses in Xinjiang, and my hats off to President Biden for putting them on the list as well. They should go on that OFAC list.

Simone Gao:

Right. Those two lists from, from the State Department and the Commerce Department should definitely be synchronized. I mean, this is a problem that people have been talking about for a long time. Hopefully, it will be solved soon. Thank you so much, Mr. Secretary, and thank you for joining Zooming In today.

Keith Krach:

Alright, Simone. Thanks very much.

Simone Gao:

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