Disclosing China's Corruption Risks: A Securities Regulation Perspective

TABLE OF CONTENTS INTRODUCTION I. REGULATING CORRUPTION RISKS THROUGH INFORMATION DISCLOSURE II. THE STANDARD-BASED DISCLOSURE REQUIREMENT FOR CORRUPTION RISKS III. DEFICIENT DISCLOSURE A. Who Discloses? B. Who Does Not Disclose? C. A "Semi-Pooling" Equilibrium IV. PRACTICAL CHALLENGES IN DISCLOSURE DRAFTING A. Issuer Disincentives B. Lack of Due Diligence Opportunities C. Market Norm and Group Think V. CUTTING THE GORDIAN KNOT WITH A RULE-BASED DISCLOSURE REQUIREMENT VI. POSSIBLE OBJECTIONS TO THE RULE-BASED APPROACH A. Just Another Example of Lawyers Asking for Useless Additional Disclosures? B. Cost Matters? C. Isn't the Current Requirement for Reporting on Internal Controls Sufficient? D. Is a Chinese Problem Worth a General Rule of U.S. Securities Regulation? CONCLUSION INTRODUCTION Corruption has long been understood as a pervasive problem plaguing China's business environment. (1) The country ranked 80th on the latest annual Corruption Perception Index published by Transparency International in 2013, lower than Brazil and South Africa. (2) A high degree of government involvement in economic affairs and a business culture emphasizing personal ties and informal relationships are believed to have contributed to widespread corrupt practices, which continue to pose significant challenges to foreign corporations with investment and operations on the ground. (3) A long list of high profile multinationals implicated in corruption scandals in China (4) has in recent months included big names such as Avon Products, Inc., GlaxoSmithKline pic, and J.P. Morgan Chase & Co. (5) Even without conducting business in China or with Chinese counterparties, investors may become exposed to China's corruption risks by investing in securities issued by Chinese or "China-based" companies. (6) Corruption risks may affect securities investors in multiple ways. The eruption of corruption and fraud scandals involving China-based companies could lead to market volatility and trading disruption in the companies' securities. (7) Enforcement actions under Chinese laws and extraterritorially applied anti-corruption laws, such as the Foreign Corrupt Practices Act (the FCPA), generally have a significantly negative impact on a company's normal operations and business prospects and consequently on its investment value. (8) Those companies that strive to comply with applicable anti-corruption laws may also see their competitiveness and profitability reduced if their competitors engage in corrupt business practices. (9) Although the latest wave of accounting scandals, shareholder litigation, and regulatory actions led to the delisting and deregistration of dozens of China-based companies, (10) the total count of China-based companies registered with the United States Securities and Exchange Commission (the SEC) likely remains over 200. (11) Beyond the public offering market, many China-based companies have also gained access to massive amounts of U.S. capital over the past decade through exempted global offerings of securities under Rule 144A and Regulation S. (12) Absent dramatic changes in China's domestic capital markets, U.S. investors and regulators should continue to expect a sizable flow of transactions in securities of China-based companies reaching the U.S. market. [13] China-based securities scandals have so far mainly concerned accounting irregularities as opposed to pure corruption violations. As illustrated in the latest shareholder suits arising from the corruption investigation of PetroChina, (14) however, the continuously intensifying anticorruption campaign that China's current leadership is implementing (15) may cause more corruption-related scandals to be exposed, to the detriment of issuers and investors. (16) To protect investors, United States regulators should examine whether existing regulations suffice to protect against the corruption risks associated with China-based securities. …