China’s coming lawfare offensive

Jay Newman is a former senior portfolio manager at Elliott Management.

As the SEC and Federal prosecutors reflect on Elon Musk’s glass house, they’ve completely missed the house of mirrors Beijing has built under their noses. 

The myopia of US financial regulators is historical fact, but obliviousness to efforts by the Chinese Communist party — and its security and regulatory apparatus — to manipulate information flows that affect domestic and international capital markets is still surprising. 

China has accelerated the implementation of an integrated program, founded on Xi Jinping Thought, to weaponise law, with both territorial and extraterritorial effect. Expressly termed “lawfare,” this program seeks to reshape economic relations with the rest of the world, creating a capital market “with Chinese characteristics”.

Analysis by the Washington-based Foundation for Defense of Democracies signals China’s intention. The goal, foreign minister Wang Yi is quoted as saying, is make to “good use of rule-by-law as a weapon and constantly enrich and improve the legal toolbox for foreign struggles” against governments, businesses, and individuals Beijing views as insufficiently deferential. 

The central elements are China’s amended Counter-Espionage Law (2023) and new Law on Foreign Relations (2023). The old Counter-Espionage Law focused on unmasking spies. The amended law targets ordinary business practices, such as gathering information on local markets, potential partners, and competitors. While the old law sought to protect “state secrets and intelligence,” the new law adds an all-encompassing new category — “other documents, data, materials, or items related to national security or interests,” which could mean anything. 

The effect has been to make potentially radioactive any negative information about China, including its economy. As mainFT reports: 

Multiple local brokerage analysts and researchers at leading universities as well as state-run think-tanks said they had been instructed by regulators, their employers and even domestic media outlets to avoid speaking negatively about topics ranging from fears of capital flight to softening prices. Seven well-regarded economists told the Financial Times that their employers had told them some topics were off-limits for public discussion.

The Foreign Relations Law is equally sweeping, and makes clear that it targets foreigners as much as Chinese nationals. “Foreigners and foreign organisations in mainland China shall comply with Chinese law and must not endanger China’s national security, harm the societal public interest, or undermine societal public order.” 

Taken as a whole, this legal framework is already having a chilling effect. Full and frank disclosure to investors and regulators around the world is, in effect, now illegal under Chinese law. The below FDD infographic shows how the Counter-Espionage and Foreign Relations laws fit into a suite of statutes:

It’s no secret that foreign information, research, and consulting groups such as Mintz, Bain and Capvision and have been raided or otherwise targeted by Chinese authorities.

In March Deloitte was told to “learn a lesson” after being fined $31mn for what a the official investigation called “serious deficiencies” in its audit of a state-owned bad-debt manager. Employees of financial firms Franklin Templeton and BlackRock have been ordered to attend CCP lectures, per Bloomberg:

Some bank executives and business heads have to take around a third of working time to study Xi Thought, joining activities and courses, or reading four books from Xi every month, according to people familiar with the matter. Attendance is mandatory this year and they also need to submit papers on what they’ve learned.

New IPO regulations from the China Securities Regulatory Commission require that lawyers strictly implement New Overseas Listing Regulations banning negative information about China. Article 12 provides:

Securities companies, securities service agencies and personnel engaged in overseer issuance and listing of domestic enterprises . . . shall not express opinions in documents that distort or derogate national legal polities, the business environment, the judiciary, etc.

The Hong Kong Stock Exchange repealed rules requiring discussion of risks from political structure, economic environment, foreign exchange controls, enforcement of foreign court judgments, implementation of arbitration agreements, government controls distorting the allocation of capital and resources, the sustainability of economic growth, and government interference in business operations.

Recently, CSRC chair Yi Huiman announced a novel pricing method for Chinese IPOs: “valuation with Chinese characteristics.” Yang Chengchang, adviser to the State Council, explained that “valuation with Chinese characteristics” means a potential premium for industries and enterprises “closely integrated with Chinese-style modernisation”. Companies involved in biotech, AI, new energy, and electric vehicles could receive investment and valuations based on support for CCP policies, according to the FDD analysis.

The FDD report makes the case that Xi’s long-term disciplinary and counter-espionage campaign creates an information vacuum that he wants to fill with views of market conditions aligned with Party goals. The “airbrushed economy”, as Matthew Pottinger, the lead author of the report, calls it, relies on a toolkit of regulations, politically directed investment marketing, informal messaging and, ultimately, coercive lawfare. 

The SEC, not completely asleep at the switch, has advised PRC firms listed in the us that those changes put at risk the agreement worked out in August 2022 to avoid delisting of Chinese companies from us stock exchanges. The SEC reiterated in June that firms need to . . . 

.. provide more prominent, specific, and tailored disclosure about China-specific matters so that investors have the material information they need to make informed investment and voting decisions.

Those risk factors include:

• The percentage of shares owned by foreign government entities;

• Identification of all CCP members who are on the board of the issuer or the operating entity for the issuer;

• Material impacts that intervention or control by the PRC in the operations of these companies has or may have on their businesses or the value of their securities;

• Disclosures of material impacts of the Uyghur Forced Labor Prevention Act, including compliance risks or supply chain disruptions that companies may face if conducting operations in, or relying on counterparties conducting operations in the Xinjiang Uyghur Autonomous Region.

That’s not enough. 

Criminalisation of due diligence, censorship of research, restrictions on free speech, intrusion into investment decision-making, and control of data mean PRC and US regulators are diametrically opposed. Hong Kong and mainland lawyers, bankers, and their fundraising clients can choose to observe PRC restrictions, or US rules. They can’t do both.

Chinese companies have gone dark. Investors cannot assess the financial condition of Chinese companies, or Western companies with Chinese operations, that adopt Chinese characteristics. Soon, the SEC will be forced — perhaps by Congress, if SEC leadership won’t act — to summarily delist Chinese entities.

The alternative could be continuation of the SEC’s de facto subordination to PRC regulators. PRC lawfare requires fealty from all companies with Chinese operations. The cost of non-compliance is high — in some cases it may be existential. Companies that fulfil their SEC mandate to disclose PRC risk factors could face harassment or the destruction of their in-country operations for failing to comply with the PRC’s suite of new laws. 

Western corporate boards of directors face stark choices. Do they face up to the reality of Chinese rules, stop investing and write-off existing investments? Or do they roll the dice, double down — like Micron, Tesla and Apple have done — and risk multimillion dollar fines and liability? Shareholder derivative lawyers: sharpen your knives.

If the CCP wages lawfare on Western companies, as now appears likely, the economic fallout will be massive. The SEC will either set and enforce high standards for transparency and disclosure, or bow to China’s strict requirements for opacity and government fiat. 

“If the SEC doesn’t challenge Beijing’s primacy,” Pottinger, a former US deputy national security adviser, told me, “it will end up like an airport X-ray machine operator who is good at spotting nail clippers, but misses the suitcase bombs that could bring down planes.” 

Further reading:
— The dangerous game of floating by China’s new rules (FTAV)