China and the Rise of Law-Proof Insiders

Jesse M. Fried is Dane Professor of Law at Harvard Law School and Ehud Kamar is Professor of Law at Tel Aviv University Buchmann Faculty of Law. This post is based on their recent paper.

Alibaba Group Holding Limited (Alibaba), which in 2014 conducted a record-breaking initial public offering (IPO) on the New York Stock Exchange and in mid-2020 was valued at over $500 billion, is based in China but is subject to U.S. securities law and to Cayman Islands corporate law. It is one of hundreds of U.S.-listed firms that are based in China but subject only to the securities and corporate laws of other jurisdictions. In a paper recently posted on SSRN, China and the Rise of Law-Proof Insiders, we show that this arrangement renders the insiders of these firms law-proof. As a result, the law cannot prevent or deter them from expropriating substantial value from U.S. investors.

The main problem, we show, is that almost every person or thing required to enforce the law—the insiders, the insiders’ assets, the firms’ records, and the firms’ assets—is behind China’s “Great Legal Wall” and out of reach both for private plaintiffs and for public prosecutors in the United States. China cannot be expected to extradite defendants, enforce foreign judgments, allow foreigners to file claims in its courts, or even permit litigation-critical information to be shared with foreign authorities or plaintiffs’ lawyers. Enforcement is even harder when, as is typically the case for large Chinese technology companies like Alibaba, the firm domiciles in the Cayman Islands rather than in the United States. And the problem is not merely hypothetical. China-based insiders of China-based firms have expropriated billions of dollars from U.S. investors, making clear both the imperviousness of China’s Great Legal Wall and insiders’ willingness to exploit it.

Our analysis has implications for understanding the motivation and effect of cross-border listing. A popular view is that a firm lists its securities in a foreign country to bond itself and its insiders to that country’s tough disclosure and enforcement regime and thereby raise capital at a lower cost. Our analysis suggests that listing in a foreign country can have the opposite effect and purpose: insiders may list their firms solely outside their home jurisdiction to raise enforcement obstacles and make themselves legally unreachable. We further show that a firm can erect even higher barriers to enforcement by domiciling in a jurisdiction like the Cayman Islands that is home neither to the firm’s insiders nor to its investors. More generally, our work suggests that one must know the extent to which corporate-governance rules are enforceable to evaluate their effect.

Our analysis has implications also for U.S. securities regulation. We show that U.S. securities regulation oddly favors Chinese entrepreneurs taking firms public over American entrepreneurs. First, while American entrepreneurs cannot lower enforcement risk by, say, capping personal liability or eliminating certain enforcement mechanisms, Chinese entrepreneurs can do so by ensuring that key insiders and their assets, and the firm’s assets and records, remain in China. Second, while American entrepreneurs’ firms are domestic issuers subject to standard disclosure requirements, China-based and other foreign entrepreneurs can choose whether their firms will be treated as domestic issuers or as foreign private issuers required to disclose much less.

Whether this biased system harms American investors depends on the validity of a key premise underlying U.S. securities regulation: that investors cannot adequately price variations in enforcement and disclosure at the IPO. If this premise is correct, the system not only disadvantages American entrepreneurs but also likely harms American investors buying stock in China-based law-proof firms. The solution is to level the playing field up: the law should require China-based firms and other non-U.S.-based firms to demonstrate that their insiders are not law-proof as a condition for listing in the United States, and it should subject these firms to the same disclosure requirements as U.S.-based firms. Conversely, even if the premise is incorrect and the bias in the law does not harm American investors, the system still disadvantages American entrepreneurs, as they cannot choose the level of enforcement and disclosure optimal for their firms. In this case, U.S. securities regulation should allow any firm to choose its level of disclosure and enforcement at the IPO, and limit the law’s role to enforcing this choice. Either way, the law needs fixing.

While we show that China-based insiders of firms like Alibaba are law-proof, we do not claim that all or most China-based insiders will expropriate investors. These insiders may be constrained by ethical beliefs, a need to preserve their reputation, or a desire to travel or conduct business in the United States or other countries that will enforce U.S. judgments or effect extradition. Some insiders might wish to protect assets outside of China that are not easily moveable and are vulnerable to seizure. In addition, while so far China has turned a blind eye to massive expropriation of U.S. investors by Chinese residents, it may wish to prevent expropriation in the future, especially at a highly visible firm. Finally, China-based firms that go public in the United States sometimes employ legally-reachable non-Chinese nationals as directors or officers. As long as they remain in their positions, their China-based colleagues may refrain from wrongdoing to avoid jeopardizing them. Any of these constraints might provide some assurance to U.S. investors. But they are likely no substitute for the types of legal protection available to investors in U.S.-based, U.S.-listed firms. And when it comes to those forms of legal protection, we show that there is little for U.S. investors in China-based firms to rely on.

The full paper is available here.

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