Why Are American Investors Funding Chinese Fraud?

If you think this concern is misplaced, think again.

By Christopher A. Iacovella

October 19, 2019

Wall Street’s ETF issuers and index providers have funneled billions of dollars of American investor money out of the U.S. and into Chinese companies pushing the “you can’t miss out on China growth” narrative. The problem for investors is they have no insight into whether these companies are growing, profitable, or losing money because the Chinese Communist Party (CCP) regularly asserts a national security privilege to prevent routine audits from taking place. This intentionally keeps investors in the dark and subjects them to a risk of fraud that is very real.

Why has this happened? Wall Street is using a loophole that allows Chinese companies to avoid the SEC’s rigorous company-specific disclosure and audit regulations and still be included in an index sold to investors through an ETF. Normally, ETF issuers rely on index providers to conduct diligence on each company they put into the index, but diligence in China is impossible because the Communist Party won’t allow it. This roadblock should have immediately stopped the sale of these securities to America’s retail investors. But, in true Wall Street fashion, it didn’t because the ETF issuers desperately want access to the Chinese market and the index providers bowed to a regime that pressured them to increase China’s access to global capital. As a result, neither the index providers nor the ETF issuers know whether the Chinese companies in the indexes they sold are Enron-like frauds, arms of the Chinese military, or supporting human rights abuses. 

If you think this concern is misplaced, think again. Earlier this year, Kangmei Pharmaceutical, a Chinese company included in MSCI indexes, had over $4.4 billion go “missing.” While the company called it an “accounting error,” China’s late-to-the-party regulator called it a “premeditated and malicious cheating of investors.” How many more of these companies will have their cash go missing when the CCP determines their useful life has come to an end? As more frauds emerge, it will be America’s mom-and-pop investors who get stuck holding the bag, with limited legal recourse. It defies logic to think that retail investors are exposed to this type of risk 11 years after a financial crisis triggered by asset-backed securities filled with fraudulent mortgages.  

Incredibly, the diligence failure doesn’t stop there. As if ignoring the risk of fraud isn’t bad enough, the indexes also include companies placed on the U.S. government Entity List and OFAC Sanctions List. This generally happens when a company is “acting contrary to the national security or foreign policy interests of the United States” or is a “threat to the national security, foreign policy or economy of the U.S.” Yet, American investor money continues to flow into these companies. Does that make sense to anyone, except those profiting from it? Do Americans even know that when they buy a global index ETF they could be investing in adversarial state-controlled companies like Rosneft, Gazprom, ZTE, Hikvision, or Aviation Industry Corporation of China?  

This is fiduciary malfeasance of the highest order. U.S. investors, savers, and retirees will suffer if these companies turn out to be frauds, and it’s almost certain that their money is being used to fund the buildup of China’s military and a cyber army that relentlessly attacks this country. 

The money Wall Street directed to China could have been used to fund small businesses here. America’s public companies incur an average of $1.5 million per year in compliance costs, but Chinese companies benefiting from the loophole bear none of this cost. While we believe capital should always seek out its best use, Chinese companies should no longer get a free pass from minimum audit and disclosure requirements if they want to access the American market. This change will protect investors and level the playing field for American companies competing for the same capital. 

Fortunately, this is not a partisan issue. Sen. Chuck Schumer expressed concerns in a 2013 letter to then-Treasury Secretary Jack Lew, and Sens. Marco Rubio, Jeanne Shaheen, John Kennedy, and Chris Van Hollen, along with SEC Commissioner Robert Jackson have all raised these issues more recently. We agree with their message: Investor protection and transparency in America’s capital markets must not be compromised. 

Any company that refuses to submit itself to basic regulatory scrutiny or has been sanctioned by the U.S. government must be removed from these indexes. While the rise of passive index investing has its benefits, it’s time for Washington to prioritize America’s retail investors by closing the loophole before it causes massive losses in their portfolios.

Christopher A. Iacovella is CEO of the American Securities Association.

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