GSX Techedu is a Chinese private tutoring company, that is listed on the New York Stock Exchange.
At its peak in January, it had a market Cap of around 37 billion dollars, it has since fallen 98%
and is worth 370 million dollars. So, what went wrong? Well back in July, the Chinese government
banned the private tuition industry from making profits – which is bad, and that crashed the share
prices of all the major tutoring companies. Not everyone lost money in the fall though,
back in March executives at the company sold $119 million worth of their U.S-listed shares
through a shell company that was holding shares for executives.
They did this just three days after President Xi called tutoring a “stubborn malady.”
that was putting too much pressure on Chinese children and their parents.
Today, that 119 million dollar block of shares would only be worth around $4m.
Larry Chen, the companies CEO who does not appear to be linked to that actual $119 million dollar
sale, publicly expressed confidence in the business at the time, additionally he promised
to buy $50m worth of shares with his own money. So far, he does not appear to have bought any.
In an article published by the Financial Times earlier this week, the journalists found that
dozens of Chinese business executives managed to sell stock in their US listed companies
right as Beijing began its attacks on their businesses. It is probably somewhat
reasonable to believe that executives within these companies knew that the government in Beijing was
unhappy with them, and that this would not be good for their companies stock price.
In the run-up to the order from the Chinese Government banning profits
in the education sector, executives at another Chinese education company
also cashed in their New York listed shares. According to the Financial Times, the team who
co-founded the online tutoring platform 51Talk began selling shares on April 1 (good choice
of date) and sold blocks of shares roughly every other day through to the end of June.
Their sales made up almost half of the traded shares on some days over
that period. By the time Beijing announced its new regulations, they had cashed out $4.3m.
The documents reviewed by the FT journalists show dozens of other well-timed share sales
by Chinese executives. While there is no proof of insider trading, many of the big
stock sells came ahead of regulatory action or the release of disappointing earnings reports.
If this had been done by an American company, the SEC would most likely be investigating.
We have seen a lot of news in the last few days that Elon Musk and his brother (Cowboy Elon) both
sold large blocks of Tesla shares which came to over $5bn in the first three days of this week,
we know this because the transactions were disclosed on a SEC form 4. This is a document
that must be filed with the SEC whenever there is a material change in the holdings
of company insiders – at some point in the future maybe tweeting about a
big stock sale will be sufficient, but for now there is paperwork required.
Disclosure of insider trades is mandatory and becomes public record once filed with the SEC.
So, how did the journalists at the FT work out that there had been these big well-timed stock
sales from the Chinese Executives of New York listed firms? You might guess that they just
went to the SEC website and looked up which forms had been filed. After all, these forms are filed
electronically with the SEC and are then made freely available to the public online. Well,
the reason that the trades by Chinese executives mostly went unnoticed is that dual listed foreign
firms are held to different reporting standards by the SEC, and this might be a bit of a problem
as a lot of American investors are unaware of this. For example, instead of filing 10K forms,
Non-Canadian foreign firms with a US listing where less than half of the voting shares are
held by Americans file a Form 20F, where the information requirements are not as strict
as the requirements for domestic U.S. companies. When it comes to corporate insiders selling stock,
US executives must report share sales to the SEC within two days. But executives at
foreign companies that are listed in the US often only report their total
shareholding once or twice a year, or not at all, depending on the size of their position.
Not only that, but large Chinese companies like Alibaba have used the fact that they have to meet
US listing requirements to gain exemptions in Hong Kong where they are also listed,
arguing that any additional disclosure to Hong Kong regulators is “unduly
burdensome” on their “corporate insiders”. In the US, under Rule 144, foreign executives
have to report when they initiate plans to sell restricted stock either by uploading documents to
EDGAR, the main disclosure system, or by mail. So obviously you would upload the documents, right?
Well, nearly all of the executives in question filed by mail, and the SEC then provide access
to these paper documents in their Washington DC reading room, they don’t just scan them
and upload them to EDGAR – the website. Since last April, the SEC has started also
accepting email notifications, but once again does not upload these to EDGAR.
The SEC is considering changing its rules to mandate that all Form 144s be filed to EDGAR.
To add further to the confusion, some Chinese tech executives use shell companies to hold
their shares and conceal their identities. Something that American Executives can not do.
As we saw earlier the private tutoring company where executives sold their stock
right before the company tanked, did this through a shell company.
A top Alibaba executive is reported to have used a Bahamas shell company
called Sky Scraper Enterprises Ltd to sell his shares. Sky Scraper allegedly
planned to sell as much as $155m worth of shares in the weeks around the planned IPO of Alibaba’s
sister company Ant Group, but had to cancel the plan after Beijing blocked the Ant IPO.
The FT gives additional examples of how in 2016 and 2017, the chief executives of New York-listed
Cheetah Mobile and Tarena International initiated the sale of shares worth as much
as $31m and $10m a few weeks before reporting quarterly results that sent their share prices
down 30 per cent and 24 per cent, respectively. Both executives had adopted their trading plans
at the end of the quarter, meaning that it might be reasonable to believe they knew that the
bad news was coming. This would be classified as material non-public information under US rules and
most likely be ruled as illegal insider trading. So what are the problems here and what can be
done? The biggest issue is that there are two different rule books, one for US listed American
and Canadian Companies, and another for foreign companies that list their shares on US exchanges,
and many investors are not aware of this difference. An example being the way that a lot
of US Listed Chinese companies give no shareholder rights to investors who buy the US listed shares,
as those shares do not confer ownership in the Chinese company, they give investors
ownership in a Cayman Shell Company – known as a variable interest entity which has a contract
with the large Chinese company- which could easily be declared illegal under Chinese law,
leaving investors with nothing. I made a YouTube Short a while ago explaining that structure.
The risks of these Variable Interest Entities, is of course disclosed in the IPO prospectus,
a document that very few investors read after the IPO has occurred. When you go
into your brokerage account or look online to read the description of these stocks,
you read all about the Chinese Company – the description of Alibaba tells you that
“The Company operates four business segments. The Core Commerce segment provides China retail, China
wholesale, International retail, International wholesale, and so on. That is a fine description
of the Chinese company that you are not buying shares in – and that foreigners specifically can’t
buy under Chinese law. It should possibly instead describe the Cayman shell company
that has no assets and has a contract (which may not be legal under Chinese Law – and could be
cancelled at any point in time) with Alibaba – an ecommerce company to pass on some of the profits.
If Americans want to invest in penny stocks which are shares in small companies that trade for less
than $5 per share there are special rules. Your broker gets you to read and sign off on
a standardized disclosure document that explains the risks associated with buying penny stocks,
your customer rights, and the solutions in cases of fraud. The broker also has to approve the
investor's transaction and make sure that the investment is suitable for that investor. It
might make sense for there to be similar rules where the risks of US listed foreign stocks,
where the companies are held to different reporting standards than domestic stocks
be clearly explained to investors in a similar manner before they invest.
The disclosure approach is something that has worked in the past, but possibly worked better
when people dealt directly with other people. The problem with these disclosures today is
that we are so used to quickly accepting terms of service from software companies
without reading them at all that if investors had to sign off on a risk disclosure in their
brokerage account, they would likely quickly scroll to the end and click the accept button
without reading or understanding anything. I’d love to hear your thoughts in the comments
section as to how the system could be approved. In May 2020 The US Senate approved new legislation
that could lead to Chinese companies such as Alibaba and Baidu possibly being delisted from
U.S. stock exchanges. The law would require them to show that they are not under the control of a
foreign government. It also requires that foreign companies listed on a US exchange be audited by
the Public Company Accounting Oversight Board – like all American companies are.
I made a video about that regulation at the time, and here
is a link if you want to watch that video next. Have a great weekend and talk to you soon, bye.