New tickers for PRC companies are popping up on the NYSE and NASDAQ once again, as U.S. listings remain hot tickets. Aptly-named PRC companies like China Lodging and China Ceramics are motivated by strong regulatory factors on both sides of the Pacific. At the same time, the SEC’s review is something of a surprise, combining a mix of rigour and relaxedness, in light of complex globe-spanning corporate structures and quite concerning disclosures.

Even the Hong Kong Stock Exchange has its pitfalls, as it is considered by some to be saturated and as a result, can be challenging for smaller enterprises to compete with conglomerates. While the Hong Kong exchange is still a popular destination for mammoth enterprises such as the Bank of Communications and China Communications Construction, small to mid-sized companies from all sectors are venturing across the ocean to the United States.

Perhaps part of the attraction for some PRC companies lies in the perception of prestige, particularly for research and development firms looking to list on the NYSE or NASDAQ. For example, China Cord Blood Group and China Life Science both listed in 2009. More likely, however, the lure of U.S. listings lies in a perception by these companies of better accessibility to capital and less regulatory scrutiny, surprisingly, when compared to the PRC process. Along with a U.S. listing though comes disclosure of legal risks associated with the SEC, which have been known to heighten scrutiny of the SEC and investors alike.

As background, applications for domestic PRC enterprises to list on the Shanghai and Shenzen stock exchanges can be cumbersome and costly due in part, to long wait times and the need to obtain approval from multiple government bodies. Both domestic stock exchanges are still inaccessible to companies based anywhere outside of China. On the surface, the exclusion of foreign companies should not be a huge issue for domestic enterprises.

Perhaps surprisingly, though, a large number of PRC-related enterprises aren’t exactly domestic: Some are entities incorporated offshore but owned by PRC natural persons or non-PRC persons, making them overseas based companies and ironically, locked out of China’s stock markets. This corporate structure exists for several reasons, including the much talked about tax benefits by incorporating in certain jurisdictions. Although the Shanghai stock exchange recently announced that it had completed a set of draft rules governing the listing and trading of overseas based companies, the timeline for the implementation of these rules has yet to be confirmed and companies needing to raise capital are probably not holding their breath.

Instead of waiting for the PRC’s door to open to companies with foreign ties deemed unacceptable, many PRC companies seek out alternate forums for their public listings. Case in point, consider the complicated structure of China Education Inc., incorporated in the Cayman Islands. China Education owns a Hong Kong subsidiary, Hong Kong Frank Education Investment and Management Limited which in turn owns 100% of a PRC subsidiary Tianjin Frank Consultancy Co Ltd. All three companies are wholly owned by a British Virgin Islands parent controlled by Michael Qu, a Singapore citizen. Since foreign investment is prohibited in primary and secondary schools in China, China Education conducts its business through Tianjin Frank and its contractual partner, Management Company, a PRC enterprise which owns the schools operated by China Education Inc.

Since Tianjin Frank and Management Company are both domestic enterprises, China Education Inc, a foreign company, gains indirect access to this restricted yet lucrative market. Not all is perfect though. In its registration statement, China Education disclosed that it desperately needed to raise capital as it only had enough funds to operate for an additional 12 months. The company also admitted that it still owed approximately US$10 million for the acquisition of a piece of property.

China Education further disclosed that its relationship with Management Company is comprised purely of contractual agreements and expressed uncertainty as to the validity and enforceability of these agreements in the event of a breach by its partner. As a reason for its doubt, China Education cited the inconsistency of PRC contract law, further complicated by its corporate structure of offshore entities domiciled outside China’s jurisdiction. The company will have to wait just a little longer as its IPO filings are being reviewed by the SEC. The documents have undergone four sets of amendments since the first filing of its registration statement on December 2 2009.

Many PRC-based companies that list on the NYSE disclose risks associated with their PRC operations, which may heighten scrutiny of the SEC and investors alike. Earlier this month, China Lodging Group Ltd, a Cayman Islands-incorporated economy hotel chain with its operations in China, completed its initial public offering on the New York Stock Exchange. In its disclosure to the SEC, the company highlighted a number of risks associated with hurdles in the PRC legal system. As a requirement of PRC law, property leases should be registered with local housing bureaus. Nonetheless, China Lodging Group admitted the possibility that most of their leases had not been registered. Furthermore, the company did not hold any land use rights in which many of its hotels were situated in China. Instead, most of its hotels operated on property that was leased from third parties who either owned the land, or leased it from another party.

China Lodging Group’s description of the legal risk of the PRC doesn’t stop there: The hotelier also informed the SEC in its filings that China passed a series of amendments to its labour laws in 2008, including a mandate for written contracts between employers and employees, something that China Lodging Group blatantly stated that its current practices may not comply with. Further disclosure by the company also stated that some of its hotels were not in compliance with laws regulating construction, hygiene and safety standards. Whether China Lodging Group’s quibbles with PRC law will irk the SEC or make a strong case for a U.S. listing remains to be seen, as its registration statement is currently being reviewed.

Despite known risks stemming from issues with the PRC legal system, the SEC has given its blessing to quite a few PRC-based companies. Included in this group is Duoyuan Global Water, a British Virgin Islands company with its principal business in China’s water treatment industry. In its registration statement, filed on January 29 2010, Duoyuan disclaimed liability from distributors violating PRC anti-corruption laws or selling counterfeit products which may or may not comply with safety laws, citing an inability to “control” these distributors. The company also stated that it may or may not possess the proper business licenses for its business activities, offering up the explanation that obtaining the proper licenses is a difficult process in China.

Of particular interest in Duoyuan’s PRC-related risk factors, and somewhat unique to the region, was Douyuan’s disclosure around the company’s chairman and chief executive officer, Guo Wenhua. Mr. Guo held a controlling 54.9% stake in the company but “his interests may not be aligned with those of shareholders” regarding increasing profitability. He also held concurrent positions with other businesses. As a chairperson, Mr. Guo is subject to PRC Company Law which governs the conduct of corporate directors. Under current legislation, corporate directors are subject to two duties: the duty of loyalty and the duty of care. Neither duty is given a specific definition in the legislation, which may impute legal risk as well1. Despite this noteworthy disclosure, Duoyuan’s shares can currently be traded on the New York stock exchange.

Despite the appeal of the U.S. markets, companies under the impression that a U.S. IPO is faster and equates to less scrutiny may be sorely disappointed. As many a filer knows, the SEC review process is neither short nor cheap. For example, when China Ceramics Co. Ltd filed its registration statement for a secondary offering in February, it became the subject of rigorous SEC staff review. The regulators pushed for more disclosure asking that the company simply explanation its operational transactions to plain English and offer detailed information on disclosure such as why the use of offshore holding companies and PRC wholly foreign owned enterprises or partnerships with domestic enterprises was considered typical for international businesses in China. China Ceramics complied, offering the explanation that offshore corporate structures offered lower cost and better tax benefits. Such back and forth is quite routine with the U.S. regulator.

Although U.S. stock markets are not easily accessible, they are still favorable choices compared to domestic stock exchanges for many seeking public listings. The choice of listing venue is, without a doubt, legally strategic. In the end though, regardless of where PRC and offshore companies choose to list, securities regulators will scrutinize their initial and continued filings, leaving the company no choice but to wait and hope for approval.

1The duty of loyalty simply prohibits acts of bribery, fraud and an obligation of confidentiality. The duty of care has no definition but in the event of serious wrongdoing, a standard of strict liability has been applied in practice.