Fidelity Joins Invesco and Schwab in Adding China Warnings to Funds

(Bloomberg) — Fidelity Investments joined a growing list of money managers warning of potential losses tied to some of China’s largest companies, including Alibaba Group Holding Ltd. and JD.com Inc.

The Boston-based asset manager updated prospectuses for the Strategic Advisers Fidelity Emerging Markets Fund and four exchange-traded funds this month to add a risk factor on companies structured as variable interest entities, also known as VIEs.

At least 10 other fund companies, including J.P. Morgan International Equity Funds, Invesco Ltd. and Charles Schwab Corp., have taken similar action since Gary Gensler, chairman of the U.S. Securities and Exchange Commission, in July outlined the potential pitfalls of investing in Chinese VIEs.

At issue is whether the Chinese government would one day invalidate the use of VIEs, a structure used by hundreds of mainland companies in the past two decades to circumvent restrictions on foreign ownership of technology companies. While China’s securities regulator issued rules in late December that provide a road map for future overseas stock sales, some uncertainty still remains surrounding those — such as Alibaba and JD.com — that have already gone public in the U.S. Both firms are listed in New York.

The new rules were “intended to resolve this ambiguity,” said Ian Liao, a partner with YK Law in Los Angeles who advises clients on cross-border transactions involving China. “I don’t know if it gets us all the way there yet.”

Until now, Chinese companies have skirted the local prohibitions by setting up entities in offshore locations such as the Cayman Islands that then list their stocks overseas. Many experts have said that foreign investors are at risk because their ownership and economic rights are based on contractual arrangements between the VIEs and their operating companies that violate Chinese law and thus could prove unenforceable.

Chinese companies that go public in the U.S. typically discuss these legal risks in the disclosure documents for their stock sales, Liao said. Most mutual funds only began to do so after Gensler said in the July statement that he worries “average investors may not realize that they hold stock in a shell company” rather than an actual business in China.

The latest warning came from Fidelity in filings this month under the heading “Special considerations regarding China.” Fidelity added language to the prospectus for the emerging markets fund and the ETFs citing the risk that VIE contractual arrangements may not be enforceable under Chinese law.

“If these risks materialize,” Fidelity said in the filing, “the value of investments in VIEs could be adversely affected and a fund could incur significant losses with no recourse available.”

The moves also come as Chinese authorities crack down on the country’s technology sector, particularly companies listed overseas.

Days after ride-hailing firm Didi Global Inc.’s $4.4 billion IPO, China shocked investors in July by announcing it was investigating the company and ordered its services be taken off Chinese app stores, tanking the company’s shares. Didi said earlier this month that it would remove its American depositary shares from the New York Stock Exchange and pursue a listing in Hong Kong.

The heightened scrutiny by Chinese regulators has been echoed by their U.S. counterparts. The SEC last month announced its final plan for putting in place a new law that mandates foreign companies open their books to U.S. scrutiny or risk being kicked off the New York Stock Exchange and Nasdaq within three years. China and Hong Kong are the only two jurisdictions that refuse to allow the inspections despite Washington requiring them since 2002.