Prepared By: Adam M. Pener, Senior Analyst, William J. Casey Institute of the Center for Security Policy

In March, 2001, the U.S.-China Commission (USCC) commissioned a study examining China’s broad funding requirements and practices, its presence in the U.S. debt and equity markets and other issues pertaining to capital markets transparency and security. The final version of this report, prepared by Adam Pener of the William J. Casey Institute of the Center for Security Policy, is the most comprehensive study of this new national security issue area to date. The release of these recommendations are intended to contribute to the USCC’s hearing of 6 December, 2001 on “China’s Capital Requirements and U.S. Capital Markets.”

The report, entitled “Capital Markets Transparency and Security: The Nexus Between U.S.-China Security Relations and America’s Capital Markets,” was presented to the Commission on June 29, 2001 and included the following recommended actions that could be undertaken by the Commission and the federal government with respect to this emerging security portfolio:

Federal Government

• Undertake a Comprehensive Study of Capital Markets Transparency and Security Issues
• Preserve SEC Rule Change and New Disclosure “Process Biases” Embodied in May 8 2001 SEC Letter to Rep. Frank Wolf (R-VA)
• Establish an Interagency Capital Markets Review Committee or Working Group
• Call for an OECD Study of Capital Markets Transparency and Security and the Harmonization of at Least Some Key Disclosure Requirements
• Conduct a Congressional Review of SEC Exemptions and Offshore Funding Processes
• Initiate a Public-Private Sector Partnership to Educate U.S. Fund Managers and Investors

U.S.-China Commission

• Review China’s Fundraising Activities in International Capital Markets
• Study the Merits and Limitations of Capital Markets Sanctions for Egregious Wrong-doing

These recommendations were excluded from the final version of the report released to the public in October so that Commissioners would have the opportunity to further consider these potential next steps. The final version of the report may be viewed on the USCC web-site (uscc.gov, under “Research Papers”). Below are brief explanations of these recommended actions.

“Next Steps” (as presented on page 75)

The field of capital markets security has only recently been introduced to America’s policy-making community. The funding patterns of global “bad actors” and those governments that may be judged to be potential adversaries of the United States are not sufficiently understood. Similarly, the functioning of America’s capital markets has never before been viewed through a national security lens. These shortcomings must be rapidly redressed.

While official Washington struggles to get a handle on the complexities of this 21st century issue area, NGO’s, some Members of Congress and other activists will likely continue to oppose certain foreign offerings that do not reflect their fundamental values and perceptions of U.S. national interests. At the same time, the fundraising activities of global “bad actors” continue to escalate, especially as the markets grow more receptive to higher yield emerging market securities.

There remain a number of immediate steps that could be undertaken by the federal government to strengthen transparency and disclosure requirements and evaluate capital markets security. Additionally, the U.S.-China Commission can play an important role in raising Congressional and national awareness regarding the PRC’s fundraising activities and offering non-disruptive policy prescriptions to relevant legislative committees and government agencies.

Federal Government

Undertake a Comprehensive Study of Capital Markets Transparency and Security Issues

In addition to examining the extent to which global “bad actors” have already penetrated the U.S. capital markets, such a study might include a detailed analysis of the funding efforts of governments -- and companies from countries -- considered to be prospective adversaries of the United States. Special attention may be given to China’s state-owned enterprises, “red chips” and other funding vehicles that help finance that country’s economic growth. Such a study could also include a review of those processes, laws and regulations governing the U.S. capital markets as well as those funding venues and exemptions that may be utilized by “bad actors” to raise funds from unwitting American investors.

The government would likewise be well-advised to understand more fully the impact of pressure campaigns by U.S. NGO’s and the broader trends of “socially-responsible investing,” both of which can significantly sway the markets and have shown escalating intensity and sophistication. Moreover, the potential effectiveness of capital markets sanctions in particularly egregious circumstances requires treatment by experts.

Preserve SEC Rule Change and New Disclosure “Process Biases” Embodied in the May 8, 2001 SEC Letter to Representative Frank Wolf (R-VA)

The operations of foreign registrants in countries under OFAC sanctions regimes have been deemed by the professional staff of the SEC to represent material risks to investors. New SEC “process biases” were formulated in response to this determination and are a critical step in assuring that the U.S. investor community is provided adequate information regarding certain global activities of foreign registrants. Any effort by some in the Administration, Congress or SEC Chairman-designate Harvey Pitt to dilute or dismantle these prudent new measures should be opposed. Should there be any slippage in these SEC measures, legislation should be enacted that embodies the findings of Acting SEC Chairman Laura Unger and her senior staff, as outlined in Ms. Unger’s letter to Representative Frank Wolf of May 8, 2000. The SEC should further seek to effect immediately the rule change requiring foreign registrants to file electronically on the SEC’s “EDGAR” system.

Establish an Interagency Capital Markets Review Committee or Working Group

The Administration should be urged to create an interagency review mechanism for those foreign registrants (and their subsidiaries, affiliates or parent companies) that are doing business in U.S.-sanctioned countries or are otherwise engaged in activities that are potentially harmful to U.S. security interests. Such a body could be co-chaired by NSC and Treasury -- to ensure the proper integration of security and financial considerations -- and include representatives from the Departments of Defense, Justice and State as well as the CIA. This type of interagency working group could be modeled after the Committee on Foreign Investment in the United States (CFIUS) which convenes on rare occasions to review the security implications of prospective acquisitions of militarily-sensitive U.S. companies by foreign firms. In those exceptional cases where this country’s vital interests could be compromised by the U.S.-based fundraising activities of a foreign entity, an interagency group should be empowered to make recommendations to the President on proposed remedial actions.

Call for an OECD Study of Capital Markets Transparency and Security and the Harmonization of Key Disclosure Requirements

Due to the globalization of finance, the evermore sophisticated fundraising activities of dubious companies and governments will eventually require multinational attention. The United States should take the lead in raising this issue with other OECD countries. To this end, the harmonization of U.S. disclosure requirements should be a subject of discussion at G-7 Finance Ministerials and the Head of State summit next year in Ottawa, Canada. The OECD should also conduct its own study of problematic entities funding themselves in global markets.

Conduct a Congressional Review of SEC Exemptions and Offshore Funding Processes

The appropriate Congressional committees should undertake a thorough review of those SEC rules and regulations that facilitate the capital raising activities of suspected global “bad actors” in our markets on a less transparent basis. Specifically, SEC Rule 144 (a) and other exemptions that allow foreign entities to access U.S. institutional investors without adhering to rigorous U.S. disclosure requirements merit review. Similarly, the impact of globalization on the capital markets should be treated from a security and “investor protection” perspective.

Initiate a Public-Private Sector Partnership to Educate U.S. Fund Managers and Investors

The risks to investors posed by national security, human rights and religious freedom concerns are not yet properly understood by this country’s fund managers and institutional investors. The SEC, along with other relevant federal agencies, should seek to educate the financial community with respect to these new risk factors. Due diligence assessments by U.S. pension and mutual funds, Wall Street underwriters and other integral market players should be expanded to include these emerging forms of political risk that have been demonstrated to exert downward pressure on the value of select foreign securities.

U.S.-China Commission

With its broad mandate to examine, among other economic issues, the security dimensions of the bilateral U.S.-China financial relationship, the Commission can play a valuable role in raising awareness to capital markets security issues and fostering a better understanding of China’s fundraising efforts in our markets.

Review China’s Fundraising Activities in International Capital Markets

The Commission should conduct interviews -- or take testimony from -- market participants that play a central role in facilitating China’s capital markets activity. This should include institutional investors that purchase Chinese securities. A review of the PRC’s past activities in the markets and those specific entities that have already tapped U.S. and other Western markets warrants further study. Particular attention should be paid to Hong Kong “red chips” and other listing vehicles for Chinese state-owned enterprises as well as the relationships between mainland companies and their Hong Kong subsidiaries or affiliates. Similarly, experts on China’s complex PLA business structure could provide useful insights with respect to Beijing’s efforts to finance portions of its robust military modernization program with overseas capital.

Study the Merits and Limitations of Capital Markets Sanctions for Egregious Wrong-doing

As stated, selective capital markets sanctions remain largely untested, but would likely prove effective if properly employed. The Commission should study the potential impact of this policy option on individual companies as well as foreign governments. If deemed appropriate, the Commission should consider “mapping out” how capital markets sanctions might be structured should the need arise.