Some big-name Chinese stocks are facing the prospect of getting booted from the New York Stock Exchange and Nasdaq if they refuse to let US regulators see their financial audits. A revived effort by the US Securities and Exchange Commission (SEC) to gain access to audits of overseas companies that began under former President Donald Trump is continuing under President Joe Biden. Alibaba Group Holding and Baidu are among 200-plus companies in the regulator’s crosshairs, and although the process has years to play out, investors have started to pay attention.
1. Why does the US want access to audits?
The 2002 Sarbanes-Oxley Act, enacted in the wake of the Enron Corp. accounting scandal, required that all public companies have their audits inspected by the US Public Company Accounting Oversight Board. In the ensuing two decades of negotiations, China has refused to grant access. The long-simmering account- ing issue morphed into a political one as tensions between Washington and Beijing ratcheted up during the Trump administration. The Chinese chain Luckin Coffee, which was listed on Nasdaq, was found to have intentionally fabricated a chunk of its 2019 revenue. The following year —in a rare bipartisan move — Congress moved to force US-listed companies based in China and Hong Kong to finally allow inspections.
2. Where does it stand?
As required by the law, known as the Holding Foreign Companies Accountable Act (HFCAA), the SEC has started publishing its “provisional list” of companies identified as running afoul of the requirements. While the move had long been telegraphed, the first release in early March fuelled a sharp decline in US shares from companies based in China and Hong Kong as it dashed hopes for some kind of compromise. China’s securities regulator issued a statement saying “positive progress” had been made in talks while reaffirming its opposition to what it called “politicising securities regulation.” The SEC is compelled by law to press ahead, and its chair Gary Gensler has pledged to enforce the three-year deadline for Chinese firms to permit the inspections. “The path is clear,” Gensler told Bloomberg News in an August 2021 interview. “The clock is ticking.”
3. What’s the broader issue?
See also: Spilling the beans on the cost of Brexit
Critics say Chinese companies enjoy the trading privileges of a market economy — including access to US stock exchanges — while receiving government support and operating in an opaque system. In addition to inspecting audits, the HFCAA also requires foreign companies to disclose if they are controlled by a govern- ment. Meanwhile, the SEC is also demanding that investors re- ceive more information about the structure and risks associated with the shell companies, which are known as variable interest entities (VIEs), that Chinese companies use to list stocks in New York. Since July last year, the SEC has refused to greenlight new listings. Gensler has also said more than 250 companies already trading will face similar requirements.
4. Why don’t Chinese firms share their audits with the PCAOB?
They say Chinese national security law prohibits them from turn- ing over audit papers to US regulators. According to the SEC, more than 50 jurisdictions work with the PCAOB to allow the required inspections, two historically have not: China and Hong Kong.
See also: Marvel's latest movie will show if superheroes ever get tired
5. How soon could Chinese companies be delisted?
Nothing is going to happen this year or even in 2023 — which explains why markets initially took the possibility in stride. Un- der the HFCAA, a company would be delisted only after three consecutive years of non-compliance with audit inspections. It could return by certifying that it had retained a registered pub- lic accounting firm approved by the SEC. However, when the SEC actually started publishing firms’ names, the market react- ed sharply. For example, the Nasdaq Golden Dragon China Index plunged 18% during the week ended March 11, after the agency released the first five names.
6. How are they added?
It is a rolling process and a function of when companies report their annual financials and an auditing firm that the PCAOB has identified as being non-compliant. For example, fast food company Yum! China Holdings reported on Feb 8 in New York, and it was added March 8.
7. Ultimately, how many will be affected?
There is not much discretion. If a company from China or Hong Kong trades in the US and files an annual report, it will be on this list soon because these have been identified as non-compliant jurisdictions. In all, the PCAOB has said it has blocked from reviewing the audits of more than 200 companies based in China or Hong Kong, including Alibaba, PetroChina, Baidu and JD.com. All of them are expected to be on that list in the next few months. Chinese companies traded in the US have a combined market capi- talisation of hundreds of billions of dollars.
8. Are some of them really controlled by China’s government?
For more stories about where money flows, click here for Capital Section
Major private firms like Alibaba could probably argue that they are not, although others with substantial state ownership may have a harder time. As of May last year, the US-China Economic and Security Review Commission, which reports to Congress, counted eight “national-level Chinese state-owned enterprises” listed on major US exchanges.
9. Why do Chinese companies list in the US?
They are attracted by the liquidity and deep investor base of US capital markets. They offer access to a much bigger and less volatile pool of capital, in a potentially speedier time frame. China’s own markets, while giant-sized, remain relatively underdeveloped. Fundraising for even quality companies can take months in a financial system that is constrained by state-owned lenders. Dozens of firms pulled planned IPOs last year after Chinese regulators tightened listing requirements to protect the retail investors who dominate stock trad- ing, as opposed to the institutional investors and mutual-fund base active in the US. And until recently, the Hong Kong ex- change had a ban on dual-class shares, which are often used by tech entrepreneurs to keep control of their startups after going public in the US It was relaxed in 2018, prompting big listings from Alibaba, Meituan and Xiaomi.
10. How has China responded?
In December, China unveiled new rules that require all companies seeking IPOs or additional share sales abroad to register with China’s securities regulator. The requirements apply to new shares only and will not affect the foreign ownership of companies already listed overseas such as Alibaba or Baidu. However, Chinese firms in industries banned from foreign investment will need to seek a waiver before proceeding for share sales and overseas investors in such companies would be forbidden from participating in management and limited in their ownership. — Bloomberg Quicktake
Cover image: Bloomberg
