Listing on U.S. equity markets has long been the ultimate ambition for many Chinese companies, but in the wake of recent probes and scandals, that goal is becoming more illusory as regulators give greater scrutiny to companies vying for U.S. listings as well as those already listed on the exchanges.
While Nasdaq-listed iQIYI – known as China's Netflix – announced in August that it faced a probe by regulators after analyst firm Wolfpack alleged up to 44 percent inflation of revenues, Luckin Coffee Inc. was caught in a financial scandal and delisted from the Nasdaq on June 29 after admitting to fabricating $310 million in bogus transactions. These two high-profile cases could merely be the tip of the iceberg since according to the U.S.-China Economic and Security Review Commission (USCESRC), nearly half of the Chinese companies that have listed on U.S. exchanges have not undergone Public Company Accounting Oversight Board (PCAOB) supervision.
Although U.S. investors were showing an appetite for Chinese stocks and IPOs, the climate had begun cooling even before the various accounting scandals surfaced.
As of 2019, there were 156 Chinese companies listed on U.S. exchanges, with a total market capitalization of $1.2 trillion – down from $1.8 trillion in 2018. At least 11 of these companies were state-owned enterprises, according to the USCESRC.
Last year, 25 Chinese issuers went public in the U.S. according to Renaissance Capital, a firm that sells IPO-focused exchange-traded funds. That figure was down from 32 Chinese listings in 2018, which was the peak since 2010.
Building a Wall
President Donald Trump's aggressive trade war with China has fueled U.S. scrutiny of Chinese firms already listed in the U.S. and those seeking entry.
On May 20, the U.S. Senate passed a bill known as the Holding Foreign Companies Accountable Act that would amend the Sarbanes-Oxley Act to impose auditing requirements on foreign firms that the PCAOB is "unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction."
Under the bill, which is yet to be enacted, foreign firms would face delisting by the SEC if they do not allow the PCAOB to conduct audits on the firms for three consecutive years.
The trade war aside, U.S. lawmakers laid out their concerns over the billions of dollars of U.S. institutional investments in Chinese equity markets, including from government funds, pensions and college endowments, that they see as creating a risk of future instability.
"The estimated $84 billion of U.S. government pension fund exposure is only 14 percent of the total approximate $600 billion ... of U.S. investment in Chinese equities," said Louis Y. Lau, an investment director at Brandes Investment Partners in San Diego, who added that the $600 billion invested in Chinese equities is "14-18 percent of free float and 7-9 percent of Chinese market cap."
Compliance in Non-compliance
On June 4, the White House issued a presidential memorandum calling for "firm, orderly action to end the Chinese practice of flouting American transparency requirements without negatively affecting American investors and financial markets."
The memorandum called on the the government's Working Group for Financial Markets (PWG), including the SEC chairman, to more closely to monitor Chinese firms listed on U.S. exchanges, in part by giving the PCAOB access to such firms' auditing records.
"We are waiting to see the language of the legislation. It seems to be broad strokes with very few details of how to parse the various participants in the market," said Liza Mark, the chief representative partner for the Shanghai office of law firm Haynes and Boone referring to legislation recommended by the PWG.
New listing standards may provide a transition period until January 1, 2022 for listed companies from China and other "noncompliant" jurisdictions to come into compliance, though Mark said the magnitude of the task makes it hard, if not impossible, to comply by the deadlines. Such legislation would affect Chinese companies as well as many multinational corporations with interests in China, such as Apple, Mark added.
"Risk analysis in dealing with China-based companies goes beyond the financial reports," confided a vice president of marketing with a foreign bank in Hong Kong. "You need to develop a relationship with the business to understand the fundamentals of the company."
He said that in his decades of working in risk management on the mainland, he had learned this is a philosophy deeply ingrained in Chinese cultue and in the operation of the Chinese government and business entities. He emphasized that transparency is not something Western governments can mandate, because that is not how business operates in China.
He also noted that Chinese markets are heavily populated by retail investors who are less concerned with accounting than Western institutional investors, which is why fabrications by companies like Luckin occur, and are, in fact, somewhat tolerated.
"Chinese companies, especially those with overseas ambitions, have accelerated their risk management strategies, in part due to the concern of being non-compliant and exposed and also in part to remain competitive amongst industry peers," said Tim Klatte, a partner at Grant Thornton Shanghai and the chairman of the Shanghai AmCham Ethics and Compliance Committee. "The regulatory environment continues to tighten, which is positive overall for the market, as a new standard has been set, and the bar continues to rise for overseas listing requirements."
According to Klatte, this has resulted in companies aggressively hiring ethics and compliance experts to review existing controls and proactively align with industry standards for anti-fraud, anti-corruption policies.
One Company, Two Listings
Though change is happening in China, it is a slow process, and Chinese law would have to be amended for American depository receipt companies to be subjected to accounting oversight in the United States, said Lau. Therefore the tension between Washington and Beijing may drive many companies to delist on their own.
Meanwhile, Alibaba and other Chinese companies have opted for secondary listings in Hong Kong. Lau said he expects even more Chinese companies to relist in Hong Kong or in China's A share market rather than comply with U.S. accounting requirements.
"Chinese regulators can also argue that relisting at home can give domestic investors a chance to invest in some of their fastest-growing companies," Lau said, "as most ordinary Chinese aren't able to invest in overseas markets easily."
Added Mark, of Haynes and Boone law firm: "As the U.S. moves to shut down access to its markets, Chinese firms need alternate capital markets."
"They need to provide stability for their investor base."