INSIGHTS | What’s at stake in fight over delisting Chinese firms

Everyone can see that the diplomatic, economic, and trade relationship between the United States and China is deteriorating. A subset of the issues plaguing the relationship stem from recent fraudulent behavior from Chinese companies listed in US markets.

Washington is trying to fight the opacity of these publicly traded Chinese firms to protect US investors, in part spurred by revelations of Luckin Coffee’s fraudulent behavior earlier this year. The last month has seen the SEC open investigations into two more US-listed Chinese tech companies, while US politicians are considering a delisting ultimatum to force Chinese companies to provide more information to regulators.

Bottom line: US authorities have long complained about their ability to scrutinize Chinese companies’ books, but China’s rules don’t clearly forbid it and SEC investigations into Iqiyi and GSX Techedu could be a chance to make a deal. Nothing is set in stone (or law) yet, but Chinese companies are already moving to what is, perhaps, a better home for them: Hong Kong.

Foreign vs. domestic filers: Foreign firms listed in the US have different listing requirements than domestic firms, and have for a long time. For example, foreign filers are not required to file quarterly reports, many companies do file them anyway, but they aren’t required by the SEC. Foreign filers also don’t have to disclose executive compensation in proxy statements because proxy statements are not required, nor are insider sales (Section 16 filings). Currently the PCAOB does not have an agreement with Chinese authorities allowing for oversight of US-listed Chinese company auditors.

Why tighten regulations now? I believe it is driven by retail investor losses from Luckin Coffee, the extent of that fraud, and the large amount of press coverage Luckin Coffee enjoyed as the “Starbucks challenger,” and DC taking a more hawkish turn on China in recent years.

A brief timeline

US-listed Chinese equities have had a rough time in 2020.

• Jan. 31: Anonymous short report on Luckin Coffee claims the coffee startup inflated sales by more than 69%  in Q3 2019 and 88% in Q4 of the same year.
• April 2: Luckin Coffee admits to falsifying almost RMB 2.2 billion in sales.
• April 6: Wolfpack Research short report on Iqiyi, accusing the streaming service of revenue fraud.
• May 20: Holding Foreign Companies Accountable Act (HFCA) passes in the Senate.
• Aug. 6: President’s Working Group (PWG) press release and report are released by the Treasury Department.
• Aug. 13: Iqiyi discloses SEC investigation, shares tumble.
• Sept. 2: GSX Techedu discloses SEC investigation, shares tumble.

The proposed regulatory environment

The HFCA bill: Per the Congressional Research Service’s summary, the bill would require that:

1. Publicly listed companies must establish they are not owned or controlled by a foreign government.
2. They must declare whether their auditor is subject to Public Company Accounting Oversight Board (PCAOB)  inspection.
3. Companies are given three years of non-inspection by the PCAOB, and then they are banned from trade on US exchanges, if they are not properly inspected.
4. If a company’s auditor is not subject to oversight by PCAOB, then it must disclose the percentage of shares owned by governmental entities, whether the governmental entities have a controlling financial interest, information on any board members who are officials of the Chinese Communist Party (CCP), and whether the articles of incorporation contain any “charter of the CCP.”

The PWG report: The working group is an advisory group convened by the president. It’s made a series of recommendations, mostly for the SEC, to adopt similar rules, but on a tighter deadline:

• Enhanced listing requirements that guarantee access to audit working papers.
• A suite of extra disclosures and guidance meant to shed light on the risks of investing in non-cooperating jurisdictions.
• Currently listed companies have until Jan. 1, 2022 to comply, and new listings (IPOs) must comply before trading.

The PCAOB: The regulator at the center of the conflict is a relatively young body that specializes in overseeing the accounting firms that audit US-listed companies. It’s separate from the Securities and Exchange Commission, which enforces securities laws and regulates stocks and options and the exchanges on which they are traded.

• The PCAOB was established by Sarbanes Oxley Act of 2002, a law created in the aftermath of accounting scandals like Enron.
• The Texas energy company went bankrupt in 2001 after years of misleading shareholders. Its auditor, Arthur Andersen, was found guilty of obstructing justice for shredding documents. Its business never recovered.
• The PCAOB regularly oversees non-US auditors who work for US-listed companies. However, it complains that China does not provide the access the board needs to do effective oversight.

Unanswered questions

The grey area: Can the PCAOB inspect US-listed Chinese company books? Depends who you ask.

• Yi Huimin, the Chairman of China’s Securities Regulatory Commission, told Caixin that China has never prohibited or prevented Chinese companies from providing audit working papers to foreign regulators. He added that such information exchange should be conducted through regulatory cooperation and comply with security and confidentiality regulations.
• In their filings, Chinese companies tell a different story. Most US-listed Chinese companies disclose in their Risk Factors their auditors operating in China are “not permitted to be subject to inspection by the PCAOB” (quote from Bilibili’s filing; many others have similar language).
• So, PCAOB inspection is neither explicitly prohibited nor explicitly permitted, the proverbial “gray area.”

Could they reach a deal? Many countries’ audit oversight authorities have cooperative arrangements with the PCAOB. The agreements are signed between either an independent audit oversight authority or a securities exchange regulator.

• China doesn’t have independent audit oversight, so an agreement would likely be between the PCAOB and China’s stock market watchdog, the China Securities Regulatory Commission (CSRC). A trial joint inspection was attempted in 2017, but failed to achieve agreement.
• Maybe the current on-going SEC investigation into Iqiyi will provide an opportunity for the SEC and the CSRC to hash out the issues and cooperate. This is something I will be watching.

Unclear deadline: How much time do US-listed Chinese companies have to get compliant? Again, it depends.

• According to the HFCA: three years from whenever the law becomes effective.
• But the clock isn’t ticking yet. To become law, HFCA would need to pass the House of Representatives and be signed by the President.
• While these steps have not happened yet, they can happen in one or two days if there’s sufficient political motivation.
• According to the PWG recommendation: Jan. 1, 2022 for currently listed companies, new listings would have to comply immediately, or at least as soon as exchanges adopt the requirement.
• If the SEC and CRSC can come to a workable understanding on Iqiyi, it could bode well for all US-listed Chinese companies. In the best case, they may be able to tick the PCAOB oversight box immediately.

Early responses

Chinese firms flock to Hong Kong: Even though a tighter US regulatory environment for Chinese publicly listed companies is still under construction, Chinese tech firms have indicated their intention to move away from American markets.  

• In the last 12 months, many US-listed Chinese firms have listed or plan to list shares on the Hong Kong Exchange. Companies already listed include Alibaba (HK:9988), JD.com (HK:9618), Beigene (HK:6160) and Netease (HK:9999).
• Unlike its big brother Alibaba, Ant Group will list simultaneously in the Shanghai and Hong Kong stock exchanges, the fintech giant said in July.
• Markets speculate that more firms will follow, including Baidu, Iqiyi, Wuba, Sogou, China Distance Education, among others.

Hong Kong is a better home for these companies: Listing in the US has been popular in recent decades because of easier listing requirements, allowance of dual-class shares, a deep and liquid market, an investor base that was eager for growth and technology companies, and the fact the companies and their shareholders could receive US dollars for their shares, a global currency free of capital controls. But the Hong Kong Exchange has been improving in many areas.

• Since April 2018 Hong Kong allows dual-class share structures that are popular with technology companies. Secondary and dual-class listings will benefit from passive flows with the Hang Seng Indexes allowing them in their market indices from August 2020.
• There are also natural advantages for listing in Hong Kong. Hong Kong investors benefit from proximity to China and being embedded in Asia, making them more familiar with these markets and domestic trends. They operate in the same time zone.
• There is little-to-no language barrier for Hong Kong investors, Cantonese speakers are 96% of Hong Kong, according to Language Magazine, and they can read Mandarin.
• The Hong Kong Exchange is a deep and liquid market. The Hong Kong Dollar is still freely convertible into other currencies.

Looking ahead: Regardless of whether the SEC, PCAOB, and CSRC can reach an agreement, I expect more Chinese companies to make the move to Hong Kong, assuming convertibility of HK Dollar continues unabated. Perhaps they’ll even follow Ant Group and seek a dual Hong Kong-Shanghai listing.

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