Corporate Finance

Anti-Trust: The Battle Over China-Based Issuers

China-based companies are still not complying with PCAOB audit inspections. Does Congress have the answer?
Ramona DzinkowskiOctober 14, 2020
Anti-Trust: The Battle Over China-Based Issuers

In a period when China-U.S relations are fractious, it was perhaps inevitable that a perennial issue with Chinese companies listed in the United States would rear its head.

But China-based companies are also making headlines this year, and not in a good way. Luckin Coffee, iQiy, GSX Techedu, and TAL Education are but a few of the better-known entities that have come under increased scrutiny from the Securities and Exchange Commission for alleged inaccurate filings and (in some instances) outright fraud.

Luckin Coffee is the mothership of such cases. Its corporate officers are charged with falsely reporting over $300 million in sales (or half of its total) during the last three quarters of 2019. Just in September, online education company GSX Techedu confirmed it was being investigated after short sellers called out huge second gains in revenue and K-12 course enrolment.

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While it’s unfair to paint all China-based companies with the same brush, the high incidence of investigations is underscoring the need for U.S. regulators to finally tackle a longstanding problem: the lack of audit transparency of Chinese firms listed on U.S. exchanges.

“Although Chinese companies have been improving over the years, it’s characteristic of Chinese firms, on average, to perform worse in terms of transparency and unmanaged risk than other emerging market companies,” says Wilco Van Heteren, executive director of ESG research at Sustainalytics, a global provider of environmental, social and corporate governance assessments. [Unmanaged risk is material ESG risk that has either been insufficiently managed or not managed at all.]

As Roger Robinson, president and CEO of research firm RWR Advisory Group, told an SEC emerging markets roundtable in early September, issuers based in China and listed in the United States are “not subject to [Public Company Accounting Oversight Board] audits … they’re not compliant with Sarbanes Oxley/Dodd-Frank; their finances are kept in a black box and they’re not disclosed because of the status they hold as state secrets … these make for a golden invitation for fraud and investor-protection problems.”

While Robinson overstates the level of secrecy somewhat, Congress and at least one U.S. stock exchange are taking the problem seriously. The question is whether they will be successful at finally getting Chinese firms to open up their audits — or whether their actions will drive Chinese firms out of U.S. public markets.

Long History

More than seven years ago, the PCAOB signed a memorandum of understanding on enforcement cooperation with the China Securities Regulatory Commission (CSRC) and the Ministry of Finance. It provided for the exchange of auditors’ workpapers between the two countries. However, the PCAOB says “Chinese cooperation has not been sufficient for the PCAOB to obtain timely access to relevant documents and testimony necessary for the PCAOB to carry out enforcement matters.” The PCAOB says that it has been denied access to conduct inspections at 133 of the 145 publicly held Chinese companies, whose auditors are located in China and Hong Kong.

Most state-owned and formerly state-owned Chinese enterprises (private companies) are stuck between a rock and a hard place. Chinese law prohibits them from complying with PCAOB audit inspections on the grounds that they may reveal state secrets. The Chinese branches of the Big Four accounting firms also argue that sharing workpapers would violate Chinese laws prohibiting anyone from providing documents about securities business activities to overseas regulators.

Fast-forward to this year. The SEC and the PCAOB jointly issued a statement in April warning investors about investing in “emerging market” (i.e., Chinese) companies given the absence of PCAOB inspections, among other things. And then in May Congress finally acted.

The U.S. Senate unanimously passed the Holding Foreign Companies Accountable Act. The act would amend Sarbanes-Oxley to require certain issuers to disclose information regarding foreign jurisdictions. If the PCAOB were unable to inspect an accounting firm’s audits for three consecutive years, the issuer’s securities would be banned from trading on a U.S. national exchange or on over-the-counter markets. The bill would also require issuers to disclose ownership and control by non-U.S. governmental entities and identify Chinese Communist Party officials on their boards of directors. President Trump has backed the potential delistings.

Nasdaq Restrictions

Nasdaq has responded by putting added restrictions on initial public offerings. In its “Proposed Rule Change to Apply Additional Initial Listing Criteria for Companies Primarily Operating in Restrictive Markets,” Nasdaq is targeting companies “primarily operating in a jurisdiction that has … national security laws or other laws or regulations restricting access to information by regulators of U.S.-listed companies.”

The proposal requires a minimum public float for such companies. The aim is to ensure that the issuer has “adequate liquidity, distribution, and U.S. investor interest to support fair and orderly trading in the secondary market, which will reduce trading volatility and price manipulation, thereby protecting investors and the public interest.”

The New York Stock Exchange has been relatively silent on the subject. Its only public comment came from NYSE president Stacey Cunningham in August. She said that all issuers need to operate under similar standards, but that the NYSE also wants to ensure American investors don’t lose out on access to leading companies.

Not lost to any exchange must be that Chinese issuers are a source of revenue. The 145 companies currently listed are about evenly split between the NYSE and Nasdaq and have a market capitalization of more than $1.2 trillion. And more continue to list in the United States, despite the controversy. During the first half of 2020, 17 Chinese companies went public on NASDAQ and NYSE, up from 11 in the same period last year.

The Fallout

What would the fallout be should Chinese companies be blocked from listing on U.S. exchanges by legislation or otherwise? Some say they will easily go elsewhere. According to Agathe Demarais, global forecasting director of The Economist Intelligence Unit, America’s loss will be Hong Kong’s and Europe’s gain.

“London [with its large and liquid capital markets] is the obvious choice, and potentially Hong Kong—although the situation around Hong Kong makes things more complicated,” she notes. “In the long term [losing Chinese companies] would erode the global financial dominance of the U.S.”

Neither Hong Kong nor Shanghai are equity market backwaters. They were right behind the Nasdaq in terms of the number of global IPOs in the first half of 2020. Shanghai had 76 new listings that raised $13.6 billion. The exchange’s new STAR market dedicated to high tech companies is doing particularly well.

The move in late summer by payments warehouse Ant Group to list on the Hong Kong Stock Exchange and Shanghai instead of the NYSE or Nasdaq suggests that Chinese companies are already wary of the political risks. Ant cited “geopolitical tensions, regulatory challenges, and protectionist policies that may support domestic players” as risk factors in public markets outside of China. Missing Ant Group’s IPO is a big loss for the U.S.: its potential $30 billion capital raise would surpass Alibaba’s $22 billion in proceeds raised on the NYSE in 2014.

Should Chinese companies be forced to exit the US capital markets, will investors follow them to other exchanges? Potentially, yes. Sustainalytics points to the unexpected behavior of investors in China-based companies.

“Comparing ESG risk levels against price-earnings ratios, our data didn’t show the pattern that we expected, “ says Van Heteren. “For Chinese companies with low unmanaged risk levels, it shows shares trade at a very low premium in terms of price-to-book values. Companies in our high unmanaged risk categories seem to trade at a larger premium, which would suggest lower risk to investors. The numbers don’t add up when it comes to investing in Chinese stocks.”

A Standoff

One of the other problems with forcing existing Chinese issuers out would be the work of decoupling Chinese companies from the U.S. capital markets. Demarais says it would be a near-impossible task. “There is a high chance that [the Holding Foreign Companies Accountable Act] is going to go through; however, the enforcement of the bill is going to be very tricky. It’s like a messy divorce with a lot of assets and a lot of legal tricks. So, I would say that the value of the bill would be mainly for signaling purposes.”

While the potential long-term impacts of the act are heatedly debated, other options have been put on the table.

A counterproposal to the act was submitted by the Chinese securities regulator in August. Fan Xinghai, vice chairman of the CSRC, said in an interview with Bloomberg that the commission is “sincere” in wanting to solve the standoff over accounting issues. The concessions made would include letting U.S. regulators see the audit workpapers of some of China’s most sensitive state-owned companies, but the CSRC would still redact information concerning national security.

As of mid-September, the PCAOB had rejected the proposal on grounds that “for more than a decade we have sought to establish a cooperative relationship with China that is consistent with others around the world. Such a relationship, however, cannot be meaningfully pursued without the Chinese first embracing our core access principles. Despite the CSRC’s recent claims, its proposals remain materially deficient.”

Might there be a private-sector solution? In statements at the SEC Emerging Markets Roundtable in September, Carson Block, founder and chief investment officer of Muddy Waters Capital, suggested a financial incentive to improve the audits of Chinese companies.

“We propose that the U.S. parents of these global auditing firms effectively provide collateral for audit failures of their PRC [People’s Republic of China] affiliates in the form of financial guarantees. … That’s the most important proposal that we have that we think can help rectify the situation and give investors greater assurance without delisting en masse.”

With the Big Four only coming around recently to the notion that a public company audit should catch fraud, that proposal seems unlikely to go much further.

The Big Four and other auditing firms profit from having large, publicly held Chinese clients, But the ongoing politically charged fight is risky for them as well. In 2017, Hong Kong-based Crowe Horwath CPA Limited was sanctioned by the PCAOB for refusing to cooperate with a PCAOB investigation of a publicly traded Chinese company. The sanctions agreed to included being censured by the PCAOB and having the audit firm’s registration revoked for at least three years. That’s not a situation any audit firm would want to be in again.


Ramona Dzinkowski is a journalist and president of RND Research Group.

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