1. Why does the US want access to audits?
The Sarbanes-Oxley Act of 2002, enacted in the wake of the Enron Corp. accounting scandal, required all public companies to have their audits inspected by the US Public Company Accounting Oversight Board. According to the SEC, more than 50 jurisdictions are working with the board to allow the necessary inspections, while two historically have not: China and Hong Kong. The long-running issue turned into a political issue as tensions between Washington and Beijing rose under President Donald Trump’s administration. The Chinese chain Luckin Coffee Inc., which was listed on the Nasdaq, deliberately turned out to have produced part of its turnover in 2019. The following year, in a rare bipartisan move, Congress moved to force action.
As required by law, known as the Holding Foreign Companies Accountable Act or HFCAA, in March the SEC began publishing its “preliminary list” of companies identified as being in violation of the requirements. While the move had long been telegraphed, the first group of names led to a sharp drop in U.S. stocks in companies based in China and Hong Kong as it shattered hopes of some sort of compromise. In total, the PCAOB has said it is blocked from reviewing more than 200 of these companies. The companies say Chinese national security law prohibits them from handing over audit papers to U.S. regulators. SEC President Gary Gensler said in late March that the Chinese authorities were facing “a difficult set of choices.” A few days later, China announced it would change a 2009 rule restricting the sharing of financial data for offshore listed companies, potentially removing one hurdle.
3. What is changing China?
The China Securities Regulatory Commission said the requirement that on-site inspections be conducted primarily by Chinese regulators or rely on their inspection results would be removed. It said it would provide assistance for cooperation with foreign regulators. The CSRC said it is rare in practice for companies to provide documents that contain confidential and sensitive information. However, if required during the audit process, they must obtain approvals in accordance with related laws and regulations.
4. What is the broader question?
Critics say Chinese companies are enjoying the trading privileges of a market economy – including access to US stock exchanges – while receiving state aid and operating in an opaque system. In addition to inspecting audits, the HFCAA requires foreign companies to disclose whether they are controlled by a government. The SEC also requires investors to receive more information about the structure and risks of shell companies – known as variable rate entities or VIEs – that Chinese companies use to list shares in New York. Since July 2021, the SEC has refused to give the green light for new listings. Gensler has said that more than 250 companies already trading will face similar demands.
5. How quickly can Chinese companies be delisted?
Nothing will happen this year or even in 2023, which explains why the markets initially took the opportunity in their stride. Under the HFCAA, a company would only be delisted after three consecutive years of non-compliance with audit inspections. It could return by confirming that it had retained a registered public accounting firm approved by the SEC.
6. How many companies will be affected?
There is not much estimate. If a company from China or Hong Kong trades in the United States and submits an annual report, it will soon find itself on the SEC’s list simply because they have been identified as incompatible jurisdictions. In the March interview, Gensler pointed out that the law focuses on incompatible countries rather than specific companies.
7. What do investors do in response?
If a US-listed Chinese company also has shares traded in Hong Kong, shareholders have the option to convert their US Depositary Shares (ADSs) into Hong Kong shares. Some do just that by transferring the US shares to the depository bank and instructing it to cancel them. The bank then instructs the custodian bank to deliver Hong Kong ordinary shares to a brokerage account in Hong Kong’s central clearing and settlement system. The process usually takes two business days.
8. Are some Chinese companies really controlled by the government?
Large private companies like Alibaba could probably argue that they are not, although others with significant state ownership may find it more difficult. From May 2021, the U.S.-China Economic and Security Review Commission, which reports to Congress, counted eight “Chinese state-owned enterprises at the national level” listed on major U.S. stock exchanges.
9. Why have Chinese companies listed in the US?
They are attracted by the liquidity and the deep investor base in the US capital markets, which provide access to a much larger and less volatile pool of capital within a potentially faster time frame. Although China’s own markets are gigantic, they are still relatively underdeveloped. Fundraising for even quality companies can take months in a financial system limited by state-owned lenders. Dozens of firms withdrew planned IPOs last year after Chinese regulators tightened listing requirements to protect retail investors dominating equities, as opposed to institutional investors and mutual funds active in the United States. And until recently, the Hong Kong Stock Exchange had a ban. on dual-class stocks, which are often used by tech entrepreneurs to keep control of their startups after they were listed in the US. It was eased in 2018, leading to large listings from Alibaba, Meituan and Xiaomi.
(Adds new section 7 on investors’ conversion of US equities to Hong Kong equities)
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