Storm Clouds Darken Over US-Listed Chinese Stocks
As I first wrote in this blog nearly six months ago (“Storm Clouds Linger Over US Listed Chinese Stocks“), there is a crisis looming over all 110 Chinese concept stocks listed in the U.S..
In recent months, that crisis has grown in magnitude, with no resolution in sight.
At the heart of the issue is the fact that the US regulator, the SEC, has requested access to the audit working papers of nine listed Chinese companies, whose main operations are in China, which are involved in fraud investigations.
The five accounting firms involved, all of whom are registered with the US accounting watchdog regulator, Public Company Accounting Oversight Board (PCAOB), have refused to provide the working papers. Their stated reason for refusal is based on the view that China’s secrecy laws protect audit materials.
The SEC in turn maintains the five are in violation of the Sarbanes-Oxley Act.
The SEC, PCAOB and China’s Security Regulatory Commission have been in a back and forth dialogue on this crisis for many months, with neither side showing much flexibility.
Early in December, the SEC upped the ante by beginning a formal legal action against the five accounting firms, which include the Chinese member firms of the Big Four global accounting firms.
The day the latest SEC action was announced, share prices of two-thirds of the China concept stocks plunged, although they have since recovered some of the lost ground.
The latest SEC action is asking the court to decide whether the audit firms should be punished and/or and denied the right to practice within the SEC’s jurisdiction.
The potential upshot is that, if the audit firms lose their right to perform audit services, all Chinese companies could in effect be forced to delist.
A secondary question is whether in such a case these audit firms would also lose their right to perform audit services for US multinational company operations in China.
In my original post in July, I quoted the respected Professor Paul Gillis (www.ChinaLawBlog.com) as saying he foresaw only a 20% chance that all US-listed Chinese stocks might be forced to delist. More recently he has revised that estimate upwards, to an 80% chance.
In either case, the reputational damage to Chinese companies and to China is already very serious. In the event of a blanket delisting of Chinese companies in the U.S., the US reputation as a leading source of global capital would also suffer.
Many early reports about this problem put much of the blame on several US research houses which were also engaged in short-selling. They were indeed important catalysts, driven at least in part by vested interests, but the problem is much broader and deeper than that.
Apart from some instances of alleged fraud at the nine companies which are the subject of SEC investigations, many US listed Chinese companies exist in a gray regulatory area. They are offshore companies incorporated in places like the Cayman Islands, with variable interest entities (VIEs), structured to avoid Chinese regulatory restrictions in industry segments where foreign investment is not permitted.
The VIE structure has been tolerated by the Chinese government thus far, which is fortunate for many high-flying Chinese companies, especially in the education and internet sectors. The current SEC-CSRC impasse has made many of those companies and their investors nervous because it has put the VIE structure under a very bright spotlight. Some observers speculate that official tolerance for it may be waning.
Gray areas invite fraud. Investor confidence requires a certain degree of transparency, and confidence that effective oversight is in place when allegations of fraud occur.
Secrecy is a valid part of any nation’s laws and regulations. On the other hand, companies seeking an IPO must be prepared to play by the rules and regulations in the jurisdiction they choose to list in.
Expert observers are unclear on how long it will take to resolve the current impass, or what concessions the CSRC, SEC and PCAOB might be prepared to offer.
In the meantime, if there is a potential beneficiary, it may well be Hong Kong, which is the most promising alternative listing site for China concept stocks as well as many other new Chinese IPOs in the pipeline.
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