The clock is ticking on a three-year timeline for the forced delisting from US exchanges of 248 Chinese stocks that are defying auditing requirements.
The stakes are huge. The US is set to lose Chinese companies with a combined market capitalisation of $2.1 trillion, or almost 4% of the value of all companies listed on US exchanges, including over-the-counter markets. China will lose access to the world’s biggest capital market, which has raised more than $100 billion for its companies to modernise and helped upgrade their governance and management standards.
But with both sides dug into entrenched positions, the marriage of convenience is facing an irretrievable breakdown. Relations between the world’s two biggest economies have plummeted in recent years amid disputes over trade protectionism, intellectual property rights, China’s alleged forced technology transfers and much more. There’s little optimism on either side that a compromise is possible as the two nations drift toward decoupling their equity markets.
“We are in a very different place now,” says Jeff Mahoney, general counsel with the Council of Institutional Investors, a nonprofit association whose members have combined assets under management of about $4 trillion. “If you were in Las Vegas taking bets on whether we will see Chinese companies delisted in the US in the coming years, you should bet we will.”
Hopes that things may improve got a boost November 25 when Chinese authorities said they are working with their Washington counterparts to prevent companies being delisted.
“We don’t think that delisting of Chinese firms from the US market is a good thing either for the companies, for global investors or Chinese-US relations,” Shen Bing, director general of the China Securities Regulatory Commission‘s department of international affairs, told a conference in Hong Kong. “We are working very hard to resolve the auditing issue with US counterparts, the communication is currently smooth and open. There is a risk of delisting of these companies but we are working very hard to prevent it from happening.”
How Did We Get To Delisting?
Listed Chinese companies were for years allowed to flout US auditing norms. That was in part because of the long-held belief that greater exposure to western capital markets would help China’s communist system evolve into something much more like western market economies. That view no longer holds sway in Washington. The perception now is that China doesn’t play fair and has evolved into a predatory strategic competitor with values sharply at odds with those of the western world.
Factor in long-festering concerns over the huge trade deficit with China, intellectual property protection, national security and the Covid-19 pandemic and the result is a pernicious, pervasive anti-China sentiment in the US.
The roots of the delisting issue itself go back almost two decades. When the dust settled after the dotcom bubble burst in the late 1990s, it became clear the accountants whom investors relied upon to audit listed companies were themselves colluding to cook the books. In response, the US passed the Sarbanes-Oxley Act in 2002. It featured strict new rules to allow regulators to audit the auditors, among numerous other provisions.
Sarbanes-Oxley also created the Public Company Accounting Oversight Board (PCAOB) to oversee listed company audits. The PCAOB has complained for years that China-based companies have not complied with audit requests and the board’s website lists roughly 300 instances of denied inspections, with the overwhelming majority from US-listed Chinese companies.
In 2013 – more than a decade after Sarbanes-Oxley – the PCAOB signed a memorandum of understanding on audit oversight with the China Securities Regulatory Commission and the Ministry of Finance that looked set to solve the problem. But over the next seven years, Beijing prevented Chinese-based auditing firms from complying with US law on audit inspections.
Over all those years and despite regular PCAOB complaints, the Securities and Exchange Commission (SEC) took no action. The law said the SEC could delist those companies, but did not require it to do so. So, it did not.
Why? Well, as Shaswat Das, counsel with Washington-based law firm King & Spalding, says: “What regulator wants to see more than 200 companies migrate to markets overseas and over $2 trillion go out the door?”
But now it has no choice. The US Congress passed the Holding Foreign Companies Accountable Act (HFCA) in December 2020, and the SEC issued implementing regulations in March 2021. Under the new law, if the Public Company Accounting Oversight Board (PCAOB) certifies it has not been able to review a company’s audits for three consecutive years, the SEC must delist it – previously it could exercise its discretion. Based on this timeline, the first delisting may happen as soon as 2024.
China has also dug in, issuing regulations that prohibit Chinese companies from complying with PCOAB audit requests even if they want to. And Beijing has stepped in to stop more companies listing in the US, notably by reining in Didi Global after it sought a US listing despite the current tensions in what some see as a message to other Chinese companies.
“The Chinese authorities launched an investigation into Didi only after the IPO,” says Das. “They could have intervened to stop the Didi IPO, but they waited and I think that was deliberate, to send a message to other companies not to list in the US. They want to control the narrative, to be able to say ‘We weren’t kicked out of US markets, we brought these companies home for national security reasons.’ ”
The Luckin Tipping Point
While many factors contributed to anti-China sentiment in the US, the straw that broke the camel’s back on listed companies was probably the Luckin Coffee scandal that left US investors out of pocket due to management fraud that Sarbanes-Oxley was designed to eliminate.
The SEC alleges that Luckin fleeced US investors of more than $864 million through its IPO and debt instruments – all rendered close to worthless after the company filed for bankruptcy protection in the US under Title 15 in February 2021.
What’s At Stake as Delistings Unfold?
American investors in China stocks listed in the US have $1.1 trillion in investments at risk, according to estimates by the Rhodium Group. Chinese investors held $700 billion in equity and $1.4 trillion in debt securities issued by US entities at the end of 2020, it says. Altogether that’s $3.2 trillion, and US investors hold about another $100 billion in Chinese bonds.
Previous China Stocks Delisting
Previous delistings provide the best window on what the future may hold for investors – and it doesn’t look good. In late 2017, China-based and US-listed Qihoo 360 announced a deal to be taken private by a group of investors led by its CEO, Zhou Hongyi, who held a 61% majority stake in the company.
The deal valued Qihoo at about $9.3 billion. It was then relisted on the Shanghai stock exchange, where its market cap soared to $56 billion. In a 2019 article published in the Harvard Law School Forum on Corporate Governance, Harvard Law School professor Jesse Fried and Burford Capital’s Matthew Schoenfeld assert that Qihoo’s CEO alone made $12 billion in the relisting exercise.
”Beijing may be deliberately tanking these companies’ shares to pave the way for Chinese investors to acquire interests at lower prices,” they said.
Similarly, shares in state-run China Telecom had traded in the high $40 to low $50 range from 2016 to 2019, but slid after former President Donald Trump signed an executive order forcing companies deemed tied to China’s military to delist from US exchanges. China Telecom shares had plunged to $27.51 on the day it was delisted from the New York Stock Exchange.
While US investors who held shares once worth up to $50 each were left holding the bag by the delisting, China Telecom appears to not have suffered much. Only months after the US delisting, the company announced plans to raise $7.3 billion in a Shanghai listing, a 90% premium to the trading price for its shares listed on the Hong Kong stock exchange.
How Delistings Will Likely Play Out
Unlike some other measures taken against China during the Trump administration by executive order, the new law cannot be easily undone. An executive order can be quickly reversed by the next president – or the same president. But changing the HFCA would require an act of Congress, and that seems unlikely.
“When the US Congress lines up and passes a law unanimously, that says a lot,” says George Calhoun, founding director of the Quantitative Finance Program at the Stevens Institute of Technology. “When was the last time Congress voted unanimously on anything? Even after 9/11, one Congresswoman voted against going to war in Afghanistan. No one voted against this.”
So any compromise reached between senior leaders or regulators in the US and China must comply with PCAOB audit requests, and the US Congress would have to act to stop delisting. Such a reversal would require the 435 members of the House of Representatives to either repeal or amend the HFCA. Then the 100 members of the Senate would have to pass similar legislation, and then the two legislative bodies would meet to reconcile differences between the two bills. And once they do, if both chambers again pass the amended version, it goes to the president, and if he signs it, it becomes law. That is a lot of “ifs.”
“I don’t think this is going to change from the US side,” says Calhoun. “The only way I see things changing is if Beijing blinks.”
• Neal McGrath
• This story was updated on November 25 with comments from Shen Bing, director general of the China Securities Regulatory Commission’s department of international affairs.