WARNING: By the end of this year, there is a very real chance that U.S. securities regulators may forcibly delisting every Chinese company currently listed on a U.S. stock exchange
The US May Have To Use The Nuclear Option On Chinese Stocks
China and the U.S. appear to be an a collision course over accounting. That’s a lot more serious than it sounds. By the end of this year, unless a compromise can be reached, there is a very real chance that U.S. securities regulators may end up employing the “nuclear option”: forcibly delisting every Chinese company currently listed on a U.S. stock exchange — such as Sinopec, Sina.com, China Life, and China Unicom.
It’s a potential catastrophe-in-the-making that few investors or politicians have given any serious thought to.
Last year, the US-listed stocks of more than a few Chinese companies took a beating following accusations by short sellers and research shops like Muddy Waters that SinoForest and other companies — many of which had avoided IPO scrutiny by arranging reverse mergers with already-listed entities — were grossly exaggerating their real assets and business performance in their official financial statements. These accusations prompted the Securities and Exchange Commission (SEC) to launch several fraud investigations into the Chinese companies in question.
Rather than assisting the SEC in its cross-border probes — as other countries regularly do — the China Securities Regulatory Commission (CSRC) has actively blocked the SEC’s information requests, insisting that audit materials on Chinese firms fall under China’s ambiguous yet draconian State Secrets Law. This April, when the SEC issued a subpoena to the Chinese arm of Deloitte, demanding the audit records of Longtop Financial (which collapsed last May after Deloitte resigned as its auditor), Deloitte refused, noting that the CSRC directly ordered them not to turn over such papers.
The firm argued it could be dissolved and its partners jailed for life if they were to comply. In May, the SEC responded by initiating administrative proceedings to punish Deloitte China for violating its duties under the 2002 Sarbanes-Oxley Act. Penalties could include suspending the firm’s authority to perform audits for US-listed companies, which are required under U.S. securities laws. Apparently similar subpoenas have been issued to each of the other “Big Four” global audit firms (E&Y, KMPG, and PWC), and have met with similar replies.
There is a further complication. The Sarbanes-Oxley Act also established the Public Company Accounting Oversight Board (PCAOB), a five-person body appointed by the SEC. Public accounting firms that wish to perform audits on US-listed companies must register with PCAOB, and PCAOB is required, by law, to conduct inspections of those firms. So far, Chinese authorities have refused PCAOB permission to inspect auditors based in China, including the local arms of “Big Four” global audit firms. Last month, it looked like PCAOB might have worked out a compromise that would let it observe Chinese regulators perform their own inspection, but the SEC action against Deloitte China appears to have derailed that plan. The stage is set for a deadlock with serious, potentially disastrous implications, as my fellow CPA and Peking University counterpart Paul Gillis describes in his blog:
The PCAOB faces a December deadline to complete inspections of Chinese accounting firms that are registered with the PCAOB. It seems highly unlikely that they will meet this deadline, since Chinese regulators will not let them come to China. While the PCAOB could extend the deadline, they have already been under political pressure to act … Without resolution, the only meaningful option for the SEC, and the PCAOB, is for the PCAOB to deregister the firms and for the SEC to ban them from practice before the SEC.
The consequence of those actions would be that U.S. listed Chinese companies would be without auditors and unable to find them. Having an auditor is a listing requirement of the exchanges, so under exchange rules the companies face delisting. The U.S. listed Chinese companies would be unable to file financial statements as required. That should lead the SEC to eventually deregister the companies with the SEC.
Paul notes that shareholders in the delisted Chinese companies would still own their shares, but would be unable to trade them on U.S. exchanges. The companies would probably try to list their stock on other non-U.S. exchanges such as Hong Kong, which could prove an expensive and cumbersome option. The effect on US-China relations, and on investor confidence in cross-border investments in either direction, would be devastating. Yet the alternative would be to allow Chinese companies to trade their shares on U.S. exchanges while openly flouting U.S. securities laws — not just Sarbanes-Oxley, which is somewhat controversial, but anti-fraud provisions dating back to the 1930s.