Last week it was announced that The US and China had reached an agreement allowing the
US Public Company Accounting Oversight Board – known as the PCAOB - access to audits
of Chinese companies that are listed on US exchanges.
This deal would halt the threatened delisting of around 200 Chinese stocks that are listed
on US exchanges.
Now, this agreement is not really that new.
China had agreed back in 2013 after years of negotiations to allow the PCAOB to inspect
the audit work of Chinese companies whose securities traded in the United States.
But this agreement then collapsed when US auditors actually travelled to China to check
the accounts of a large tech company and were stonewalled by regulators.
So now, almost 10 years later, US officials, along with Chinese companies and people who
own Chinese shares, are hoping that the new agreement will produce a different outcome.
There aren’t a lot of details available right now, but the agreement was a rare and
somewhat surprising concession from the Chinese government at a time when geopolitical tensions
are quite high.
The deal is apparently based on the original deal from 2013.
The press is reporting that auditors — the majority of whom are the Chinese arms of Big
Four accountants will transfer the companies’ financial working papers to Hong Kong, where
PCAOB officials will be able to inspect them.
OK, so, what is the PCAOB I hear you ask…?
Well, it’s a US government agency that was established by the Sarbanes-Oxley Act in 2002
to oversee the audits of public companies and other securities issuers.
The Sarbanes-Oxley Act required that auditors of U.S. public companies be subject to independent
oversight for the first time.
Previously, the auditing profession was self-regulated.
So, the PCAOB is there to check that the auditors are doing their job.
Now, all of this regulation came in the wake of the Enron accounting scandal back in 2001
which brought down Arthur Andersen – Enron’s auditor.
Andersen was found criminally liable for obstruction of justice on the grounds that they persuaded
their employees to shred Enron-related documents.
It was a huge scandal at the time, and it was decided that auditors possibly needed
more oversight.
Thus we have the PCAOB.
So, for quite a while, US politicians and regulators have been making noise about the
issue that international companies listed on US exchanges have different rules applied
to them than domestic companies do.
And a lot of US investors are not even aware that there is a regulatory difference.
Back in December 2020 President Trump passed the holding foreign companies accountable
act, which was essentially an amendment to the Sarbanes Oxley act, and it required foreign
companies listed on US Stock Exchanges to certify that they are not under the control
of a foreign government, and it required that their audits be checked by the PCAOB.
To be clear, this law didn’t just focus on Chinese companies.
The SEC at the time said that there were 224 US listed companies that are based in countries
where there were obstacles to PCAOB inspections and that 158 of those companies (which is
around 70%) were Chinese.
So, it focuses mostly on Chinese companies, but really applies to all foreign companies
listed on US exchanges.
Under the 2020 law, if companies didn’t comply with the regulations for three consecutive
years, their securities would be banned from US exchanges.
So, it wasn’t a particularly draconian law either, and right now most foreign companies
comply with all of the regulations.
You have possibly seen in the news that five Chinese state-owned companies with a combined
market capitalization of more than $300 billion announced plans to delist voluntarily from
US exchanges earlier this month.
This is only so surprising as these companies would not have been able to certify that they
are not under the control of a foreign government and most of the trading in these companies’
shares already took place in Hong Kong or mainland China.
The fact that these announcements all occurred at once - does imply that they were coordinated.
So, why did the auditing of foreign companies become an issue all of a sudden back in 2020?
Well, there had been several scandals that raised questions about the state of Chinese
accounting practices, and whether US stock exchanges were doing enough to protect investors
from fraud.
An example at the time was Luckin Coffee, who were found to have fraudulently overstated
sales by hundreds of millions of dollars.
When this came out, the stock fell by more than 90% and was delisted from NASDAQ in June
2020.
You could look at this auditing dispute as being tied to Trumps general disagreements
with China, but it was probably the most bipartisan piece legislation that was passed during the
Trump presidency.
It’s possibly more accurate to view it as a push back by US securities regulators after
a few accounting scandals like the Luckin Coffee example, towards better overall corporate
governance and better governance is usually good for both markets and investors.
There are a number of different models of corporate governance around the world, depending
on the variety of capitalism in the country in question.
The Anglo-American model emphasizes the interests of shareholders.
The multi-stakeholder model associated with Continental Europe and Japan also recognizes
the interests of workers, managers, suppliers, customers, and the broader community.
The Chinese model has been described as state capitalism because the state directs and guides
all major aspects of the Chinese economy.
The nature of this model has been changing significantly under Xi who appears to view
all Chinese companies - both state and private sector - as instruments of a one-party state.
In such a situation, the governance structure is not aligned with stakeholders, and that
can be a problem for investors.
Corporate governance is obviously of great importance to investors.
It’s the reason that they can have faith in the capital markets and invest their savings
in businesses knowing that they will be treated fairly.
These businesses then grow, provide jobs, economic growth, and supply goods and services
to the marketplace.
Good corporate governance tends to provide a positive feedback loop.
I have a chapter in my Corporate Finance book, which I’ve linked to in the description
on this topic, where we looked at the various laws and listing requirements around the world.
You can see that there has been a general trend towards better corporate governance
over time.
This is because companies who treat stakeholders fairly can attract capital more easily and
then tend to grow.
In recent years, we have seen some examples – often Silicon Valley examples - that buck
that trend.
In the US Facebook (I refuse to call them Meta – because that’s silly) is an example
I used, as they went public with a multiple share class structure giving Founder shares
ten times the voting rights of common shares.
This meant that Mark Zuckerberg didn’t have to actually listen to public shareholders.
And that is obviously not a shareholder friendly structure.
Later Snap went public selling shares with no voting rights.
I also included the example of Alibaba in the book, noting that when a US investor buys
shares in Alibaba, they don’t actually get an ownership stake in the Chinese company
which they might expect as an investor, instead they get a stake in Alibaba, a Cayman-Islands
based shell company that has a contractual arrangement with the Chinese company to pass
on any cashflows.
This structure is known as a variable interest entity.
The reason for this type of structure is that the Chinese government doesn’t permit foreign
investment in certain industries like education, media, telecom, and technology.
The VIE structure was a way to work around these government regulations and raise capital
abroad.
Most offshore-listed Chinese firms use this structure, which gives them the ability to
raise capital internationally, but the structure has neither been recognized nor denied by
Chinese authorities in a general sense.
In fact, cases challenging the VIE structure have mostly shown that Chinese authorities
are reluctant to clarify its legal status, possibly because it gives them regulatory
flexibility while bringing foreign investment into the country to leverage economic growth.
It should be obvious that the structure involves significant legal risks for investors, as
if these structures were invalidated, foreign investors could find themselves with very
little legal standing.
An good example of things can go wrong is when Jack Ma (the founder of Alibaba) spun
off Alipay as an independent company under his own ownership without consulting or compensating
Softbank and Yahoo – who were the largest two international shareholders in Alibaba.
Yahoo owned 43% of the company, and this valuable asset being stripped away caused Yahoo’s
stock price to fall almost 10% when it was announced.
So why is the Chinese government so reluctant to comply with American audit and listing
requirements when other countries are not?
Well, it would appear that while American regulators are upset about a lack of accounting
transparency, Beijing is furious that their most impressive companies have shown a preference
for listing in New York rather than Shanghai or Hong Kong.
When we look at the Didi scandal from last year, this becomes clear.
Didi, the Chinese ride sharing company raised $4.4bn in an IPO on the New York Stock Exchange
a bit over a year ago.
Just days after the IPO, the Chinese government ordered that Didi’s app be removed from
Chinese app stores, they banned the company from signing up new users and announced an
investigation into the company’s cyber security practices.
Didi then announced that they were delisting in the United States less than 6 months after
going public and after the stock price had fallen around 85%.
The fact that Didi went public in New York – under a VIE structure, entirely bypassing
the Chinese capital markets looked to the Chinese Communist Party like an embarrassing
endorsement of American capital markets and possibly even a vote of no confidence in China’s
markets.
Didi was just following the well-worn path of other big Chinese tech companies, but under
Xi’s leadership this was unacceptable.
President Xi, it would appear wants to boost the status of Chinese exchanges, and the Chinese
capital markets look particularly unimpressive if they are unable to attract the nation’s
biggest and best companies.
In the aftermath of Didi’s IPO, Chinese regulators warned that other companies hoping
to follow in its footsteps – by listing abroad - would be subject to more stringent
approval procedures, especially if they manage data deemed sensitive by Beijing.
For the US, the credibility of its capital markets relies on listed companies complying
with the audit requirements.
Companies can and do look around the world to find exchanges to list on, and with fewer
and fewer companies going public due to the growth of private markets, exchanges do compete
for this business, but no regulatory regime or exchange wants to be recognized as the
place where companies with questionable corporate governance and accounting irregularities look
to when raising capital.
Despite shares of US-listed Chinese companies rising last week on reports that a deal was
coming close, there has been no major move in US listed Chinese stocks.
This implies that investors are not yet convinced that the Chinese delistings which would take
effect in 2024, are off the table yet.
Goldman Sachs, who have done a lot of investment banking work, listing Chinese companies on
US exchanges over the years - published a report on Monday, saying that there is still
a 50 per cent chance that Chinese companies will eventually be delisted.
This is down from around 95 percent two months ago, but, it is still a coin flip.
It is somewhat surprising that China have shown any willingness to strike a deal on
this front, given the recent tensions with the USA, and it may signal a thawing of the
frosty relationship between China and the United States.
Some of this may relate to the sharp contraction we have seen in the Chinese economy, as this
announcement comes at a time that China is rolling out measures to support its economy.
The China Securities Regulatory Commission, announced on Friday that the sides had found
a “feasible path” for the US to carry out audit inspections while maintaining China’s
national security over sensitive data.
China still has a huge bureaucracy which means that a number of authorities can still intervene
and block the provision of information.
It’s really only when the audit information is actually handed over that we’ll know
that China has resolved this issue of what is and what is not considered sensitive data.
Gary Gensler - the chair of the SEC said as much in his statement where he said “The
proof will be in the pudding,” . “This agreement will be meaningful only if the PCAOB
actually can inspect and investigate completely audit firms in China.”
“If it can’t, roughly 200 China-based issuers will face prohibitions on trading
of their securities in the US if they continue to use those audit firms,” he added.
Gensler said that the agreement “marks the first time we have received such detailed
and specific commitments from China that they would allow PCAOB inspections”
If you enjoyed this video you should watch my video on the global consequences of Chinas
economic slowdown next.
That’s it for now, Have a great day, and talk to you again soon.
Bye.