The New Bill Approved By The Senate Might Change Investing In Chinese Companies Forever


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The United States still remains the most desirable destination to raise capital, and listing a company’s equity securities on a U.S. stock exchange is considered the “gold standard”. Considering the stellar economic growth of China in the last couple of decades, it didn’t come as a surprise when companies with roots in China opted for American markets to raise capital. The number of Chinese companies listed on U.S. stock exchanges has grown consistently in the last 8 years.

Source: KrAsia

There is an ongoing debate as to the accuracy of numbers reported by many of these companies as U.S. regulators continually failed to get their hands on the audit workpapers. The spectacular fall of Luckin Coffee (LK) has already refreshed memories of accounting malpractices by Chinese companies. With this backdrop, the Senate passed a bill on May 20 that could lead to the delisting of many Chinese companies from U.S. stock exchanges. This bill has similar characteristics to the Equitable Act introduced by Marco Rubio on June 5, 2019. A closer look at this new bill and the regulatory framework applicable to companies in China leads to the conclusion that Chinese companies listed on U.S. stock exchanges are in for a period of significant uncertainty this time around.

The bill

The new bill, introduced by Senator John Kennedy and Chris Van Hollen, aims to put an end to foreign companies raising capital from American investors without proving that they are not controlled by a foreign government. Under the below two conditions, a company would not be allowed to list their securities on a U.S. stock exchange or will be delisted in case securities are already listed.

  1. A company fails to show that it is not controlled by a foreign government.
  2. The Public Accounting Oversight Board (PCAOB) is not allowed to audit the company for three consecutive years.

If the House approves this bill, these rules would be applicable to all foreign companies alike. Chinese companies, in particular, will come under significant pressure as a result of its local rules that would be discussed in the next segment of this analysis.

The conflict of regulation

The PCAOB was established in 2002 in a bid to boost the investor confidence of market participants after the catastrophic fall of Worldcom and Enron that wiped $150 billion of shareholder assets, collectively. In a nutshell, the PCAOB audits the auditors to ensure that financial statements of publicly listed companies are presented accurately and fairly.

The institution, however, has so far failed to audit the auditors of Chinese companies that are listed on American stock exchanges as a result of a conflict in the regulatory standards. There are two rules that govern Chinese companies.

  1. The Chinese Accounting Law
  2. The Chinese Archive Law

Under the first law, all companies are required to archive and preserve their audit papers. So far, so good. The conflict, however, arises from the stipulations of the Archive Law that prohibits archived documents from being transported out of China if either of the below conditions are met.

  1. The archived documents, including audit papers, are deemed as valuable to the state and the general public.
  2. The documents are classified as confidential, or Restricted Private Archives.

According to Wang Chen of the Columbia Law School, Chinese auditors must seek the approval of the government before granting access to audit papers to the PCAOB as these might reveal confidential information about companies as per the law.

With this, the conflict should be fairly apparent to the readers. While a Chinese company listed on a U.S. stock exchange is required to submit audit papers to the PCAOB for inspection, the Chinese law prohibits such action.

If the new bill passed by the Senate gets inked to the law, Chinese lawmakers would be required to tweak their policies to collaborate with the efforts of the U.S. regulators to make capital markets more transparent and trustworthy. Tensions between the two nations are once again rising and reaching some middle ground on this matter suddenly seems a distant reality.

Investing in Chinese companies might change forever

Some investors would never consider investing in a company domiciled in China, but there are others who believe it would not be prudent to ignore international markets altogether, especially China which is projected to be the largest economy in the world by 2050.

The Hong Kong Stock Exchange is already emerging as a popular destination for Chinese companies to raise capital. For instance, Alibaba Group Holding Limited (BABA) listed their securities in Hong Kong last November after a regulatory change allowed dual-class shares to list on the exchange, including secondary issues of ordinary shares. Nelson Yan, head of offshore capital markets investment products at Creditease Wealth Management told Bloomberg:

Hong Kong will become the core market for Alibaba trading in the future. More people will convert their U.S.-listed Alibaba shares into Hong Kong-listed ones, not just because of potential index-related flows but because overall ADR performance is increasingly clouded by accounting concerns.

If the U.S. and China fail to collaborate on this regulatory conflict, we might see more Chinese companies opting to list their securities in Hong Kong, and investing in high-growth Chinese companies will change forever under such circumstances.

Conclusion

There is an ongoing political debate among investors whether the recently approved bill by the Senate to regulate Chinese companies will ever be inked to the law. However, the best course of action is to be prepared for the worst. On the other hand, some investors believe that the rules would not make the life of billion-dollar tech giants such as Alibaba any difficult. However, a deeper dive into the regulatory framework in China reveals that companies of any scale will be exposed to the risk of being delisted from American stock exchanges. If this risk materializes, the market value of all these companies will only go one way in the coming months, regardless of the financial performance. Considering this uncertainty regarding the future, I would refrain from investing in Chinese companies until there’s more clarity about the regulatory outlook.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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