Will China’s Compromise on Foreign Audits Be Enough to Stop Stock Market Expulsions?

Almost 100 Chinese companies now face the threat of being delisted from American stock exchanges by the U.S. Securities and Exchange Commission (SEC).

Earlier this month, the SEC added over 80 Chinese companies to a record of U.S.-listed firms that are facing potential expulsions amid a long-running auditing standoff between the U.S. and China.

The latest batch, the sixth by the regulator, includes some of China’s largest and most successful corporations, including, China Petroleum & Chemical, Bilibili, NetEase and JinkoSolar Holdings.

So far, 128 Chinese companies have been named, including 105 on the provisional list and 23 on the conclusive list. In the past year ending March 31, a total of 261 Chinese companies, with a total market capitalization of $1.4 trillion, listed on U.S. exchanges. But more Chinese companies, including China’s eight state-owned enterprises listed in New York, face the threat of delisting.

China is the only jurisdiction that has created a “Catch-22” predicament for its listed companies. The country’s national state secrecy laws prohibit its foreign-listed companies from handing over their full financial and working documents to foreign authorities and auditors. That conflicts with the U.S. Holding Foreign Companies Accountable Act (HFCAA), legislation that Congress passed in 2020 and aims to remove foreign companies from U.S. bourses if they fail to comply with U.S. auditing standards for three consecutive years.

The Catch-22 created by the regulatory conflict has yet to be resolved. In March, the SEC announced the first batch of Chinese companies, which includes Yum China Holdings, the owner of fast-food joints KFC, Taco Bell and Pizza Hut in China, will be delisted imminently for failing to comply with the HFCAA.

Then last month, China extended a compromise by announcing new rules that allow foreign auditing of the financial documents of Chinese companies that have listed or intend to list in the U.S. But lawyers say the new rules are unclear and the government has failed to demonstrate complete commitment to transparency, particularly as the new provisions don’t actually change the application of its national state secrecy laws.

“The China Securities Regulatory Commission (CSRC) has said they’re going to take a more practical approach to the application of state secrecy laws, but what’s that going to look like?” said Washington, D.C.-based Claudius Modesti, a partner at Akin Gump Strauss Hauer & Feld who previously served as an SEC enforcement attorney, federal prosecutor and the first director of the enforcement division of the Public Company Accounting Oversight Board (PCAOB). “From the U.S. side, we are not sure whether the work papers submitted are going to have the information in them to support the audit. And that’s what we can’t really determine until this process plays itself out.”

That process could take months and potentially years, which wouldn’t do much for those Chinese companies that have already been identified by the SEC.

“A lot of people are focused on what the Chinese government is proposing, but that’s just a very preliminary step to the most important step, which is, what will the PCAOB be able to see once it inspects the working documents of those listed companies,” Modesti explained. “Both sides have been through a process of back and forth on how to potentially do this, but they’ve never successfully gone through an inspection. That’s when the rubber is going to hit the road.”

According to one Hong Kong-based partner at a Wall Street firm, the U.S. isn’t too bothered about a compromise—the dispute had been brewing for a long time, and the SEC is fully prepared to cut the Chinese companies loose, especially since the regulator has come under great pressure from lawmakers to force Chinese companies to improve disclosure standards, he said.

Chinese disclosure standards have come under scrutiny on several occasions in the U.S. Luckin Coffee, China’s version of Starbucks, is said to be one of the culprits that triggered closer scrutiny of Chinese companies that have listed in the U.S. In 2019, the coffee retailer admitted to submitting fraudulent revenue numbers. It was later delisted but has since experienced a remarkable comeback and is now rumored to have listing plans for Hong Kong.

According to George Wu, a Hong Kong partner at DLA Piper, the threat of being delisted in the U.S. and China’s new rules around foreign auditing will not impact eligibility and considerations around listing in Hong Kong. Having one more listing venue is a good add-on for those U.S.-listed Chinese companies regardless of whether the ongoing discussions about foreign auditing are successful, he said.

Some U.S.-listed companies have already taken steps to mitigate their risks. The Hong Kong market has benefited from the listings of several, including, Baidu, NetEase, Li Auto and Bilibili.

If Chinese companies like NIO Inc. and JinkoSolar, which are not dually listed, do indeed get pushed out of the U.S., the natural alternative venue is resoundingly Hong Kong, lawyers say.

But not all will be able to list there. According to Hong Kong listing rules, companies either have to generate an aggregate net profit of at least $6.45 million over the three preceding years or have a minimum market capitalization of $255 million at the time of listing, and revenue of at least $64 million.

Comparatively, the New York Stock Exchange requires companies to have a much smaller market capitalization base to list—$200 million or an adjusted pre-tax profit of $2 million (rather than net profit), in the past two years.

For those companies that do not currently meet the conditions for returning to list in Hong Kong, Wu said the new foreign auditing rules promulgated by the Chinese government “may help stabilize their investors’ confidence as well as stock market performance while they seek alternative solutions, including the possible new listing chapter in HK that may come out in the coming years.”

The unsettled questions surrounding U.S. listings may be a headache for Chinese companies singled out by the SEC, but it’s good news for capital markets players in Hong Kong—particularly for U.K. firms, which have in recent months taken a back seat on Hong Kong IPO work. Over the past couple of years, U.S. firms have topped the charts for advising on more Hong Kong listings than U.K. firms, which have traditionally dominated the local IPO market.

One Wall Street partner said that law firms are already aggressively pitching for privatization work in order to get a slice of the listing advice.

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