1. Why does the US want access to audits?
The Sarbanes-Oxley Act of 2002, enacted after the Enron Corp. accounting scandal was enacted required all public companies to have their accounts reviewed by the US Public Company Accounting Oversight Board. In the ensuing two decades of negotiations, China has denied access. The long-simmering accounting problem turned into a political one as tensions between Washington and Beijing rose during the Trump administration. Nasdaq-listed Chinese chain Luckin Coffee Inc. was found to have intentionally fabricated part of its 2019 earnings. The following year, in a rare bipartisan move, Congress moved to force US-listed companies based in China and Hong Kong to finally allow inspections.
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As required by law, known as the Holding Foreign Companies Accountable Act, or HFCAA, the SEC has begun releasing its “tentative list” of companies found to be in violation of the requirements. While the move had long been telegraphed, the initial release in early March sent US shares of China- and Hong Kong-based companies sharply lower as it dashed hopes of some sort of compromise. China’s securities regulator issued a statement saying “positive progress” had been made in the talks while reiterating its opposition to what it called “politicizing securities regulation.” The PCAOB called speculation about a deal “premature”. The SEC is required by law to move forward, and its chairman, Gary Gensler, has pledged to enforce the three-year deadline for Chinese firms to approve the inspections. “The way is clear,” Gensler told Bloomberg News in an August 2021 interview. “The clock is ticking.”
3. What is the broader problem?
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Critics say Chinese companies enjoy the trading privileges of a market economy – including access to US stock exchanges – while receiving government support and operating in an opaque system. In addition to inspecting audits, the HFCAA also requires foreign companies to disclose whether they are controlled by a government. Meanwhile, the SEC is also demanding that investors get more information about the structure and risks associated with the shell companies, known as variable interest entities, or VIEs, that Chinese companies use to list stocks in New York. Since July 2021, the SEC has denied the green light for new listings. Gensler also said more than 250 companies already trading will face similar requirements.
4. Why don’t Chinese companies share their audits with the PCAOB?
They say China’s national security law prohibits them from handing over exam papers to US regulators. According to the SEC, more than 50 jurisdictions are working with the PCAOB to facilitate the necessary inspections, two have not done so in the past: China and Hong Kong. (The China Securities Regulatory Commission is scheduled to consider March 17 allowing U.S. officials to see documents from companies that don’t hold sensitive data, such as restaurant operator Yum! China Holdings Inc. or travel platform Trip.com Group Ltd That news came a day after President Xi Jinping’s administration promised a series of measures to support the country’s financial markets and allay concerns from global investors.)
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5. How soon could Chinese companies be delisted?
Nothing will happen this year or even 2023 – which explains why markets initially embraced the possibility with ease. Under the HFCAA, a company would only be delisted after three consecutive years of failing to comply with audit inspections. It could come back by certifying that it has hired an SEC-approved registered public accounting firm. However, when the SEC actually started publishing company names, the market reacted violently. For example, the Nasdaq Golden Dragon China Index plunged 18% in the week ended March 11 after the agency released its top five names.
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It is an ongoing process and function when companies report their financial statements and an accounting firm that the PCAOB has identified as non-compliant. For example Yum! China reported in New York on February 8th and was added on March 8th. The social media platform Weibo Corp. was added on March 23.
7. How many will ultimately be affected?
There isn’t much discretion. If a company from China or Hong Kong trades in the US and files an annual report, they will soon be on this list as these have been identified as non-compliant jurisdictions. Overall, the PCAOB has said it is barred from reviewing the audits of more than 200 companies based in China or Hong Kong, including Alibaba, PetroChina, Baidu and JD.com. They are all expected to be on this list in the coming months. US-traded Chinese companies have a combined market capitalization in the hundreds of billions of dollars.
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8. Are some of them really controlled by the Chinese government?
Big private companies like Alibaba could probably argue they aren’t, although others with significant government ownership may have a harder time. In May 2021, the US-China Economic and Security Review Commission, which reports to Congress, counted eight “Chinese national-level SOEs” listed on major US stock exchanges.
9. Why are Chinese companies listing in the US?
They are attracted by the liquidity and deep investor base of US capital markets. They offer access to a much larger and less volatile pool of capital in a potentially faster time frame. China’s own markets, while huge, are relatively underdeveloped. In a financial system constrained by government lenders, raising funds can take months, even for quality companies. Dozens of firms canceled planned IPOs over the past year after Chinese regulators tightened listing requirements to protect retail investors who dominate stock trading, as opposed to institutional investors and mutual funds operating in the US. And until recently, the Hong Kong Stock Exchange had a ban on dual-class stocks, which are often used by tech entrepreneurs to maintain control of their startups after they go public in the US. In 2018, it was relaxed, leading to large listings from Alibaba, Meituan, and Xiaomi.
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10. How did China react?
In December, China introduced new rules requiring all companies seeking IPOs or additional sales of shares overseas to register with China’s Securities and Exchange Commission. The requirements only apply to new shares and do not affect foreign ownership of companies already listed abroad, such as Alibaba or Baidu. However, Chinese companies in industries prohibited from foreign investment must apply for an exemption before conducting stock sales, and foreign investors in such companies would be prohibited from participating in management and their ownership would be restricted.
(Updated Section 2 with PCAOB comment; Weibo’s listing in Section 6. An earlier version of this story has been corrected to delete the reference to Alibaba’s Feb. 24 report, which was for the fourth quarter.)
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