Thursday, July 2, 2020

The Case For Delisting Chinese Companies From U.S. Stock Exchanges

Editorial Note: We are delighted to present this essay by contributing columnist Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

The Trump administration is considering whether to step into the controversy over whether foreign companies listing their stock on U.S. exchanges should be subject to the same accounting and audit regulations as U.S. companies. The problem is some foreign companies are reluctant to provide access to the Public Company Accounting Oversight Board to enable it to conduct audit inspections of registered public accounting firms. Absent equal access, there is a disconnect between regulatory oversight of U.S. companies and foreign firms.

According to the SEC, 224 U.S.-listed companies representing more than $1.8 trillion in combined market capitalization are located in countries where there are obstacles to PCAOB inspections of the kind. About 95 percent of firms whose financial statements cannot be reviewed use Chinese auditors.

The Public Interest

The public interest demands that foreign governments provide such access to level the playing field and protect investors. U.S. investors need to know that foreign companies are following the same rules that U.S. companies follow. Effective audits and regulatory oversight provide the foundation of trust in foreign companies listed on U.S. exchanges.

The world’s capital markets are global, as are the world’s largest companies. It is important that capital investment continue to flow internationally and U.S. stock markets are a major player in that process. In return for free access to foreign companies listed on U.S. exchanges, foreign companies must abide by market rules. One such requirement is for the PCAOB to have access to audits conducted by registered firms in order to inspect audits and make sure the financial information is of high quality and reliable.

U.S. Regulations

In order for the securities to be traded in U.S. capital markets, public companies, whether located in the U.S. or abroad, must comply with certain U.S. legal requirements, including the requirement to periodically file financial statements with the U.S. Securities and Exchange Commission. Sarbanes-Oxley requires that the auditor of these statements—whether a U.S. auditor or a non-U.S. auditor— must be registered with and be subject to the jurisdiction of the PCAOB. This includes undergoing regular PCAOB inspections to assess the auditor’s compliance with U.S. law and professional standards in connection with its audits of public companies.

According to the SEC, the PCAOB has conducted inspections of registered audit firms in 50 different non-U.S. jurisdictions (https://www.bloomberg.com/news/articles/2020-05-20/senate-passes-bill-to-delist-chinese-companies-from-exchanges). For the most part, regulators from foreign jurisdictions have cooperated with the PCAOB and allowed U.S. auditors to have access to the audit information of foreign companies. Still, this level of interconnectedness creates challenges, including regulatory oversight with respect to U.S.-listed companies with international operations.

Chinese Companies

Chinese companies that list their shares in the U.S. have long fought with the PCAOB over audit inspections. In some cases, the government either prohibits it or is not interested in cooperating with U.S. regulators. The Chinese typically explain it by saying the financial information may contain state secrets. More likely, it is a cultural issue in that by examining the audits already conducted by Chinese audit firms, a message is sent that those firms and, indeed, the Chinese system cannot be trusted  

President Trump and U.S. lawmakers have decided to get involved. Back in May, the President said that regulators are looking to see whether Chinese companies should be forced to comply with American accounting rules. Senators Chris Van Hollen (D-Md.) and John Kennedy (R-La.) have sponsored bipartisan legislation (Holding Foreign Companies Accountable Act) that would kick Chinese companies off U.S. stock exchanges if they continue to deny the PCAOB to access their audits (https://www.congress.gov/bill/116th-congress/senate-bill/945).

The U.S. Senate overwhelmingly approved the Act (S.945) on May 20, 2020, that would bar Chinese companies such as Alibaba Group Holding Ltd. and Baidu Inc. if they do not certify that they are not owned or controlled by a foreign government. Moreover, if the board is unable to inspect the issuer’s public accounting firm for three years, the issuer’s securities are banned from trade on a U.S. exchange or through other methods.

Costs and Benefits of Delisting

The costs of delisting Chinese companies should not be ignored. Indeed, the Trump administration may back off if it means delisting Chinese companies that do not comply with U.S. regulations when that motivates Chinese firms to flee to a competing foreign stock exchange. There may not be the appetite to deprive Americans of the chance to invest in Chinese companies. The stock exchanges may be reluctant to lose the presence of an important emerging market.

The benefits of removal from the exchanges are many. It starts with being able to verify that the audits were conducted in accordance with U.S. standards, which may be part of the reason Chinese authorities are reluctant to open up the books of Chinese companies. In China, most of the enterprises are state-owned and the standards for auditing are set by the government. Most important, holding both U.S.-based and foreign-based audit firms to the same PCAOB oversight rules enhances trust, a key element of transparency.

Chinese companies benefit by having access to American markets but they do not play by the same rules. A lack of transparency into the ownership and finances of Chinese companies has been criticized by American businesses. In particular, China has classified some auditor reports on company finances as state secrets, thereby prohibiting cross-border transfers of audit documentation.

Conclusions

U.S. audit firms suffer when Chinese authorities place barriers to access audit reports including those of Chinese affiliates of the Big Four accounting firms. Recently, each paid $500,000 to the SEC to settle a dispute about their refusal to provide documentation on Chinese companies, which an American judge ruled was a violation of U.S. law.

Recent examples of delisting illustrate why it is so important for the PCAOB to be able to audit Chinese affiliates of U.S. Big 4 audit firms. Failing to open up the books so that the PCAOB can conduct an audit inspection can mask a financial fraud that would otherwise be detected. A good example is Chinese company Luckin Coffee Inc., which recently disclosed it had an accounting fraud.  Luckin’s shares were sold on the exchange for just one year. It was touted as a Chinese rival to Starbucks. But trading was halted in April 2020 after an internal investigation found about $310 million in fabricated transactions.

Chinese companies should be held to the same standards as other foreign companies that list their stock on U.S. exchanges. There is no sound basis to give preferential treatment to Chinese companies simply because they are reluctant to open their books and audits for inspection by U.S. regulators.

Steven Mintz, professor emeritus Cal Poly San Luis Obispo