China and the U.S. Stock Market: Nowhere to go.

As we have discussed in our recent posts, the U.S. and China are now engaged in a process of economic restructuring. See The US-China Trade War: Winter is Coming (published one day before President Trump tweeted out the newest tariffs) The US-China Cold War Starts Now: What You Must do to Prepare (published three days after the tweeted tariffs). The Section 301 tariff dispute is only one aspect of a much larger process  we have been calling the New Normal. See China, the United States and the New Normal (from October 6, 2018) The New Normal has already and will continue too impact many areas of U.S./China financial cooperation. One important area it will greatly impact is the access of Chinese companies to U.S stock markets.

It is estimated that more than 200 Chinese companies have listed in various ways on U.S. stock exchanges with an estimated total market value exceeding 1.8 trillion U.S. dollars. Even at the height of the trade war, NASDAQ continues to announce that Chinese companies will do IPOs on the NASDAQ exchange. These IPOs are economically important to  NASDAQ and NASDAQ officials have stated that they welcome the new listings and are hoping for more in the future. See Nasdaq executive dismisses ‘discredited’ Steve Bannon’s call to bar Chinese companies from US capital markets.

But there is a fundamental problem with Chinese listings. The central core of the U.S. stock markets is that publicly listed companies are subject to financial oversight. First, they are audited by accredited U.S. auditing firms. Second, these audits are further monitored by the Public Company Oversight Board (PCOB). These regulations are applied with rigor against U.S. and European companies that list in the U.S., but Chinese companies are entirely exempted from such oversight.

This exemption from oversight is a product of Chinese government regulation. The Chinese government takes the position that allowing a foreign agency like the U.S. Securities and Exchange Commission (SEC) or the PBOC to audit Chinese companies on Chinese soil is an offense against Chinese government sovereignty. The initial response to this position was for the SEC/PBOC to say: fine, then just send the audit reports to us in the U.S. and we will audit over here. The Chinese then shut that option down by taking the position that the audit reports of Chinese companies constitute a Chinese government state secret. As a state secret, the audit reports cannot be allowed to leave China. According to a joint statement by the SEC and PCAOB from December 2018:

The business books and records related to transactions and events occurring within China are required by Chinese law to be kept and maintained there. China also restricts the auditor’s documentation of work performed in the country from being transferred out of China. . . . China’s state security laws are invoked at times to limit U.S. regulators’ ability to oversee the financial reporting of U.S.-listed, China-based companies. In particular, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers.

Stated more directly, unlike companies from the U.S. and Europe and everywhere else in the world, Chinese companies that list on the U.S. stock exchanges are exempt from meaningful financial oversight. This is a longstanding scandal that is finally coming to a head. On June 5, U.S. Senators Marco Rubio (R-FL), Bob Menendez (D-NJ), Tom Cotton (R-AR) and Kirsten Gillibrand (D-NY) introduced the Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges (EQUITABLE) Act. U.S. Representatives Mike Conaway (R-TX), Tim Ryan (D-OH), and Mike Gallagher (R-WI) introduced companion legislation in the House. See Disclose or leave: US bill vows to delist even biggest Chinese players As explained by Senator Rubio, this Act is intended to achieve the following three goals:

1. Force the PRC government to allow full access for audit of Chinese companies listed on U.S. exchanges.
2. Where such access is denied, compel those companies to delist. Under the current plan, the companies will be given three years to delist. The current view is that these companies will move to the Hong Kong exchange.
3. For the future, Chinese companies that fail to comply with the audit requirement will not be permitted to list.

The likelihood that the Chinese government will comply with this demand is at most two percent. This then means that if this legislation is passed (which is looking likely), all Chinese companies currently listed on the U.S. markets will be delisted and no future listings from Chinese companies will be permitted on the U.S. markets.

The operators of NASDQ have openly expressed opposition to this legislation. In a NASDAQ report, the author stated: “But torching shares valued at around $1.8 trillion is a harsh price to pay for transparency.” See China audit crackdown is a Wall Street nightmare. This is the same argument the SEC has been using for years to justify its refusal to take action on this issue. The argument is essentially that the damage has been done and now requiring the delisting of these unregulated Chinese companies would cause more harm than good. This was always a weak argument. However, the ultimate failure of the argument is that Chinese companies continue to list. They continue to be unregulated. So the damage increases as the SEC looks the other way. For a short history of Chinese company stock fraud on US stock exchanges, check out The Dirty $50 Billion Scam Wall Street Is Getting Away With.

The argument of the SEC and NASDAQ is nonsense. “Transparency” is at the core of the U.S. public market system. Torching shares at ANY valuation is a required price to pay to maintain transparency. It makes no business sense to allow the PRC government to harm the integrity of the U.S. public markets merely to allow the listing of shaky IPOs. Members of Congress see this and so they are taking direct action to remove authority from an unresponsive SEC.

It is not clear whether this legislation will be adopted. Wall Street opposes it and you  do not need me to tell you that Wall Street is very powerful. Moreover, the SEC has allowed this scandal to continue for decades and unwinding it now will be a Wall Street nightmare, as commentators have quite accurately pointed out. Moreover, the net effect will be to push this business to Hong Kong, to the ultimate detriment of the U.S. markets. So the stakes are high and the arguments will be intense.

Readers should note that the argument of Wall Street and the SEC has been: the damage has been done and we just have to live with it. This is similar to the response of many U.S. retailers on the tariff issue. A large group of retailers just sent the Trump administration a letter requesting it back off on tariffs against China, using a similar argument: the damage has already been done. The China price is already built into the structure of American business and it is too damaging to fix the situation now. So the U.S. should just back off and go back to the Old Normal. See Over 600 U.S. companies urge Trump to resolve trade dispute with China: letter.

Though this argument at first sounds ridiculous, it is in fact a very powerful, made even more powerful by its being made by some exceedingly powerful constituencies. The U.S. has allowed the situation with China to progress to this point at least since the Clinton administration. The current U.S. economy has been built on a foundation provided by China as manufacturer for the world, creator of the China price, and investor in U.S. stock markets.

Is the U.S. now willing to endure the pain of dealing with the issues? Will the United States  continue to allow unregulated Chinese companies to list on the U.S. public markets? Will it continue to chase the China price by allowing China to export its government created surpluses into the U.S.? The answers to these questions are not clear. But at least the issues are clear.

Right now, the prevailing view is that no matter who wins the U.S. presidency in 2018 that person will be at least as “anti-China” as Trump. Way back in August, only 38 percent of Americans saw China favorably and I presume that number has dropped considerably since then. Even if the next President is pro-China, she or he will likely be too late to change much.

Chinese investment in the U.S. is down “by nearly 90 per cent since its peak in 2016, including a sharp drop in 2018 and early 2019.” All sorts of companies have moved their manufacturing from China or are scrambling to do so. See Google is moving US-bound Nest production out of China (“Google’s production shift is part of an increasing trend. GoPro is moving its US-bound production to Mexico. Yesterday, Foxconn said it was prepared to move the production of US-bound iPhones outside of China before new tariffs as high as 25 percent kick in at the end of the month.”). The international lawyers at my firm are all working overtime helping our clients move from China to countries like Thailand, Vietnam, Malaysia, Taiwan, Mexico, etc.

No matter what happens with the tariffs, we are going to keep seeing large numbers of anti-dumping and countervailing duty cases being brought against goods coming into China and the duties that stem from those cases are going to lead to an effective ban on huge numbers of products from China. Or as one of my firm’s international trade lawyers puts it:

Truth is that with all the trade issues involving China and bipartisan anti-China sentiment prevalent in the United States, now is a great time to bring such actions. The international trade lawyers at my firm mostly defend against antidumping and countervailing duty claims instead of bringing them — we represent mostly the overseas producers and exporters and the US-based importers — so I say all this not to encourage more such actions, but as a simple statement of fact. If you are importing products from China, you need to assess and know the trade risks of your imports and to think about alternative sourcing.

Based what I keep hearing from my own firm’s China lawyers and international manufacturing lawyers, many American and European companies are seeking to diversify their product manufacturing away from China. See China-US Decoupling Continues and Will Continue, but Must be Done Right and China Manufacturing: Is the Bloom now Off That Rose? and The China-US Trade War and the Winner is….MEXICO. It appears US foreign policy is to drive business from China to countries like Mexico (note how quickly President Trump’s mini-tariff war with Mexico was resolved), the Ukraine, Vietnam, Thailand, the Philippines, and Indonesia, among others. What this means big picture is that the price of products coming from China to the United States will continue rising and, as one of our China lawyers so often tells our clients: “you need to act accordingly.”

Earlier this week, Bloomberg Businessweek did a big story on how the FBI and the National Institute of Health (NIH) are investigating and  “purging Chinese cancer researchers from top institutions.”

With so much US-China decoupling already having happened and so much more already in place to happen — pretty much no matter what — I have to wonder how many legitimate Chinese companies are still looking to list in the United States in any event. Even if this ban on Chinese stocks is not passed, will the Chinese government allow its companies to list in the United States? Who does not believe the Chinese government is not already pressuring Chinese companies already on American exchanges to leave them? See China opens Nasdaq-style board to lure tech firms back home. I realize there are a large number of Chinese companies set to IPO in the United States in the next year, but with China’s new board taking only “profitable companies,” and the incredibly poor performance history of so many Chinese companies that have done U.S. IPOs, I cannot help but wonder whether even a majority of these planned IPOs will happen even if the ban does not go through. In other words, is the economic damage NASDAQ and the SEC are touting even close to reality?

In It’s time to end the ‘China hustle’ on U.S. stock exchanges, Paul Gillis, one of the leading experts on Chinese public company accounting practices calls for the United States to crack down on Chinese companies listing on US stock exchanges:

“We’re bending our laws again for the Chinese for the sake of making money,” said Paul Gillis, professor at Peking University’s Guanghua School of Management. “Ordinary Americans are not aware they have a rising exposure to firms that are not adhering to U.S. laws.”

What are your thoughts?

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.