For more than a decade, Chinese companies raised billions by listing their shares on American stock exchanges while avoiding the accounting-quality checks that other public firms endure.
But economic tension between the two global superpowers, amplified by political outrage in the U.S. over China’s role in the spread of the new coronavirus, has pushed a financial-markets issue into the political mainstream. Legislation passed by the Senate—and now introduced in the House—would kick Chinese companies off U.S. stock exchanges unless their audits are inspected by U.S. regulators.
No firms would immediately lose their listing under the proposed legislation, but investors worry it will further inflame tensions between Beijing and Washington at a particularly bad time. Shares in major Chinese companies listed in the U.S. dropped sharply in the days after the Senate passage. With the global economy reeling from the coronavirus, a worsening of the relationship could create more skepticism about the resumption of trade talks and send both U.S. and Chinese shares lower.
“Chinese companies have failed to meet U.S. standards that were agreed upon in writing when their companies were listed,” said Michael Farr, president of money-management firm Farr, Miller & Washington. “The problem is that compliance failures have gone unaddressed and bad behavior has increased.”
Unlike other countries, China has never given U.S. regulators routine access to audit records needed to review the quality of financial accounting, according to U.S. officials, who have sought a deal for years. That covers about 200 companies with a total market value exceeding $1.4 trillion, according to S&P Global Market Intelligence.
Investors have often been willing to overlook the regulatory gap as they snapped up shares of Chinese companies, including Alibaba Group Holding Ltd., that made their debuts on U.S. exchanges. Wall Street banks, which underwrote the stock sales and are supposed to conduct due diligence on the companies, have been rewarded with more than $1.4 billion in fees, according to data from Dealogic. The major stock exchanges also benefited from lucrative, attention-getting global listings.
The Senate legislation requires the Chinese companies with shares traded here to disclose to the Securities and Exchange Commission whether they are owned or controlled by state authorities.
While many of the Chinese companies traded in the U.S. aren’t state-owned, such as Alibaba and e-commerce rival JD.com Inc., others are fully or partially under Chinese government control. China is less likely to allow audit work papers for state-owned firms to ever be shared with overseas regulators, according to securities lawyers. Shares of many Chinese firms have been hit hard since the passage of the Senate bill on Wednesday, with Alibaba and JD.com falling 8% and Baidu Inc. dropping 5.8%.
China says sharing audit work papers would violate its sovereignty and risk leaking state secrets. This year, it outlawed complying with overseas securities regulators without the permission of its own market supervisor and various components of the Chinese government.
The SEC has stepped up its warnings about the regulatory blind spot in recent months, including after the disclosure of accounting fraud at Luckin Coffee, a once-highflying Chinese startup and competitor to Starbucks Corp.
Luckin, which went public on the Nasdaq Stock Market and is being investigated by the SEC, said some employees fabricated $310 million in revenue. It has since fired its chief executive and chief operating officer, and its shares have fallen to a recent $1.39 from $50 in January. The SEC said last month that the agency’s ability to promote and enforce standards in China and other emerging markets is severely limited.
Before Luckin, there was a string of Chinese frauds in the U.S. stock market. The SEC sued Deloitte Touche Tohmatsu CPA Ltd. in 2011, seeking records it needed to conduct a fraud investigation of the audit firm’s former client, China-based Longtop Financial Technologies Ltd. In 2016, the SEC sued Longwei Petroleum Investment Holding Ltd., a fuel company based in China that had been listed on the New York Stock Exchange’s market for smaller companies, over claims that it fabricated aspects of its business. The SEC prevailed in the case in 2019.
Backers of the proposed U.S. crackdown say what had been a low-profile issue in financial markets took on greater political meaning after this year’s economic crash.
“What has helped with this is all things coronavirus,” said Rep. Mike Conaway (R., Texas), who sponsored similar legislation last year. “China’s response has brought a lot of issues to the forefront, one of which is, should they have access to our markets with different rules than everybody else?”
Critics say the SEC and the Public Company Accounting Oversight Board could have moved in the past to cut off Chinese companies from U.S. markets over the audit-inspection stalemate. But barring the Chinese audit firms, for instance, would have negative consequences for U.S. multinationals that use the firms for their China operations.
The Senate legislation, co-written by Sens. John Kennedy (R., La.) and Chris Van Hollen (D., Md.), must pass the House to become law. A version of the bill was introduced in the House by Rep. Brad Sherman (D., Calif.), who chairs a key subcommittee that focuses on investor protection and said the bill may need a technical fix.
“We needed the SEC and the PCAOB to move in this direction, but now it looks like Congress will,” Mr. Sherman said. “I think this passes the House in the next two months, hopefully in improved form.”
The House is likely to approve the bill, said James Lucier, managing director at Capital Alpha Partners LLC, an investor-focused policy research firm.
SEC Chairman Jay Clayton said that the Senate legislation offers a new way to get China to comply with PCAOB requirements. The companies and their auditors would have three more years to comply with inspection requirements—or face delisting from the Nasdaq or NYSE.
“The Senate bill is a legislative attempt to get China to comply with the oversight requirements,” Mr. Clayton said. “The status quo is not acceptable.”
Photo: Chinese companies such as Alibaba could be forced to give up their listings on U.S. stock exchanges. – BRENDAN MCDERMID/REUTERS