The US Could Forcibly Delist Every Chinese Stock In The US

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China and the U.S. appear to be on a collision course over accounting.  That’s a lot more serious than it sounds.  By the end of this year, unless a compromise can be reached, there is a very real chance that U.S. securities regulators may end up employing the “nuclear option”:  forcibly delisting every Chinese company currently listed on a U.S. stock exchange — such as Sinopec,, China Life, and China Unicom.It’s a potential catastrophe-in-the-making that few investors or politicians have given any serious thought to.

Last year, the US-listed stocks of more than a few Chinese companies took a beating following accusations by short sellers and research shops like Muddy Waters that SinoForest and other companies — many of which had avoided IPO scrutiny by arranging reverse mergers with already-listed entities — were grossly exaggerating their real assets and business performance in their official financial statements.  These accusations prompted the Securities and Exchange Commission (SEC) to launch several fraud investigations into the Chinese companies in question.

Rather than assisting the SEC in its cross-border probes — as other countries regularly do — the China Securities Regulatory Commission (CSRC) has actively blocked the SEC’s information requests, insisting that audit materials on Chinese firms fall under China’s ambiguous yet draconian State Secrets Law.  This April, when the SEC issued a subpoena to the Chinese arm of Deloitte, demanding the audit records of Longtop Financial (which collapsed last May after Deloitte resigned as its auditor), Deloitte refused, noting that the CSRC directly ordered them not to turn over such papers.

The firm argued it could be dissolved and its partners jailed for life if they were to comply.  In May, the SEC responded by initiating administrative proceedings to punish Deloitte China for violating its duties under the 2002 Sarbanes-Oxley Act.  Penalties could include suspending the firm’s authority to perform audits for US-listed companies, which are required under U.S. securities laws.  Apparently similar subpoenas have been issued to each of the other “Big Four” global audit firms (E&Y, KMPG, and PWC), and have met with similar replies.

There is a further complication: The Sarbanes-Oxley Act also established the Public Company Accounting Oversight Board (PCAOB), a five-person body appointed by the SEC.  Public accounting firms that wish to perform audits on US-listed companies must register with PCAOB, and PCAOB is required, by law, to conduct inspections of those firms.  So far, Chinese authorities have refused PCAOB permission to inspect auditors based in China, including the local arms of “Big Four” global audit firms.  Last month, it looked like PCAOB might have worked out a compromise that would let it observe Chinese regulators perform their own inspection, but the SEC action against Deloitte China appears to have derailed that plan. The stage is set for a deadlock with serious, potentially disastrous implications, as my fellow CPA and Peking University counterpart Paul Gillis describes in his blog:

The PCAOB faces a December deadline to complete inspections of Chinese accounting firms that are registered with the PCAOB. It seems highly unlikely that they will meet this deadline, since Chinese regulators will not let them come to China. While the PCAOB could extend the deadline, they have already been under political pressure to act … Without resolution, the only meaningful option for the SEC, and the PCAOB, is for the PCAOB to deregister the firms and for the SEC to ban them from practice before the SEC.

The consequence of those actions would be that U.S. listed Chinese companies would be without auditors and unable to find them. Having an auditor is a listing requirement of the exchanges, so under exchange rules the companies face delisting. The U.S. listed Chinese companies would be unable to file financial statements as required. That should lead the SEC to eventually deregister the companies with the SEC.

Paul notes that shareholders in the delisted Chinese companies would still own their shares, but would be unable to trade them on U.S. exchanges.  The companies would probably try to list their stock on other non-U.S. exchanges such as Hong Kong, which could prove an expensive and cumbersome option.  The effect on US-China relations, and on investor confidence in cross-border investments in either direction, would be devastating.  Yet the alternative would be to allow Chinese companies to trade their shares on U.S. exchanges while openly flouting U.S. securities laws — not just Sarbanes-Oxley, which is somewhat controversial, but anti-fraud provisions dating back to the 1930s.

In the meantime, Chinese regulators have been moving to exert even greater secrecy and control over companies’ financial information.  Local bureaus of the State Administration for Industry and Commerce (SAIC) have started restricting public access to domestic corporate filings, after short sellers and analysts used information gleaned from those filings to call company financial statements into question.  Of more immediate concern, the Ministry of Finance is following through on plans to force the “Big Four” global audit firms to surrender majority control of their Chinese operations over to local CPAs, and dramatically reduce the number of foreign-certified CPAs they employ.  As Paul Gillis notes on his blog:

One of the unintended outcomes of the restructuring of the Big Four in China will be that the firms will likely be required to re-register with the PCAOB.  That could pose a problem, since the PCAOB has said they will accept no new audit firm registrations from China until the issue of inspections is resolved.

I was pondering the irresistible-force-meets-immovable-object dilemma here last night when I happened across a seemingly unrelated passage in Jim Fallows’ new book China Airborne, which offered a glimmer of hope.

In 1997, Jim relates, three Chinese airlines — Air China, China Eastern, and China Southern — had just been awarded, or applied for, very prestigious and strategically important routes to the United States, and had purchased brand-new state-of-the-art Boeing planes to fly those routes, with many further orders expected.  However, the safety record of Chinese airlines in the 1990s was atrocious.  In order to actually fly those routes, the airlines required approval from the U.S. Department of Transportation (DOT), the parent body of the FAA.  The DOT, at the FAA’s urging, demanded “confirmation that China’s regulatory standards, as applied by the CAAC, conformed to the worldwide guidelines laid out by international agreements.”  Until then, it was no fly.

The Chinese were furious, believing the Americans had double-crossed them by selling the planes and then reneging on the routes.  The whole thing could have concluded in respective chest-beating and a very ugly, damaging stand-off.  Instead, Boeing took the initiative (since its future sales were on the line) through a series of seminars, tours, and training sessions to reconcile the two points of view.  Key to its success was the way it handled Chinese sensitivities:

One [way] was to present all their recommendations in terms of meeting international standards for air safety and airline procedures, rather than seeming to say, This is how we do it in the U.S. of A.  Presenting the challenge this way made it far more palatable to the Chinese side.  Learning to comply with international standards was one more sign of modernization in China; doing things the “American way” could seem like a sign of continued subservience.  The examples were, of course, from American practices at the FAA or the operational details of Boeing and United Airlines, but the leitmotif was that Americans had learned how to make their practices meet international standards, and they could help the Chinese do the same thing.

Bridging the gap in securities regulation will surely be more difficult than fine-tuning some phrases — especially since Chinese companies that truly are fraudulent have a lot to hide.  But Chinese aviation officials had a lot to hide too, back then.  Many of them, once they realised how far they fell short of “international standards,” doubted whether they could ever make the grade, and feared losing face and making others lose face if they tried.  But working with their American partners, they succeeded:  China’s airline industry today has an admirable safety record, which has laid the foundation for ambitious plans for China to claim a leading role in the global aviation industry.  Caixin reports that at least some officials at CSRC are sympathetic to what the SEC is trying to achieve, and they certainly don’t want to seem too far out of step with their international (and much more cooperative) peers.

If China wants Shanghai to become a “global financial centre,” or the Renminbi to develop into an “international currency,” it has to do the same thing in securities regulation that did in airline safety regulation.  It has to win the confidence of global investors just as it successfully won the confidence of global travellers.  China closing the windows and battening the hatches to avoid embarrassment is not a solution; but neither is Americans telling the Chinese “it’s our way or the highway.”  The U.S. has to make a forceful, compelling argument that adopting international norms of openness and cooperation will help China achieve its ambitions — but that until then, it’s “no fly” for unsafe stocks on U.S. markets.

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