EDITOR NOTES: Investors seeking diversification may opt for international stocks, Chinese companies being one of the stronger allocations. But beware, as the SEC warns. China is obstructing US regulatory calls for transparency. Many Chinese companies either do not have solid auditing procedures or they’re refusing to show the results of their audits. You can’t tell if a company’s fundamentals are strong, weak, or straight out fraudulent. What began as a war in trade has now shifted to the financial realm. And should the situation go south, the biggest victims will be American investors who sought diversification in these untrustworthy assets.
You’ve heard about the trade war with China. There may be a separate, potential “financial war” brewing.
The Securities and Exchange Commission wants you to know more about what is happening with Chinese companies that list in the United States. The regulators also want you to know that they are having a really hard time finding out exactly what is going on.
Thursday, the SEC is holding a roundtable discussion on emerging markets, but it’s really about the next phase in an ongoing effort to get Chinese regulatory authorities to be more transparent about what is happening inside Chinese companies that list on U.S. exchanges.
This has been a problem for years but it is now getting serious traction due to the escalation of trade disputes with China.
More than a decade ago, hundreds of Chinese companies went public in the U.S. via reverse mergers, merging into public but mostly dormant U.S. companies. Many turned out to be frauds, so many that a movie, “The China Hustle,” was made about the whole wild affair.
One particularly weak point stands out: auditing procedures. The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board. It required that every domestic and foreign accounting firm that issues audit reports for companies that report to the SEC register with the board. The board is required to periodically inspect registered firm audits of U.S. public companies, including those done by foreign firms.
Over time, the PCAOB negotiated agreements with foreign counterparts that allowed them to perform audit inspections, but they have been stymied by their regulatory counterparts in China, which claim that audit records are state secrets.
Brendan Ahern, chief investment officer of Kraneshares, which runs several China exchange-traded funds, said the Chinese government’s ownership of many companies was a part of the problem. “Across the 200 listed Chinese companies there are a few state-owned enterprises,” he said, and revealing financial information about them is particularly sensitive to the Chinese. Ahern added that he believed China should comply with the U.S. regulatory requirements.
Last year, SEC Chair Jay Clayton and PCAOB Chairman William Duhnke III went public with their concerns. They reiterated their frustration in a Feb. 19 statement, where they noted that the board “continues to be prevented from inspecting the audit work and practices of PCAOB-registered audit firms in China on a comparable basis to other non-U.S. jurisdictions.”
This roundtable should be viewed as part of a continuing effort to build a case against China’s recalcitrance, according to Roger Silvers, an accounting professor at the University of Utah who previously worked for the SEC and who submitted comments to the roundtable.
“China has been very obstructionist” in blocking requests for access to its audit records, Silvers said. “There is a growing sense of frustration with China, and now with the trade wars and the Covid-19 outbreak there is a growing appetite to pick a fight with China. There is a change in the geopolitical climate.”
The roundtable will parade out witnesses describing the problems, including Carson Block, founder and chief investment officer at Muddy Waters Capital, who was involved in uncovering the Luckin Coffee accounting fraud. In a statement emailed to CNBC in April, Block claimed that Luckin was a “wake-up call for U.S. policymakers, regulators, and investors about the extreme fraud risk China-based companies pose to our markets.”
Congress is also taking some interest. On May 20, the Senate passed the Holding Foreign Companies Accountable Act, which would require foreign companies to comply with PCAOB standards. If the PCAOB is unable to inspect an issuer’s public accounting firm for three consecutive years, the issuer’s securities will be banned from trading on a U.S. national exchange.
The bill is now in the House for consideration.
Sen. Marco Rubio, R-Fla., has also introduced a bipartisan bill that would delist foreign companies that do not comply with U.S. accounting and oversight regulations.
Not surprisingly, the White House is also pushing for action. On June 4, the White House issued a “Memorandum on Protecting United States Investors from Significant Risks from Chinese Companies.”
“It is both wrong and dangerous for China to benefit from our capital markets without complying with critical protections that investors in those markets rightfully expect and deserve,” the memorandum reads. “China’s actions to thwart our transparency laws raise significant risks for investors.”
The memo directs the President’s Working Group on Financial Markets to address to investors from China-based companies and draft a report within 60 days.
And that, Silvers said, is the main issue: How far is the U.S. willing to go to force China to comply with U.S. regulations?
One possibility: U.S. exchanges that believe foreign companies are not following U.S. law could begin delisting companies. John Tuttle, vice chairman of the New York Stock Exchange, and John A. Zecca, Nasdaq’s global chief financial and regulatory officer, are speaking at the roundtable.
Another possible next step: The PCAOB could deregister the auditors. Because the companies need to have an auditor that is listed with the board, the SEC or the exchanges could then delist the company.
Silvers says even more extreme actions could be taken, what he described as “nuclear options.”
“The SEC might be able to make a rule that said, you are not allowed to have subsidiaries that are not audited by firms that can’t be inspected by us. It would mean Apple, IBM, Nike would have to cut ties with those subsidiaries. But if that happens, you are talking about an all-out trade war.”
“They have to be careful not to cut off their nose to spite their face,” he continued, adding that U.S. consumers could be hit by retaliatory measures that would restrict access to foreign goods.
Silvers also noted that there is a much broader question of whether it is desirable to stop any investment in China or stop any means of China gaining access to our markets.
“There is a part of me that says disclosure to investors is key,” he said. “Caveat emptor: If you invest in China, you do it at your own risk.”
Originally posted on CNBC