EDITOR NOTE: Many retail investors are jumping headlong into Chinese stocks or ETFs with considerable Chinese exposure. For some, it's a deliberate move, as China is at the forefront of technological innovation. For others, however, many are unaware of their exposure. China refuses to comply with US regulatory requirements for transparency. WIthout it, it's impossible to know whether a company you’re investing in is solid or fraudulent. Sadly, US investors bear the brunt of this risk, as every blind investment is no more than gamble--one that can empty out your pockets at any time, depending on the size of your bets.
A US regulator said on Thursday talks with China about improving oversight of US-listed Chinese companies will be futile until Chinese authorities accept fundamental US principles.
Over the past decade, “there have been near constant discussions with Chinese authorities,” said William Duhnke III, chairman of Public Company Accounting Oversight Board (PCAOB), the group that inspects the audits of the listed foreign companies.
“These efforts have failed to result in a viable model for cooperation because the Chinese authorities refused our principles and practice,” said Duhnke at a virtual round table organised by the US Securities and Exchange Commission (SEC) on Thursday to review risks posed by lack of oversight on foreign companies in emerging markets, including China.
“From our perspective, any further discussions about access are unlikely to be productive unless and until the Chinese authorities are willing to embrace certain principles that ensure our fundamental ability to accomplish our mission,” Duhnke added.
The round table, announced in May, was designed to hear the views of investors, market participants, regulators and industry experts about the risks of investing in emerging markets particularly China.
US securities laws require all companies – domestic and foreign – that are listed on the capital markets to provide audits for inspections by the PCAOB.
But regulators have been unable to inspect for compliance and enforce these rules and regulations on listed Chinese companies. US regulators have been struggling to work out a plan to allow audit inspections of its companies with Beijing.
In 2018, US regulators said that it faced “obstacles in inspecting the principal auditors’ work” on 224 listed companies, 213 of which were Chinese.
American investors face larger risks as US markets in the past decades have increased exposure to companies with significant operations in China as its economy grew to be the world’s second largest after the US. The total market capitalisation of Chinese companies listed on the New York Stock Exchange and the Nasdaq has reached US$1.7 trillion.
Passive US investors in mutual funds, index funds and exchange-traded funds (ETFs) are bearing the brunt of the risks, US regulators and market participants warned. Unlike large active managers that can investigate a company’s financials with their own research firms, such investors do not have resources or access to do so.
“With the retail investors, you’ll see this glaring disparity between the fund managers of BlackRock and Vanguard of Wall Street and the retail investors who are investing in indices and ETFs. And they have no clue as to what’s in their portfolios,” said Roger Robinson, president and chief executive of RWR Advisory Group, a Washington-based business consultancy.
Robinson pointed to US ETFs with exposure to China that are in public pension systems for 48 states and university endowments.
“When you talk to American retail investors the way I’ve had the opportunity to do state by state, they are out of their minds over the fact that they're building [China’s] newest aircraft carrier and other advanced weapon systems that are fuelling the human rights abuses of the surveillance state,” said Robinson, referring to Chinese firms that have been accused of being complicit in human rights abuse.
Luckin Coffee was the latest China-based company headed to the Wall Street graveyard. Less than a year after the Chinese rival to Starbucks went public on the Nasdaq, an employee was found to have
fabricated as much as US$310 million in sales.
In April, SEC, together with PCAOB, issued a statement warning about outsize risks associated with such stocks.
“Our ability to promote and enforce these standards in emerging markets is limited and is significantly dependent on the actions of local authorities – which, in turn, are constrained by national policy considerations in those countries,” said the regulators, led by SEC Chairman Jay Clayton.
“As a result, in many emerging markets, including China, there is substantially greater risk that disclosures will be incomplete or misleading.”
In May, US lawmakers introduced sweeping legislation that could put US-listed Chinese firms at risk of losing access to the world’s largest capital markets. The bill – the Holding Foreign Companies Accountable Act – passed the US Senate by unanimous consent on May 20 and awaits a vote in the House of Representatives.
If both chambers approve the bill and President Donald Trump signs it into law, Chinese companies will be required to hand over company audits to be inspected. Under the bill, failure to provide information for three straight years would lead to trading bans of the shares.
The Chinese securities regulator said the US politicised securities regulations to direct certain provisions in the bill at China rather than based them on professional consideration of security laws.
“The bill ignored completely the fact that regulators of China and the US have been working hard to improve audit inspection,” said China Securities Regulatory Commission in a statement in May.
“China assisted PCAOB on an investigation of a Chinese accounting firm in 2017. China has also in multiple occasions suggested detailed plans to PCAOB on how to jointly inspect audits since 2019. We hope US regulators could respond to these suggestions.”
In a rebuttal to that statement, Duhnke said on Thursday that “the fact remains that [Chinese authorities] reject our principles and application. It made it clear in both their negotiations and failed attempts and cooperation”.
And those principles ensure “our ability to conduct inspections and investigations consistent with our mandate, the ability to select an audit work and potential violations be examined and access to firm personnel audit work papers and other information or documents, being relevant by our team,” said Duhnke.
“To date, the Chinese authorities refused to allow us to conduct our oversight in terms consistent with the rest of the world,” he added.
Originally posted on SCMP