Delisting China: Making Investing Fair Again

Enforced Audit Review

China’s Luckin Coffee, which was meant to be the People’s Republic of China (PRC) answer to Starbucks, was threatened with delisting from NASDAQ when it was discovered that employees had fabricated $310 million in sales. And Luckin is just one of many Chinese companies which have falsified sales data or failed to comply with audit reviews.

Senator John Kennedy told Bloomberg “Chinese firms claim they can’t comply [with SEC/ PCAOB audit reviews] because Chinese national security law prohibits them from turning over audit papers to U.S. regulators.” The problem with out-of-compliance Chinese firms in US markets is amplified by the sheer number of firms. There are around 700 Chinese companies in America’s stock and bond or capital markets.

China has about 86 companies listed on the New York Stock Exchange, around 62 in the NASDAQ, and more than 500 in over-the-counter market.” The total value of the Chinese company stocks traded in the US is approximately $1 Trillion with around $8 billion being traded each day. The U.S.-China Economic and Security Review Commission reported to Congress that as of February 2019, at least 11 Chinese companies listed on major U.S. exchanges were 30%, or more, state-owned.

Risks to American Investors

Companies such as China Mobile Ltd. and China Life Insurance Co. are clearly state firms, but even companies where the government holds no shares can be significantly controlled by the Chinese government. A glaring example would be Anbang Insurance, which the Chinese government took over after it became financially distressed. Anbang ran into financial difficulty after going on a major acquisition spree in the US.

This happened when it purchased New York’s Waldorf Astoria hotel, Strategic Hotels & Resorts, the office portion of 717 Fifth Avenue, Hotel del Coronado near San Diego, the Westin St. Francis in San Francisco, several Four Seasons resorts, as well as Manhattan’s JW Marriott Essex House hotel. As a result of the Chinese government taking over Anbang, the Communist Party of China (CCP) now controls these luxury properties in the US.

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Inflated sales figures and falsified financial data present undisclosed risks for American investors. Representative Brad Sherman of California, who sits on the House Financial Services Committee, told reporters “For too long, Chinese companies have disregarded U.S. reporting standards, misleading our investors.” The issues of lack of transparency and non-compliance are part of a greater China strategy which the west has followed since the US normalized relations with China in 1982.

The theory said that if the west engaged with China and helped the country develop economically, China would begin to reform from within, moving toward greater openness and possibly even democracy. While waiting for China to transform, the US ran a tremendous trade deficit with them, allowed them to steal its intellectual property and jobs, and to cheat on trade. Now, nearly 40 years later, China has not moved towards greater openness or democracy.

On the contrary, the country is reverting to Mao-style leadership, with Xi Jinping holding the top position in all three major components of government, for life. As for adopting western trade and investment standards, President Donald Trump’s economic adviser Larry Kudlow said, “We have learned that Chinese companies are not transparent…They do not meet the norms, the regulations.”

Enforcing Accountability

Now the Holding Foreign Companies Accountable Act has passed the US Senate and moved on to the House of Representatives. “Publicly listed companies should all be held to the same standards, and this bill makes common sense changes to level the playing field and give investors the transparency they need to make informed decisions,” said Senator Chris Van Hollen, who introduced the legislation. The Bill would require all companies, including Chinese companies, to disclose whether they are owned or controlled by a foreign government.

Additionally, they must submit to three annual audit reviews from the Public Company Accounting Oversight Board (PCAOB). Among the largest Chinese firms affected are Alibaba and Baidu. Whether a company is state-owned/controlled, or truly owned by public shareholder has long-reaching implications for a firm’s behavior. Publicly traded companies, unless they disclose otherwise, are essentially obligated to act in the interest of their shareholders. Decisions made by the firm should be those that maximize shareholder value. State-owned or state-controlled companies, however, act to further the objectives of the Communist Party of China.

This often includes making decisions which do not maximize profit. It is unfair for US investors to invest in these companies, believing the companies will act in the interest of shareholders, only to discover that the company is making poor business decisions in order to help a foreign government whose interests are often at odds with those of the US government. This act will also apply to companies listed in Hong Kong. Currently, PCAOB reports that it is blocked from reviewing the audits of 200 China or Hong Kong based firms, including Alibaba, PetroChina, Baidu and JD.com.

Worsening Investment Climate for China

Larry Kudlow told reporters that “nobody can invest confidently in Chinese companies” and that the U.S. “needs to protect investors from the country’s lack of transparency and accountability.” Another potential blow to China is that there is legislation being proposed in the congress for President Trump to sanction the nation over the coronavirus cover-up. Additionally, legislation has been introduced which would allow citizens to sue China for damages. These suits could go into the trillions of dollars. Commenting on the potential lawsuits, Kudlow said “until that stuff is sorted out, nobody really can invest with confidence in China.”

According to Fox News, there are currently 60 bills in Congress to sanction China. Although no one is able to predict at this moment which or how many of these bills will be signed into law, it is clear that the investment climate for China in the US will get worse, not better. As various pieces of legislation are passed in the US, prices of Chinese stocks would most likely be driven down, making them an even riskier investment at the moment.

The US Entity List

In addition to Chinese companies potentially being delisted under new legislation, existing legislation is increasingly being strengthened and implemented to place Chinese companies on the US Entities List, which many call the black list. The US Entity List, published by the US Department of Commerce, contains foreign persons, businesses, research institutions, governments and individuals – that US companies cannot do business with, unless they obtain special licensing permission.

American firms who wish to export products and software to entities on the list must apply for a license from the Bureau of Industry and Security, an agency under the US Department of Commerce. Restrictions include exporting, re-exporting, and transferring certain items. Many companies are on the list for national security reasons. Others are there because of human rights violations.

In May, 2020, the U.S. Department of Commerce’s Bureau of Industry and Security (BIS) added 33 Chinese entities to the list. This included 28 Chinese public security bureaus and companies. Twenty-four of the companies are governmental and commercial organizations based in China, Hong Kong, and the Cayman Islands. They are barred from “supporting procurement of items for military end-use in China.”

The PRC Ministry of Public Security’s Institute of Foreign Science has also been added. The IFS was found to be “complicit in human rights violations and abuses committed in China’s campaign of repression, mass arbitrary detention, forced labor and high-technology surveillance against Uighurs, ethnic Kazakhs, and other members of Muslim minority groups in the Xinjiang Uighur Autonomous Region (XUAR).”

Huawei Technologies, the cellphone and 5G maker, is on the list because US Department of Commerce believes that “Huawei is engaged in activities that are contrary to US national security or foreign policy interest.” US chip manufacturers may no longer sell chips to Huawei. This chip ban not only prevents Huawei from using US chips, but also extends to foreign foundries that use American technologies. Tech insiders speculate that cutting off Huawei’s access to these chips may damage the company’s long-term prospects.

As of now, all major Chinese Artificial Intelligence (AI) firms are on the Entity List. In addition, all four of the “four dragons of computer vision” are or have been on the list, including CloudWalk, SenseTime, Megvii and Yitu. With new technology being a cornerstone in the CCP’s economic development plans, US blacklisting should hit China where it really hurts.