By Shang-Jin Wei
NEW YORK – After passing unanimously in the US Senate on May 20, 2020, the Holding Foreign Companies Accountable Act is heading for the House of Representatives, and US President Donald Trump is expected to sign it into law. The law requires that all companies listed on US stock exchanges submit to audits reviewable by the US Public Company Accounting Oversight Board (PCAOB), and non-compliant firms can be delisted after three years. This has generated talk that all Chinese firms could disappear from US exchanges.
Some observers might question the wisdom of such legislation, on the grounds that it could hurt returns on US household savings, financial-sector profits, and the global competitiveness of US stock exchanges. While these are legitimate concerns, a US threat to delist Chinese firms could be worth the risk, leading not only to more credible disclosures, but also, perhaps surprisingly, to more listings by high-quality Chinese private-sector firms.
Truthful disclosure and severe punishment for noncompliance constitute the bedrock of sound capital-market governance. The US applies the same criteria to all firms that seek a listing on a US stock exchange, and oversight by the PCAOB is a key element of enforcing the rules. When a listed firm makes a questionable disclosure, the PCAOB reserves the right under the 2002 Sarbanes-Oxley Act to inspect the underlying accounting documents of its auditing firm. If deficiencies are found, the auditing firm must amend its report and take steps to improve its procedures and practices. This enhances investors’ confidence in the listed firms’ disclosures.
But the Sarbanes-Oxley Act does not apply to other countries, some of which have laws or regulations that prohibit local auditing firms from turning over accounting documents to foreign regulators like the PCAOB. China is one of those countries. Belgium and France also make it difficult for the PCAOB to audit their local auditing firms, but the PCAOB expects to be able to resolve the access problem by negotiation.
There are about 150 US-listed firms that are headquartered or operate principally in China. A few are majority state-owned – including China Life, PetroChina, China Telecom, China Unicom, and China Eastern Airlines – but around 90% of them are private-sector firms. Among these are dynamic and highly profitable companies such as Alibaba, Baidu, Bilibili, Jingdong, and Ctrip.
In the past, the PCAOB has presumably tried to negotiate with Chinese authorities for access to auditors’ work product in China. But trying to compel China to grant such access has not been a policy priority because US stock exchanges, investment banks, and money-management firms like to maximize the US listing of Chinese firms.
After all, over the past 15 years, Chinese firms have dominated global initial public offerings, and US stock exchanges have been competing fiercely with those in London, Singapore, Hong Kong, Shanghai, and Shenzhen for these listings. As the number of IPOs by US-headquartered companies declines steadily (from around 300 per year in the early 1990s to fewer than 100 per year more recently), Chinese companies have become even more attractive to US stock exchanges.
Similarly, US investment banks earn fat commissions by taking firms public, and they have a home-field advantage when those listings occur on a US stock exchange. Indeed, cajoling by US investment banks is the main reason why so many Chinese companies have come to the US in the first place. And, for their part, money-management firms (or their clients) prefer – or, in some cases, are mandated – to hold US-listed stocks.
While one can see how delisting Chinese companies could reduce these US entities’ profits or global competitiveness, the potential impact on American investor interests is less clear-cut. On one hand, excluding firms that commit accounting fraud is obviously good for US investors. On the other hand, accounting fraud is rather rare, and the risk of it tends to be outweighed by the sustained, sometimes market-beating returns that many US-listed Chinese firms offer investors. Delisting them therefore could mean foregoing sound investment opportunities for US investors.
Moreover, PCAOB oversight is not the only way to discover accounting problems. Many short-selling companies specialize in investigating and uncovering fake profits or bogus growth figures, and they sometimes are more thorough and creative than the PCAOB. For example, the short seller Muddy Waters recently uncovered accounting fraud committed by Luckin Coffee, a US-listed Chinese company, by sending investigators to visit its physical stores. Luckin’s bosses are now under criminal investigation in both China and the United States.
Given that the US has a vibrant short-selling industry to keep listed companies in line, it is understandable that some observers would object to a forceful and disorderly delisting that could inflict big losses on those holding US-traded shares. But the choice is not between doing nothing and delisting all Chinese firms. The more likely outcome of the new US law is that it will strengthen the PCAOB’s bargaining position vis-à-vis foreign authorities.
Because many US-listed Chinese firms are a dynamic part of China’s economy, one should not discount the possibility that the country’s regulators will accede to their US counterparts’ requests for accounting documents sometime over the next three years, before the first delisting under the law could begin. China may withdraw its majority state-owned firms from the US market, but many private-sector companies would likely remain. Better yet, many more Chinese firms may opt for a US listing precisely because it enables them to signal the credibility of their financial disclosures.
A US listing has always been attractive to firms seeking visibility and foreign currency. The new law won’t diminish this. By enhancing the perceived quality of financial disclosures, listed firms may command a higher stock price, thereby reducing their costs of capital. When that happens, US investors, financial institutions, and Chinese private-sector firms will all stand to gain.
Shang-Jin Wei, a former chief economist at the Asian Development Bank, is Professor of Finance and Economics at Columbia Business School and Columbia University’s School of International and Public Affairs.
Copyright: Project Syndicate, 2020.