Regulatory changes for Chinese stocks remaining on track

Despite big changes at the White House in 2021, the push to protect U.S. investors in Chinese companies is still on track, as regulators prepare to hold the companies to tougher accounting standards and some face an outright ban.

"There will continue to be tension between the U.S. and China — even with a new administration taking the reins — and national security considerations as well as accounting standards will remain important," said Christian McCormick, a director and senior ESG strategist with Allianz Global Investors in Denver.

"Every single discussion we have with institutional investors, the topic of investing in China comes up."

Earlier this month, a White House executive order banned investing in Chinese companies linked to its military. As of Jan. 1, individuals or companies can no longer own direct shares or funds holding shares in 31 Chinese companies identified as security risks.

Many more U.S. investors will be affected by accounting rules expected to be proposed next month by the Securities and Exchange Commission. The SEC has authority over shares traded on U.S. exchanges as American depository receipts, negotiable certificates issued by U.S. banks that represent shares in a foreign stock traded on a U.S. exchange.

The U.S.-China Economic and Security Review Commission identified 156 Chinese companies with a combined market capitalization of $1.2 trillion, including 11 state-owned enterprises, that are listed on America's three largest exchanges, Nasdaq, New York Stock Exchange and NYSE American.

Under the proposed rules that will first go through a public comment period, Chinese companies on the exchanges would have to use auditors supervised by the U.S.' Public Company Accounting Oversight Board, which has long been frustrated in gaining access to Chinese audits.

PCAOB was created by the Sarbanes-Oxley Act of 2002 to regulate public company audits following accounting scandals at Enron Corp. and WorldCom Inc. PCAOB standards apply to any company that taps U.S. markets, and more than 50 foreign jurisdictions permit PCOAB reviews with the notable exception of China.

Chinese companies refusing to follow the expected SEC rules, if finalized, would face being delisted by the exchanges, a move welcomed by many institutional investors as a matter of principle.

"A prohibition on U.S. listing of non-U.S. companies that do not have PCAOB-inspected audits is long overdue," said Brandon Rees, Washington-based deputy director of investments for the AFL-CIO, including its $716 million retirement plan.

Mr. McCormick of Allianz agrees. "We think U.S.-listed Chinese companies having to abide by stricter standards is absolutely the right thing," he said. "The U.S. ADR market is seeing lots of (initial public offerings). Chinese companies have dominated the IPO market," he said.

According to the PCOAB, 202 Chinese public companies in China had audit reports over a recent 18 month period that represented a combined global market capitalization of about $1.8 trillion on U.S. and non-U.S. exchanges.

PCOAB officials say it is impossible to estimate the exposure of U.S. institutional and retail investors to these companies, but they note that for the 10 largest Chinese companies representing $1.3 trillion of the $1.8 trillion, trading value on U.S. exchanges was about 74% of the combined average value of shares traded in the U.S., Hong Kong and China.

That puts U.S. exchanges in a tough spot, considering how profitable Chinese listings are. In practical terms, the exchanges — willingly or otherwise — would be the enforcers of the SEC audit rules, which would prevent new non-compliant firms from listing and give already-listed firms until 2022 to come into compliance or face delisting.

So far, Nasdaq has been the only exchange to formally address the issue, filing three SEC rule proposals for companies that operate principally in jurisdictions like China with secrecy, national security or other laws that restrict U.S. regulators' access to information concerning U.S.-listed companies. Unlike SEC mandatory rules with deadlines, Nasdaq is proposing to have its own "discretionary authority" to apply listing criteria and minimum offering size, but does not include mandatory time frames.

Whether the SEC audit rules are finalized, some market observers predict that more Chinese companies considering listing in the U.S. will weigh the political risk and choosing to go private.

Institutional investors could also adjust by converting ADRs to direct listings in China or secondary listings in Hong Kong, said Brian Bandsma, who manages a $13 billion emerging markets equity portfolio for Vontobel Asset Management's $34 billion Quality Growth Boutique active equity firm in New York.

"You could always argue for another layer of protection but you have to ask, what's the benefit of the change for shareholders?" Mr. Bandsma said. For most institutional investors, the listing venue "matters even less," he said.

A Dec. 1 report to Congress from the U.S.-China Economic and Security Review Commission will have more recommendations on addressing the political and market risks from China's financial systems, including investors' risk in China's banking system.

The report is expected to give outspoken China critics like Sen. Marco Rubio, R-Fla., more chances to get tough on China through its companies. In late October, Mr. Rubio and Sen. Mike Braun, R-Ind., introduced legislation that goes further than the current White House ban. It would block access to U.S. markets by Chinese companies blacklisted by the Pentagon or the U.S. Department of Commerce, and would bar U.S. investment firms, retirement funds and insurance companies from taking stakes in Chinese companies on those blacklists.

The Senate has already passed a bill that would give Chinese companies three years to comply with audit standards or risk delisting, and the House passed a similar bipartisan bill attached to a must-pass defense spending bill for fiscal 2021.

To Mr. Rubio, "the Chinese Communist Party's exploitation of U.S. capital markets is a clear and ongoing risk to U.S. economic and national security that must be addressed."

It is one more challenge for President-elect Joe Biden to put on his China to-do list.