Think Twice before Buying Chinese Stocks

The Trump administration recently floated the idea of delisting Chinese stocks in the U.S.  This was met with ridicule and hand-wringing not only from the usual political opponents, but also from mainstream business analysts.

Though delisting Chinese companies already listed on U.S. exchanges is problematic, there are good reasons besides being a bargaining chip in the trade dispute why the U.S. should be more stringent about any Chinese company listing on U.S. exchanges.

The Wall Street Journal in a recent editorial sums up the consensus view on Chinese companies:

One benefit of listing on U.S. exchanges is that it obliges foreign firms to meet American regulatory standards for disclosure to investors.  The White House would not be protecting American investors by forcing Chinese companies to list on foreign stock exchanges where the rules are less rigorous.

The current situation is good for Chinese companies and the exchanges that collect nice fees.  The large venture capital and hedge funds that own large pieces of Chinese companies (at pre-listed prices) also benefit from having a liquid market in their local currency.  But for the average American investor, this is a great example of the connected class benefiting at the expense of the average investor.

The "disclosure" that the WSJ references is little more than window dressing.  The NYSE rules (other exchanges are similar) for listing state very clearly (emphasis added):

Foreign Private Issuers

Listed companies that are foreign private issuers (as such term is defined in Rule 3b-4 under the Exchange Act) are permitted to follow home country practice in lieu of the provisions of this Section 303A, except that such companies are required to comply with the requirements of Sections 303A.06, 303A.11 and 303A.12(b) and (c).  

And what are the other requirements in the above referenced to?

303A.06 Listed companies must have an audit committee that satisfies the requirements of Rule 10A-3 under the Exchange Act.

Rule 10A-3 was put into place in 2003 to help strengthen independent auditing.  On the face, it sound good, but there is a glaring loophole:

Accordingly, an issuer either may have a separately designated audit committee composed of members of its board or, if it chooses to do so or if it fails to form a separate committee, the entire board of directors will constitute the audit committee.  If the entire board constitutes the audit committee, the new SRO rules adopted under Exchange Act Rule 10A-3, including the independence requirements, will apply to the issuer's board as a whole[.]

In the U.S., many boards are no more than rubber stamps for the CEO.  In China, it is not at all different.  The aforementioned rule basically says the board can audit itself.

303A.11 Foreign private issuers must make their U.S. investors aware of the significant ways in which their corporate governance practices differ from those required of domestic companies under NYSE listing standards.  However, foreign private issuers are not required to present a detailed, item-by-item analysis of these differences[.]  [Emphasis added.]

303A 12 b and c are toothless notification requirements.

In December 2018, the Securities Exchange Commission (SEC) and Public Company Accountability Oversight Board (PCAOB) said, "A U.S. listing carries with it the assumption that U.S. rules and regulatory oversight apply."  However, Chinese law requires that companies' books and records be kept within the country.  It also restricts foreign audit work papers from being transferred outside China.

Another problem with Chinese companies listing on U.S. exchanges is that in many instances, the stock being offered has no ownership in the company.  It is against Chinese law for foreigners to own strategic assets in the country.  So in the case of Alibaba and other companies, investors actually own a stake in a Cayman Islands company that is under contract to receive profits from the Chinese parent but does not actually own any part of the company.

So good luck if you want to sue a Chinese company.  You will need to file suit against a company based in the Caymans, who has a contract with a company in China, where there is no rule of law close to what we accustomed to in the U.S.

There is also the fact that many of the companies listed on U.S. exchanges are in part owned by the Chinese government.  If you think those companies are going to abide by findings of independent auditors when things don't go well, naïveté will not be your friend.  See the attached link for lists of companies that have Chinese government ownership.

In summary, at one time, it may have been a good idea to open up our exchanges to Chinese companies in the hope they would become more democratic or Western in their legal and political system.  The last ten years should have disabused us of that notion.  We do not need to have stock listings with companies from countries that do not adhere to U.S. law.  Let's be clear-eyed about what we are confronting and not let the status quo become the norm.

The Trump administration recently floated the idea of delisting Chinese stocks in the U.S.  This was met with ridicule and hand-wringing not only from the usual political opponents, but also from mainstream business analysts.

Though delisting Chinese companies already listed on U.S. exchanges is problematic, there are good reasons besides being a bargaining chip in the trade dispute why the U.S. should be more stringent about any Chinese company listing on U.S. exchanges.

The Wall Street Journal in a recent editorial sums up the consensus view on Chinese companies:

One benefit of listing on U.S. exchanges is that it obliges foreign firms to meet American regulatory standards for disclosure to investors.  The White House would not be protecting American investors by forcing Chinese companies to list on foreign stock exchanges where the rules are less rigorous.

The current situation is good for Chinese companies and the exchanges that collect nice fees.  The large venture capital and hedge funds that own large pieces of Chinese companies (at pre-listed prices) also benefit from having a liquid market in their local currency.  But for the average American investor, this is a great example of the connected class benefiting at the expense of the average investor.

The "disclosure" that the WSJ references is little more than window dressing.  The NYSE rules (other exchanges are similar) for listing state very clearly (emphasis added):

Foreign Private Issuers

Listed companies that are foreign private issuers (as such term is defined in Rule 3b-4 under the Exchange Act) are permitted to follow home country practice in lieu of the provisions of this Section 303A, except that such companies are required to comply with the requirements of Sections 303A.06, 303A.11 and 303A.12(b) and (c).  

And what are the other requirements in the above referenced to?

303A.06 Listed companies must have an audit committee that satisfies the requirements of Rule 10A-3 under the Exchange Act.

Rule 10A-3 was put into place in 2003 to help strengthen independent auditing.  On the face, it sound good, but there is a glaring loophole:

Accordingly, an issuer either may have a separately designated audit committee composed of members of its board or, if it chooses to do so or if it fails to form a separate committee, the entire board of directors will constitute the audit committee.  If the entire board constitutes the audit committee, the new SRO rules adopted under Exchange Act Rule 10A-3, including the independence requirements, will apply to the issuer's board as a whole[.]

In the U.S., many boards are no more than rubber stamps for the CEO.  In China, it is not at all different.  The aforementioned rule basically says the board can audit itself.

303A.11 Foreign private issuers must make their U.S. investors aware of the significant ways in which their corporate governance practices differ from those required of domestic companies under NYSE listing standards.  However, foreign private issuers are not required to present a detailed, item-by-item analysis of these differences[.]  [Emphasis added.]

303A 12 b and c are toothless notification requirements.

In December 2018, the Securities Exchange Commission (SEC) and Public Company Accountability Oversight Board (PCAOB) said, "A U.S. listing carries with it the assumption that U.S. rules and regulatory oversight apply."  However, Chinese law requires that companies' books and records be kept within the country.  It also restricts foreign audit work papers from being transferred outside China.

Another problem with Chinese companies listing on U.S. exchanges is that in many instances, the stock being offered has no ownership in the company.  It is against Chinese law for foreigners to own strategic assets in the country.  So in the case of Alibaba and other companies, investors actually own a stake in a Cayman Islands company that is under contract to receive profits from the Chinese parent but does not actually own any part of the company.

So good luck if you want to sue a Chinese company.  You will need to file suit against a company based in the Caymans, who has a contract with a company in China, where there is no rule of law close to what we accustomed to in the U.S.

There is also the fact that many of the companies listed on U.S. exchanges are in part owned by the Chinese government.  If you think those companies are going to abide by findings of independent auditors when things don't go well, naïveté will not be your friend.  See the attached link for lists of companies that have Chinese government ownership.

In summary, at one time, it may have been a good idea to open up our exchanges to Chinese companies in the hope they would become more democratic or Western in their legal and political system.  The last ten years should have disabused us of that notion.  We do not need to have stock listings with companies from countries that do not adhere to U.S. law.  Let's be clear-eyed about what we are confronting and not let the status quo become the norm.