Chinese take away - The risk of companies delisting from US exchanges
In assessing the risk of Chinese companies listed on US exchanges being forced to delist by the US Securities and Exchange Commission (SEC) it is best to take a step back and consider why the US has taken what is seemingly a heavy-handed approach to these companies. The tension between the US and Chinese regulators began as far back as 2002 when the Public Company Accounting Oversight Board (PCAOB) was created by US congress as part of the Sarbanes-Oxley Act (SOX). The Act was passed in response to accounting scandals such as Enron and WorldCom to provide better oversight of the auditing industry with the PCAOB serving as the industry watchdog.
The Act requires that auditors of foreign companies allow the PCAOB to inspect their audit work papers for audits of non-US operations. Most foreign jurisdictions have complied with this requirement, however, Hong Kong and China have not. There has been compromises along the way with Chinese regulators offering some access to US listed Chinese companies’ auditors, however, the PCAOB has felt that when doing their respective inspections, they have not been given the access required to satisfy the oversight requirement for the companies. China’s stance on the matter is that doing so would compromise state security and therefore have been unwilling to cooperate fully with this request.
In April 2020, the issue reached breaking point when it was revealed that Chinese coffee maker Luckin Coffee, listed on the NASDAQ, was found to have inflated its revenue in 2019 by USD310m, roughly 70% higher than what the company actually achieved. By December 2020, the US House of Representatives had approved the Holding Foreign Companies Accountable Act which requires the SEC to prohibit the securities of foreign companies from being listed or traded on the US securities markets if the company retains a foreign accounting firm that cannot be inspected by the PCAOB for three consecutive years. Chinese companies listed on US exchanges (currently around 248) have until April 2024 to comply or be delisted.
This has weighed on the share price performance of Chinese companies listed in the US and, with little resolution in sight between the two countries, conversations have shifted from ‘if these companies will be delisted’ to ‘when these companies will be delisted’.
Chinese authorities have indicated that they are comfortable with US listings, however, it is plausible that to save face at some stage China might revise its view and encourage firms to give up these listings before the companies are pushed off the exchange by the SEC.
So why have so many Chinese companies chosen to list in the US rather than in Hong Kong in the first place?
The Hong Kong Stock Exchange (HKEx) is an accessible and reputable exchange for a wide range of international investors and is closer to mainland China. In addition, the conflict between the US and China with regards to access to audits is an issue that could be avoided by listing closer to home. Clearly access to sizable and sophisticated US investors is a big tick for companies wanting to raise money but another reason is that Hong Kong has more stringent listing requirements than the US. The HKEx had been ecommerce giant Alibaba’s first choice of exchange for its Initial Public Offering (IPO) in 2014. This was not, however, possible due to the company’s Weighted Voting Rights (WVR) structure whereby certain shares have higher voting power than others, a structure often used when the founders of a company want to maintain control. This share structure was not allowed on the HKEx at the time and therefore Hong Kong missed out on the largest IPO in the world at that point. This was most likely the catalyst for the exchange to amend its rules in 2018 to allow the secondary listings of WVR companies (with certain requirements) for the first time. This paved the way for Alibaba’s listing on the HKEx in 2019. Since then, there has been a string of US listed Chinese companies dual listing on the HKEx including JD.com, Yum China and Baidu.
These secondary listings are fully fungible with the US listing and therefore allow international investors, who are attracted to the longer-term fundamentals of certain Chinese companies, the opportunity to simply move their holdings from the US to the HKEx at little cost. Due to the interchangeable nature of these shares, they generally trade at similar prices on each exchange. One would need to be more concerned if you held the stock of a Chinese company listed on a US exchange which is not listed on another exchange outside of the US. It’s likely these companies are already scrambling to find a Plan B and the HKEx has made this a lot easier to achieve with further reforms having been implemented as of 1 January 2022. Even so, there may still be certain listing criteria that companies do not fulfil, so investors should focus on companies which are already dual listed.
One disadvantage of having to delist from US exchanges is that there will be certain investors who currently own shares in the US but cannot invest in Hong Kong. These investors will be forced to divest their holdings. However, there is another source of capital that Chinese companies listed on the HKEx can tap into which they otherwise would not have been able to do with a US listing. This is the Southbound Stock Connect program. The program links mainland China stock exchanges to the HKEx thereby allowing mainland China investors to buy shares in Hong Kong. The program currently excludes companies with dual listings, which would mean that dual listed Chinese stocks would need to delist from the US and move to a primary listing on the HKEx in order to participate. With little cooperation between the US and China it may be prudent for Chinese companies which are eligible for a primary listing in Hong Kong to delist from US exchanges before they are forced to and take advantage of these potential flows.
In conclusion, although the introduction of the Holdings Companies Accountable Act in the US has increased the probability of Chinese companies delisting from the US, international investors have other means of retaining their holdings should they wish to participate in the high growth and attractive valuations that certain of these companies offer. Investors should ensure, however, that the stocks they are invested in have a dual listing on another reputable exchange and are fully fungible.