Calls for Scrutiny of US-Listed Chinese Companies Will Benefit Investors

Traders work on the floor of the New York Stock Exchange (NYSE) in New York on March 20, 2020. (Spencer Platt/Getty Images)

Commentary

When Chinese beverage brand Luckin Coffee admitted to fraud—wiping out $8.3 billion of value from U.S. investors’ pocketbooks—the scandal highlighted the risks of investing in Chinese companies.

In an interview with Fox Business Network last week, President Donald Trump said his administration is “looking at” Chinese companies such as Luckin that are listed on U.S. exchanges yet don’t always follow U.S. disclosure and accounting guidelines.

Investing bears risks. And investors understand that companies from emerging markets (such as China) bear an even higher risk-reward ratio, due to the less mature economy and less developed markets of their local countries.

But that's not all with Chinese companies. There are additional risks that investors may not be aware of. While being listed on U.S. stock exchanges, Chinese companies such as Luckin aren’t held to the same accounting and disclosure standards as U.S. companies listed on those same exchanges.

There were 172 Chinese companies listed on U.S. exchanges that were valued at more than $1 trillion as of September last year, according to an annual report issued by the U.S.-China Economic and Security Review Commission.

They’re not on a level playing field with U.S. companies.

The U.S. stock market is home to companies from a multitude of industries, geographies, and financial positions. Investors’ ability to determine the fair price of a company’s stock is vital to the healthy functioning of the market. A level playing field and the integrity of market participants is paramount. That’s why the Trump administration’s investigations into Chinese companies should be a welcome development for investors.

Loopholes

As a starting point, Chinese companies should be bound by the same set of rules and guidelines as other companies listed on U.S. exchanges. But due to certain loopholes that U.S.-listed Chinese companies have exploited, they have more lax requirements compared to their American counterparts.

All U.S. companies are audited, and their auditors are professionally licensed accountants. The auditors’ work papers—the detailed records of their examination of their clients’ accounts—can be routinely examined by the U.S. accounting industry watchdog, the Public Company Accounting Oversight Board (PCAOB).

However, Chinese companies—even the U.S.-listed ones—are audited by Chinese accounting firms who don't have to answer to the PCAOB or the U.S. Securities and Exchange Commission (SEC). The SEC has attempted since 2013 to strike a deal with Chinese regulatory authorities to obtain the work papers of Chinese companies, but has been unsuccessful so far. The Chinese Communist Party (CCP) leadership views the accounts and financial records of Chinese companies as “state secrets.”

Following the Enron and WorldCom accounting fraud scandals of the early 2000s, the United States enacted the Sarbanes-Oxley Act to provide additional oversight to publicly traded companies. Among other things, the chief executives and chief financial officers of publicly traded companies must annually attest to the internal controls of their companies, and must certify that they are unaware of fraudulent acts. In certain cases, they can be held criminally liable for fraudulent acts under their watch.

Chinese companies listed on U.S. exchanges aren't subject to such oversight.

Additionally, Chinese companies listed in the United States are all considered “foreign private issuers.” Certain requirements must be met to be considered foreign private issuers (FPIs), but once certified, FPIs enjoy additional advantages compared to their U.S. counterparts.

All U.S.-listed companies must file quarterly financial statements reviewed by their auditors. But the SEC grants FPIs an exemption: the quarterly requirement is waived.

These rules were originally put in place to ease the regulatory and reporting burden of companies that predominantly list their shares on another exchange. For example, a German multinational company that lists its shares primarily on the Frankfurt Stock Exchange must abide by German regulatory standards, and the SEC didn't want to overly burden a company that may have an additional listing in New York.

But no such burden exists for Chinese companies. Most Chinese companies traded in the United States are primarily listed in New York, and have no other regulatory reporting burden. So the FPI rules actually provide Chinese companies a loophole that allows significantly less transparency than their Western counterparts.

While most investors probably don’t pay too much attention to filed financial reports or CEO certifications, they play a major role in establishing trust, integrity, and honesty in operations of a company. The U.S. regulatory framework has checks and balances in place, which affords U.S. investors the luxury to not have to pay attention to such details.

It’s easy to forget that shareholders are owners, and as owners of these publicly traded companies, they must trust that their companies are functioning properly and executives are acting in good faith. Investors may have taken that for granted, given the long history of U.S. stock markets, but they can't afford to be so blasé towards Chinese stocks.

Integrity and trust have defined the U.S. stock markets for a century. Regulators must ensure that they endure for the next century.