China and the U.S. Stock Market: Nowhere to go.

brick wall

1. The US and China are Decoupling

The U.S. and China engaged in a process of economic restructuring. See The US-China Trade War: Winter is Coming (published one day before President Trump tweeted out the newest tariffs) The US-China Cold War Starts Now: What You Must do to Prepare (published three days after the tweeted tariffs). The Section 301 tariff dispute is only one aspect of a much larger process  we have been calling the New Normal. See China, the United States and the New Normal (from October 6, 2018) The New Normal has already and will continue to impact many areas of U.S./China financial cooperation, including Chinese company access to U.S stock markets.

2. Chinese Companies on U.S. Stock Exchanges

It is estimated that more than 200 Chinese companies have listed in various ways on U.S. stock exchanges, with an estimated total market value exceeding 1.8 trillion U.S. dollars. Even at the height of the trade war, NASDAQ continues to announce Chinese companies will do IPOs on the NASDAQ exchange. These IPOs are economically important to  NASDAQ and NASDAQ officials welcome the new listings and hope for more in the future. See Nasdaq executive dismisses ‘discredited’ Steve Bannon’s call to bar Chinese companies from US capital markets.

3. Chinese Companies on U.S. Stock Exchanges are Exempt from Normal Oversight

But there is a fundamental problem with Chinese stock listings on U.S. stock markets. The central core of U.S. stock markets is that publicly listed companies are subject to financial oversight. Companies on U.S. exchanges are audited by accredited U.S. auditing firms and these audits are monitored by the Public Company Oversight Board (PCOB). These regulations are applied with rigor against U.S. and European companies that list in the U.S., but Chinese companies are exempt from such oversight.

This exemption from oversight is a product of Chinese government regulation. The Chinese government takes the position that allowing a foreign agency like the U.S. Securities and Exchange Commission (SEC) or the PBOC to audit Chinese companies on Chinese soil is an offense against Chinese government sovereignty. The initial response to this position was for the SEC/PBOC to say: fine, then just send us the audit reports and we will audit over here. The Chinese then shut that option down by claiming the audit reports of Chinese companies constitute a Chinese government state secret. As a state secret, the audit reports cannot be allowed to leave China. According to a joint statement by the SEC and PCAOB from December 2018:

The business books and records related to transactions and events occurring within China are required by Chinese law to be kept and maintained there. China also restricts the auditor’s documentation of work performed in the country from being transferred out of China. China’s state security laws are invoked at times to limit U.S. regulators’ ability to oversee the financial reporting of U.S.-listed, China-based companies. In particular, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers.

Stated more directly, unlike companies from everywhere else in the world, Chinese companies listed on U.S. stock exchanges are exempt from meaningful financial oversight. This is a longstanding scandal that is finally coming to a head.

4. Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges Act

On June 5, U.S. Senators Marco Rubio (R-FL), Bob Menendez (D-NJ), Tom Cotton (R-AR) and Kirsten Gillibrand (D-NY) introduced the Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges (EQUITABLE) Act. U.S. Representatives Mike Conaway (R-TX), Tim Ryan (D-OH), and Mike Gallagher (R-WI) introduced companion legislation in the House.

As explained by Senator Rubio, this Act is intended to achieve the following three goals:

1. Force the PRC to allow auditing of Chinese companies listed on U.S. exchanges.

2. Where such access is denied, compel those Chinese companies to delist. Under the current plan, the companies will be given three years to delist.

3. Chinese companies that fail to comply with the audit requirement will not be permitted to list in the future.

The Chinese government will not comply with this audit demand and so if this legislation passes, Chinese companies listed on U.S. markets will be delisted and no future listings from Chinese companies will be permitted.

NASDQ has openly expressed opposition to this legislation. In a NASDAQ report, the author stated: “But torching shares valued at around $1.8 trillion is a harsh price to pay for transparency.” See China audit crackdown is a Wall Street nightmare. This is the same argument the SEC has been using for years to justify its refusal to take action on this issue. The argument is that the damage has been done and requiring delisting of these unregulated Chinese companies would cause more harm than good. This was always a weak argument. However, the ultimate failure of the argument is that Chinese companies continue to list and they continue to be unregulated. So the damage increases as the SEC looks the other way. For a short history of Chinese company stock fraud on US stock exchanges, check out The Dirty $50 Billion Scam Wall Street Is Getting Away With.

“Transparency” is at the core of the U.S. public market system. Torching shares at ANY valuation is a required price to pay to maintain transparency. It makes no business sense to allow the PRC government to harm the integrity of the U.S. public markets merely to allow the listing of shaky Chinese company IPOs. Members of Congress see this and are taking direct action to remove authority from an unresponsive SEC.

5. The Future for Chinese Companies on U.S. Stock Exchanges

It is not clear whether this legislation will be adopted. Wall Street opposes it and you  do not need me to tell you that Wall Street is very powerful. Moreover, the SEC has allowed this scandal to continue for decades and unwinding it now will be a Wall Street nightmare, as commentators have pointed out. Moreover, the net effect will be to push this business to Hong Kong, to the ultimate detriment of the U.S. markets. So the stakes are high and the arguments will be intense.

Readers should note that the Wall Street/SEC arguments have been that the damage has been done and we just have to live with it. This is similar to the response of many U.S. retailers on the tariff issue. A large group of retailers just sent the Trump administration a letter requesting it back off on tariffs against China, using a similar argument: the damage has already been done. The China price is already built into the structure of American business and it is too damaging to fix the situation now. See Over 600 U.S. companies urge Trump to resolve trade dispute with China: letter.

Though this argument at first sounds ridiculous, it is in fact very powerful, made even more powerful by its being made by some exceedingly powerful constituencies. The U.S. has allowed the situation with China to progress to this point at least since the Clinton administration. The current U.S. economy has been built on a foundation provided by China as manufacturer for the world, creator of the China price, and investor in U.S. stock markets.

Is the U.S. now willing to endure the pain of dealing with the issues? Will the United States  continue to allow unregulated Chinese companies to list on its public markets? Will it continue to chase the China price by allowing China to export its government created surpluses to the U.S.? The answers to these questions are not clear, but at least the issues are.

Right now, the prevailing view is that no matter who wins the U.S. presidency in 2020 that person will be at least as “anti-China” as Trump. Way back in August, only 38 percent of Americans saw China favorably and I presume that number has dropped considerably since then. Even if the next President is pro-China, she or he will likely be too late to change much.

Chinese investment in the U.S. is down by nearly 90 per cent since its peak in 2016, including a sharp drop in 2018 and early 2019. All sorts of companies have moved their manufacturing from China or are scrambling to do so. See Google is moving US-bound Nest production out of China. Google’s production shift is part of an increasing trend. GoPro is moving its US-bound production to Mexico. Yesterday, Foxconn said it was prepared to move production of US-bound iPhones outside China before new tariffs as high as 25 percent kick in at the end of the month. The international manufacturing lawyers at my firm are all working overtime helping clients move from China to countries like Thailand, Vietnam, Malaysia, Taiwan, Mexico, etc.

No matter what happens with the tariffs, we are going to keep seeing large numbers of anti-dumping and countervailing duty cases brought against goods coming into the United States from China and the duties that stem from those cases are going to lead to an effective ban on huge numbers of products from China. Or as one of my firm’s international trade lawyers puts it:

Truth is that with all the trade issues involving China and bipartisan anti-China sentiment prevalent in the United States, now is a great time to bring such [anti-dumping and countervailing duty] actions. The international trade lawyers at my firm mostly defend against antidumping and countervailing duty claims instead of bringing them — we represent mostly the overseas producers and exporters and the US-based importers — so I say all this not to encourage more such actions, but as a simple statement of fact. If you are importing products from China, you need to assess and know the trade risks of your imports and to think about alternative sourcing.

Based what I keep hearing from my own firm’s China lawyers and international manufacturing lawyers, many American and European companies are seeking to diversify their product manufacturing away from China. See How to Leave China Safely and The China-US Trade War and the Winner is….MEXICO. It appears US foreign policy is to drive business from China to countries like Mexico (note how quickly President Trump’s mini-tariff war with Mexico was resolved), the Ukraine, Vietnam, Thailand, the Philippines, and Indonesia, among others. What this means big picture is that the price of products coming from China to the United States will continue rising and, as one of our China lawyers so often tells our clients: “you need to act accordingly.”

With so much US-China decoupling already having happened and so much more already in place to happen, I have to wonder how many legitimate Chinese companies are looking to list in the United States in any event. Even if this ban on Chinese stocks is not passed, will the Chinese government allow its companies to list in the United States? We hear rumors that the Chinese government is already pressuring Chinese companies on American exchanges to leave them.

In It’s time to end the ‘China hustle’ on U.S. stock exchanges, Paul Gillis, one of the leading experts on Chinese public company accounting practices calls for the United States to crack down on Chinese companies listing on US stock exchanges:

“We’re bending our laws again for the Chinese for the sake of making money,” said Paul Gillis, professor at Peking University’s Guanghua School of Management. “Ordinary Americans are not aware they have a rising exposure to firms that are not adhering to U.S. laws.”

What are your thoughts?

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