A long-running dispute between the United States and China over auditing and compliance standards is heating up, and it could lead to the delisting of some Chinese companies from U.S. stock exchanges.
On Thursday, the Securities and Exchange Commission warned of the potential delisting for five companies that are in the middle of the dispute: fast-food chain operator Yum China YUMC, wafer processing solution provider ACM Research ACMR, and bio-pharma firms BeiGene BGNE, Zai Lab ZLAB and HutchMed HCM, which is a biopharmaceutical producer arm under Hong Kong's CK Hutchison CKHUF.
At issue is whether Chinese firms able to provide sufficient disclosure and access to U.S.-approved auditors.
The U.S. Senate passed a bill in June 2021 that would allow the SEC to suspend companies from trading if they fail to submit their working papers to the Public Company Accounting Oversight Board for three consecutive years (2021, 2022, and 2023). The rule also requires companies to declare whether they are owned or controlled by any foreign government.
The five firms cited by the SEC have been given time until the end of March to show proof to the authorities that they have complied with the audit requirements, or else they will have to delist from the New York bourse by 2024. Shares in these five companies tumbled on the news on Thursday.
Will More Chinese Companies Have to Delist?
The escalation of the dispute between China and the U.S. comes as the Russian attack on Ukraine has heightened the sensitivity among more investors over geopolitical risks in the wake of last summer's moves by Chinese regulators to clamp down on some of the country's biggest internet companies. That action, combined with the accounting dispute, sent prices of many Chinese stocks listed on U.S. exchanges tumbling.
The latest move by the SEC could be just the first round of threatened delistings.
“These five firms were first to be included in the Provisional List because they were the first to publish annual reports for 2021,” said Ivan Su, senior equity analyst at Morningstar. “The SEC identifies what companies are subject to delisting as early as when the firm files its annual report. Therefore, we expect more Chinese ADRs to be included in the Provisional List over the next few weeks.”
For the delisting timeline, under the current provisions of HFCAA, forced delisting of Chinese ADRs can start in 2024, according to Su. "That said, the timeline can potentially move up by one year if the Accelerate Delisting Bill is signed into law. This bill passed the Senate in June 2021 but has yet to be approved in the House. If this bill is signed into law, delisting can happen as soon as next year."
The PCAOB says that preparation of reliable and independent audit reports is fundamental to safeguard the interests of investors and the public. The board has been voicing a lack of access in China, and it turned more vocal after Luckin Coffee LKNCY, the largest coffee chain in China, was found to be fabricating its sales records. This was a wakeup call for regulators to tighten oversight for noncompliant companies.
National Security Loopholes?
From the Chinese authorities’ perspective, the request for information may have crossed the line, triggering national security concerns. Chinese laws have long forbidden companies from handing audit working papers to foreign regulators on the grounds that they constitute “state secrets.”
However, given the imminent timeline of explanation on compliance and potential delisting, Su sees “a remote chance” that Chinese companies will be delisted from the U.S. stock exchanges, because the two countries are actively working to resolve this current challenge.
"We started seeing signs of the U.S. and China working together to resolve auditing challenges," he says, citing the discussion between two countries' regulators in December. "Progress is getting made, evidenced by the CSRC vice chairman's comment on Jan. 29, 2022, which stated that 'China and the United States were making progress in coordinating regulations governing Chinese companies listed in New York, and there could be a 'positive surprise' by June or earlier.'"
Su also noted, “Most of the Chinese ADRs under Morningstar’s equity research coverage have a fungible dual listing in Hong Kong. That means investors can convert their U.S. shares into shares listed on the Hong Kong bourse.”
However, risks may also be derived from the trading volume and liquidity issues that ensue. Su continues: “A majority of the trading of these Chinese ADRs currently takes place in the U.S. For instance, more than 90% of the trading volume of Yum China comes from the U.S. bourses, so investors with large positions may have concerns regarding future liquidity.”
A Running Battle Over Disclosure
The audit impasse has been discussed over the past few years as the U.S.-listed Luckin Coffee accounting scandal unfolded. Last year, the Chinese authorities initiated a probe on Didi Global and data security. Subsequently, the ride-hailing platform was voluntarily delisted from the U.S. board.
“The data collected by these companies are not even directly associated with national secrecy and seemingly unrelated to politics, too,” according to Chelsey Tam, Morningstar’s senior equity analyst covering the Chinese tech sector. She says, for example, that online recruitment company Boss Zhipin BZ and truck-hailing mobile app Full Truck Alliance YMM were also under investigation for suspected breaches of national security and cybersecurity laws. Both companies sought an initial public offering in New York in 2021.