In the wake of Luckin Coffee’s spectacular accounting scandal, the U.S. government is finally moving to tighten regulations on Chinese companies listed in the United States.
The United States has long been concerned that China blocks the main U.S. accounting regulator from accessing books belonging to Chinese companies, preventing the regulators from investigating or monitoring potential fraud at those companies, even when they are listed on U.S. capital markets. Until recently, American regulators have simply had to look the other way.
Access to audit papers is important because litigation for securities fraud against a China-based issuer is otherwise going to be a loser’s game for U.S shareholders. Today, these shareholders need to sue in China to recover anything related to a securities fraud — litigation that likely will be useless. It is for this reason that Luckin Coffee shareholders will probably be left with no recourse to recover their losses.
If U.S. regulators can access the audit papers of Chinese companies, on the other hand, this would mean not only more compliance but the opening of an avenue for shareholders and regulators to sue the auditors of Chinese companies (which are mainly Chinese branches of the Big Four accounting firms).
And so with a renewed recognition of the importance of audit access, American gloves have come off.
Not long after news of the Luckin Coffee scandal broke, the Senate passed the Holding Foreign Companies Accountable Act. The act would require that U.S. regulators have full access to accounting and other papers belonging to foreign companies listed in the United States. It would also give non-U.S. companies three years to comply or delist. It would then bar future listings of companies from non-compliant countries.
The bill is now pending in the House. Despite bipartisan support, it’s unclear if it will pass. There is opposition to the bill from many of the American elite, including the Peterson Institute for International Economics. The grounds for opposition are the same they’ve been for years. Namely, most experts think China will refuse to cave on the issue. So the result will be the mass delisting of Chinese companies, depriving the United States of access to such investments and all of the investment banking and legal fees that go with them. There are more than 150 Chinese companies listed in the United States, valued in the trillions of dollars.
But U.S. regulators seem to be coordinating around the issue. Jay Clayton, chairman of the SEC, called the Senate bill “sensible.” In the wake of his comment, the President’s Working Group on Financial Markets released a report on July 24 that directly targeted Chinese companies listed in the United States. The report made five recommendations, including one similar to the Senate bill and another calling on the SEC to force U.S. exchanges to adopt listing standards that would require access to audit papers. After the working group report, Clayton asked SEC staff to create proposals to implement its recommendations.
And so whether or not Congress acts, there is likely to be a regulatory action. The inevitability of these restrictions, no matter what political party is in control in Washington, proves there is a consensus in the United States to crack down on China. The Senate bill was sponsored by U.S. Rep. John Kennedy of Louisiana, a Republican, and U.S. Rep. Chris Van Hollen of Maryland, a Democrat. It passed by unanimous consent.
Potential to backfire
So if the new regulations are inevitable, what is the likely result? Everyone may lose out. While the U.S. government hopes to crack down on fraud, the effort will also further reorder global capital markets into competing Chinese and American spheres.
Large Chinese companies are already hedging their bets. The Chinese e-commerce giant Alibaba, for instance, listed first in the United States in 2014 and then listed again in Hong Kong last year. It is no coincidence that the enormous initial public offering from Ant Financial, expected in October, is not taking place on a U.S. exchange at all, but instead on exchanges in Hong Kong and Shanghai.
It is no coincidence that the enormous initial public offering from Ant Financial, expected in October, is not taking place on a U.S. exchange at all.
In the long run we will likely see the separation of not only capital, but regulation too. The SEC formulated its regulations for foreign companies when it was mainly European companies — like British Petroleum — accessing the U.S. listing market. These assumed that all issuers were like European ones, where the company already had a home listing and sought out an American one. The U.S. regulations were set up to defer to the home listing regulator. But even then there was never deference on audit papers and the United States has regularly accessed the audit papers of European and other issuers.
But in China there is little regulation on the Chinese companies now listed in the United States, most of which skipped listing in Hong Kong altogether. When these companies leave the United States, they will have a different regulator — a Chinese one — from their American and European competitors. Investors will ultimately have to decide where to go — for while capital can travel freely (to some extent), regulation cannot. Investors will likely demand a discount for investing in less regulated, more risky Chinese companies. U.S companies trade at a premium, in part due to the safeguards ensured by U.S. regulations. Foreign companies have for years sought that premium in U.S. markets.
And so, it is easy to see that Chinese companies will be harmed by the U.S. actions as they trade at lower amounts and lose access to the deep U.S. capital markets and the global prestige that comes with a U.S. listing. China is aware of this. Its steps to liberalize its financial services industry are a response. Shanghai’s new Nasdaq-style STAR Market1See this feature in our magazine is attempting to capitalize by creating a Nasdaq-style technology investing exchange to compete with Hong Kong.
There will be losses on the U.S. side, too. Jesse Fried, a professor of law at Harvard University, wrote that the regulations will cause a significant loss to U.S. shareholders because Chinese companies will be forced to go private and delist — since China is unlikely to comply with the new regulations — at reduced prices. U.S. shareholders will lose money. And of course U.S. investors will lose access to these investments.
So the loss from the U.S. regulatory tightening is on both sides. But as the globe restructures into U.S. and Chinese spheres for technology and supply chains as well as trade, it is hard to see a middle ground. The regulatory battle is thus a result of the same problem that’s been plaguing relations between the two countries for years now. The U.S. and China have differing views and goals, and they appear to be irreconcilable.
Steven Davidoff Solomon is a professor of law at The University of California, Berkeley, and a columnist for The Wire. Before joining The Wire, he was author of a weekly column for The New York Times as The Deal Professor. @stevendsolomon