Chinese Pragmatism, Audits and ADRs

In an important return to pragmatism by China’s leaders, they have agreed to steps which should resolve the audit issue which threatened to lead to the delisting of all Chinese companies trading on U.S. securities exchanges.

The U.S. Public Company Accounting Oversight Board (PCAOB) announced on August 26 that it had reached agreement with Chinese regulators on a process for the PCAOB to inspect the audit workbooks of accounting firms working for Chinese companies listed on U.S. securities exchanges.  This process, which will begin with trial inspections as early as September, is a breakthrough in a bilateral negotiation which had been deadlocked for many years.

By accepting the same PCAOB inspection process that has been in place in 25 other countries, China can avoid delisting of its companies in 2024, if the trial inspections go smoothly.

The wording of statements by regulators in both countries suggests that there are not likely to be additional, voluntary delistings of Chinese companies trading in the U.S., following the announcement earlier in August that five, large state-owned enterprises would withdraw from American markets.

More than just keeping ADRs listed in the U.S.

The importance of resolving this long-running regulatory dispute goes beyond the immediate impact of keeping over 200 Chinese companies trading in the U.S.

In my view, the agreement also reflects a return to pragmatism by Chinese leader Xi Jinping, suggesting that a more pragmatic approach to COVID and the property market may be coming, which I believe would pave the way for an economic recovery in China.

The audit deal is a practical decision by Xi to avoid financial decoupling from the U.S.

Coming during a time of heightened tensions between Beijing and Washington, the deal also suggests that Xi wants to reverse the downward spiral in bilateral relations.

Moreover, coming prior to the 20^th Party Congress—an important Chinese leadership meeting scheduled for this fall—the deal suggests that Xi is confident enough in his political standing that he didn’t feel the need to wait until his third five-year term as head of the Chinese Communist Party is formally confirmed.

Gensler: “The proof will be in the pudding.”

The inspection is an important first step, and PCAOB Chair Erica Y. Williams said she has instructed her agency’s inspection team “to finalize their preparations to be on the ground by mid-September so we can put this agreement to the test.” Successful inspections would allow the PCAOB to determine by the end of the year if China meets the criteria to keep its companies trading on U.S. exchanges. SEC Chair Gary Gensler emphasized this point: “The proof will be in the pudding. . . This agreement will be meaningful only if the PCAOB actually can inspect and investigate completely audit firms in China.”

The China Securities Regulatory Commission (CSRC) expressed optimism, saying it is “committed to working with U.S. regulators” and that it is “hopeful that the audit oversight issue of the U.S.-listed Chinese companies will be resolved and delisting can be avoided.”

The CSRC also explained why the two key obstacles to an inspection agreement were finally overcome now.  First, the Chinese regulator said the agreement is based on “reciprocity and mutual benefit,” and will “protect the legitimate interests of investors in line with common practices in global capital markets.”  Second, the CSRC acknowledged that “audit work papers generally do not contain state secrets, individual privacy, companies’ vast user data or other sensitive information.” The CSRC added that it reached agreement with the PCAOB for “arrangements on the treatment and use of possible sensitive information during audit oversight cooperation.” 

Background on the audit issue

By way of background, when Sarbanes-Oxley became law in 2002, one of the things that it did to try and avoid a repeat of Enron was to establish the PCAOB, which is under the SEC. This group is required by law to periodically check the workbooks of accounting firms that are auditing publicly-listed companies in the U.S., including foreign companies listed here. This required the U.S. government to sign agreements with the governments of some foreign countries whose companies are listed here in order to make it work due to differences in rules. While there has yet to be a formal agreement with China, Chinese companies listed in the U.S. have always had to comply with certain audit and financial disclosure requirements that apply to all companies listed on U.S. exchanges.

More recently, at the end of 2020, Congress passed another law, the Holding Foreign Companies Accountable Act, which states that if the PCAOB and a foreign regulator, like in China, cannot reach agreement on how to undertake these audits, then after three years companies from that country will be de-listed.

In our view, this is a dispute between the two governments. It is not that Chinese companies and the auditing firms want to avoid being reviewed or audited – this is a government to government issue. If they don't resolve this issue, then potentially by the summer of 2024, we could see forced de-listings.

We have been hopeful for a deal for some time, because resolving this issue is in the interest of both sides. Chinese companies choosing to list in the U.S. is good for our capital markets and it's also good for our investors because it puts these Chinese companies under the supervision of the SEC.  

We also note that should Chinese companies be forced to leave U.S. markets, many of them already have or would seek listings on exchanges in Hong Kong or mainland China, where investors such as Matthews Asia would continue to have access on behalf of the strategies we manage for our clients.

Definitions:
American Depositary Receipt (ADR): A certificate issued by a U.S. depositary bank representing a specified number of shares of a foreign company's stock. ADRs offer U.S. investors a method of purchasing stock in overseas companies that wouldn’t otherwise be available.

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