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  1. Home
  2. / Investing

U.S. Inspections of Chinese Listings Due to Start Next Week

With inspectors winging their way to Hong Kong, the first test will come on a deal to allow SEC access to the books of Chinese companies listed on Wall Street.
By ALEX FREW MCMILLAN
Sep 16, 2022 | 09:00 AM EDT
Stocks quotes in this article: BABA, JD, YUMC, PTR, SNP, ^ACH, ^SHI, ^LFC

The newly struck agreement between U.S. and Chinese securities regulators over audit inspections faces its first big test. Inspectors are heading to Hong Kong to scour over the books of U.S.-listed Chinese companies for the first time.

Team members from the U.S. Securities and Exchange Commission's accounting arm are "on flights" to Hong Kong today, according to SEC Chairman Gary Gensler, with work due to commence with inspections on Monday.

Since it takes 8-10 weeks to conduct the inspections and to deliver results, the SEC's first assessments of U.S.-listed Chinese companies should be complete by Thanksgiving or early December.

The inspections are now mandated by U.S. law if foreign companies want to remain listed on Wall Street. That first cohort of Chinese inspections is expected to cover some of the biggest names: Alibaba Group Holding (BABA) and HK:9988, its e-commerce rival JD.com (JD) and HK:9618, as well as the Pizza Hut and Taco Bell operator Yum China Holdings (YUMC) and HK:9987.

Gensler said he was still unsure whether the Chinese side would really allow full access. "I don't know if the Chinese are going to comply," he told the Senate Banking Committee in answer to a question from Senator John Kennedy. But Gensler said he has repeat assurances from both the Chinese Ministry of Finance and the SEC's counterpart, the China Securities Regulatory Commission, that they will.

The SEC chief also said he supports a move to cut the timeframe to kick Chinese companies off Wall Street if they don't comply to two years, from the current three.

Kennedy and fellow senator Chris Van Hollen have introduced legislation to that effect, which is currently before U.S. lawmakers. Congress, which has bipartisan support to get tough on China, passed the Holding Foreign Companies Accountable Act into law at the end of 2020, requiring these inspections.

For now, companies face delisting if they do not comply for three straight years of results. The SEC has already cited 167 Chinese companies as non-compliant on their 2021 books, meaning the first delistings would start in 2024.

Gensler said he would also like to see the deadline for compliance shortened to two years. That way, "I do think it will continue to have the right leverage," he explained. "Even if the Chinese authorities and Chinese regulators allow for compliance this year, what about next year, and what about the next year?"

Only China and Hong Kong have prevented U.S. regulators from "auditing the auditors," according to the SEC, which notes it works with officials from 50 other jurisdictions to ensure access. China has prevented even the Hong Kong branches of the Big Four accounting firms from accessing audit papers in mainland China, which Beijing worries will reveal countless "state secrets."

A string of accounting scandals at Chinese companies, culminating in the fiasco surrounding the listing of Luckin Coffee in 2019, brought the issue to a head. It's often said that, inside China, companies generate two sets of books, one for public release and one that paints the true picture of the company's operations.

I said at the time of Luckin's 2019 listing that its growth plans, requiring it to open almost seven stores per day in China, didn't make sense. And sure enough, the company imploded within a year, forced to admit that its chief operating officer and several other employees had been concocting fraudulent sales.

The SEC's Public Company Accounting Oversight Board (PCAOB) will now check up on Chinese accounting. The agreement struck at the end of August is a rule-setting "statement of protocol." The SEC says it allows the PCAOB "complete access" to Chinese accounts. The U.S. inspectors will be able to inspect audits without any redactions, from any company they choose, and interview any company or accounting staff member they select.

"At the core it's 'How can you trust the numbers in these Chinese companies unless there's someone in the US auditing the auditors?' so to speak," Gensler said of the inspection requirement. The inspectors can also transfer the information to Washington, he said.

The Chinese side, however, has painted it as a cooperative arrangement, with the Chinese obtaining and transferring any audit work papers, and Chinese officials participating in the interviews and testimony taken.

There's an apparent disconnect between the SEC's insistence that it can fly in a squad of inspectors and crack down with snap inspections, while the Chinese officials say they need to be notified of any inspections in advance so they can set them up and control them.

The deal will be put to the test on Monday. It will be fascinating to watch for reports from the SEC as to how the process is going, and whether what's on paper is translating into practice.

There were 261 Chinese companies listed in the United States as of March 31, with a combined market capitalization of US$1.3 trillion. Chinese regulators have started the process of voluntarily delisting companies that they feel cannot reveal their accounts.

Five state-owned enterprises said last month that they would delist from the New York Stock Exchange: the oil multinationals PetroChina (PTR) and HK:0857 and Sinopec (SNP) and HK:0386, as well as the subsidiary Sinopec Shanghai Petrochemical and HK:0338, alongside the Aluminum Corporation of China (better known as Chalco) and HK:2600 and the insurance giant China Life Insurance and HK:2628.

While the Holding Foreign Companies Accountable Act applies to all overseas companies listed in the United States, it does require them to identify whether they are state-owned or controlled. That's a particularly thorny issue in China, where many companies have a component of government ownership, or have it written into their charter that the Chinese Communist Party is the ultimate decisionmaker, superior to management and shareholders.

There's also a China-specific clause, requiring companies to state whether they have language relating to Chinese Communist Party control. They must also identify any board members who are members of the Chinese Communist Party.

Major fully private companies such as Alibaba, JD and Yum China, long used to dealing with venture-capital shareholders from overseas, should already have accounts that are in good shape by international standards. While identifying CCP members may produce surprises, their state ownership should be minimal at best. It will be when the inspectors move on to lesser-known companies in touchier sectors that the deal over U.S. access will truly be put to the test.

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At the time of publication, Alex Few McMillan had no position in the securities mentioned.

TAGS: Regulation | Investing | Markets | Stocks | Trading | China

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