William McGovern of Kobre and Kim in Hong Kong has penned an editorial in China Daily calling for the resolution of the present standoff between China and the SEC over enforcement of subpoenas related to stock frauds of Chinese companies to be settled through diplomacy rather than the courts. I agree with this sentiment, but I am increasingly pessimistic that diplomacy is going to work. While I understand that SEC officials will have discussions with Chinese regulators next month in Beijing, their respective positions may be irreconcilable.
John Hempton’s kleptocracy blockbuster adds further intrigue to the issue, since he asserts that the Big Four firms have signed off on frauds that are connected to princelings. I don’t see the Chinese looking for any help from U.S. regulators as they sort out the issues raised by the Bo Xilai case.
So what happens if the SEC/Deloitte case is not resolved?
I have heard that SEC subpoenas have been issued to the other Big Four firms in China as well, so the issue is unlikely to be limited to Deloitte. The PCAOB faces a December deadline to complete inspections of Chinese accounting firms that are registered with the PCAOB. It seems highly unlikely that they will meet this deadline, since Chinese regulators will not let them come to China. While the PCAOB could extend the deadline, they have already been under political pressure to act. In this election year, where China bashing might become a tool for either party, it seems unlikely an extension will be well received. The argument that Chinese companies that want to access U.S. capital markets must follow U.S. laws resonates with most people. Without resolution, the only meaningful option for the SEC, and the PCAOB, is for the PCAOB to deregister the firms and for the SEC to ban them from practice before the SEC.
The consequence of those actions would be that U.S. listed Chinese companies would be without auditors and unable to find them. Having an auditor is a listing requirement of the exchanges, so under exchange rules the companies face delisting. The U.S. listed Chinese companies would be unable to file financial statements as required. That should lead the SEC to eventually deregister the companies with the SEC. This has been called the nuclear option. Some have said it could never happen – there is simply too much money in U.S. listed Chinese stocks and that the investment community would get politicians to intervene. That might or might not work depending on the political winds.
What would happen if the SEC and the PCAOB pull the plug and deregister Chinese auditors?
Shareholders of U.S. listed Chinese companies would still own their shares, yet they would be unable to trade them on U.S. exchanges. The companies are likely to look to list their stock on an exchange outside of U.S. regulation so that it can trade again. Hong Kong is the obvious alternative. Yet, there are reasons why many of these companies did not list in Hong Kong in the first place. U.S. listing requirements focus more on disclosure of risk, while Hong Kong regulators focus more on the actual risk. Hong Kong regulators have been more cautious about the VIE structure, for instance, and more skeptical of early stage companies.
China’s own stock exchanges do not appear to offer a realistic alternative to these companies at this time. First, they are not large enough to handle the volume of companies that will be looking for a listing. ChiNext has a market cap of $135 billion, while Baidu alone has a market cap of $41 billion. I think these companies will eventually be listed on ChiNext or other Chinese exchanges, but the market needs to grow significantly before that can happen. Second, the companies would have to be restructured into domestic companies in order to list under current rules. While this restructuring could fix both the problem of offshore companies and VIE structures, it would require changes in current policy on foreign investment in certain sectors. Third, China’s foreign exchange controls need to be completely rewritten. I think all of those things will happen, but the likely time frame for reforms (up to ten years) is too long to help here.
I think the most likely scenario should the PCAOB and SEC pull the plug on U.S. listed Chinese companies will be that the companies migrate to the Hong Kong Stock Exchange. The big winners will be the investment banks, lawyers and accountants who will make a fortune relisting the companies. How investors come out will depend upon how well the market accepts the relisting of the companies.