Zhou Qinye, vice general manager of the Shanghai Stock Exchange made some very interesting comments at a conference today. Here is what he said according to the Reuter's report:
"The current situation is the result of some institutions seeking to politicize the matter, and it's difficult to predict where things are heading," Zhou told a conference.
"One way is for overseas-listed companies to delist there and come back home, including Chinese and Hong Kong stock exchanges."
"For the Shanghai and Shenzhen stock exchanges, this could be an opportunity as we know that many overseas-listed Chinese companies are not bad. So we welcome those China stocks to return home," Zhou added.
I don't disagree with Zhou's conclusion that the situation has become political and unpredictable. And while he says he welcomes these companies to come home, the reality is that many of them cannot find their way back. But he is on the right track - the many problems that we face with with U.S. listed Chinese companies, including the reverse mergers, the accounting frauds, the use of VIE structures and the inability of the SEC and PCAOB to effectively regulate all stem from a single cause. That cause is the failure of China to properly develop the institutions necessary for private enterprise to prosper in China. Private enterprise became legal at the beginning of China's reform thirty years ago, but it did not become legitimate until Jiang Zemin invited entrepreneurs into the Communist Party in 2001 as part of his Theory of the Three Represents.
While China opened up capital markets in the early 1990s, they were mostly used to reform state owned enterprises. Only recently have these markets become accessible to private entrepreneurs seeking capital. Today, Chinese exchanges are an attractive alternative to overseas listings for companies that can qualify for listing. In 2009, private companies accounted for 67% of the capital that was raised on Chinese exchanges.
So, as Zhou suggests, are China's stock markets the solution to the regulatory quagmire we are in right now? No, China's markets are still not ready to serve its entrepreneurial sector. China's entrepreneurial companies are still mostly funded with venture capital and private equity money that comes from overseas. This sector, while developing in China, is not big enough to deal with the massive capital needs of private Chinese companies. So, entrepreneurs look to foreign capital, which needs an exit strategy. Because of currency restrictions and controls on foreign ownership, Chinese markets do not offer an exit strategy for these foreign investment firms.
There are a number of U.S. listed Chinese companies that are considering delisting from U.S. exchanges and relisting in China. Shanda Interactive Entertainment has announced plans to go private, but has denied it plans to relist in China. Listing in China appears to be the only exit strategy remaining to Jack Ma after blowing up the VIE route to NASDAQ for Alipay. Long waiting lists and requirements for profitable track records have discouraged many entrepreneurial companies from listing in China. The other problem is the size of many U.S. listed Chinese companies. Baidu's market capitalization of $48 billion is 44% of the size of the entire ChiNext board. Someday, companies like Baidu will be listed on ChiNext, but not today.
Zhou also points to Hong Kong as an alternative. Hong Kong has not attracted most private Chinese companies that have listed abroad. There are many reasons for that, including listing standards that are sometimes tough for startups to meet, and a greater aversion to the VIE structures necessary for companies in prohibited industries. But if political pressures do close off the U.S. markets, Hong Kong may be the alternative.
The real problem, however, is not where these companies list. It is that they have fallen into a regulatory hole, outside the reach of both U.S. and Chinese regulators. The companies built elaborate structures to crawl into that hole, and investors are learning that the holes have created unnecessary risk, including creating an environment in which fraudsters can proliferate. Zhou's solution fixes the problem by bringing the companies back to China and into China's regulatory system.
Zhou is on the right track. The way out of this quagmire is to bring the offshore structures back into China, eliminating the need for Cayman Island holding companies and VIEs. Let the companies list directly. That provides two key benefits - investors would actually own the operations of the companies instead of relying on doubtful contractual relationships, and Chinese regulators would have the ability to actually regulate the companies. Where Zhou goes off track is when he assumes that the companies must list in China. The companies should be allowed to list wherever global markets offer the the best deal. What China needs to to do is to put in place a very simple policy:
Chinese companies are encouraged to seek public listings on any global stock market provided that they comply with all Chinese and foreign laws.
No more VIEs, no more reverse mergers, no more Cayman Island holding companies. Concerns about national security in sensitive sectors can be dealt with through separate classes of stock for locals and foreigners. Companies could seek dual listings - on both ChiNext and Nasdaq for example. But in all cases, the CSRC would remain the key regulator.
OK, that solves the China problem. How about the U.S. problem? I dealt with that by saying that companies seeking listings overseas would have to comply with all Chinese and foreign laws. While the CRSC may not have the expertise to enforce U.S. auditing and securities laws, they do have the power to do so. They can get the needed expertise by cooperating closely with the SEC and PCAOB, while retaining the right to hand out punishment to miscreants. That cooperation could easily include joint inspections, which is what the PCAOB seeks anyway. China is certain to demand that it alone deal with violations. History indicates that China has been tough with wayward accountants, so the PCAOB ought to be satisfied with that. The PCOAB could always revoke the registrations of a firm if it thought the Chinese punishment was not severe enough.