New SEC rules could lead to delisting of hundreds of Chinese firms from U.S. exchanges

The Securities and Exchange Commission has finalized new rules, effective Jan. 10, under which companies that fail to comply with audits for three consecutive years will incur a five-year trading ban. 

The earliest companies might be delisted would be 2024. The shares of delisted firms could continue to trade in the U.S., over the counter.

Promulgated in compliance with the Holding Foreign Companies Accountable Act (HFCAA), the rules are meant to counter Chinese companies listed on U.S. exchanges that refuse to have their audits verified. 

The Public Company Accounting Oversight Board (PCAOB) was created by the Sarbanes-Oxley Act of 2002 to oversee the audits of public companies, providing external and independent oversight of auditors. The Chinese side claims that Chinese firms are in compliance, as they are audited by the big four accounting firms. The problem is that the Chinese regulators do not allow the audits to be sent to the PCAOB.

Chinese law requires companies to obtain the permission of the government before allowing foreign securities regulators to inspect their activities. The companies must also obtain government permission before providing foreign parties with documents or materials relating to capital markets activities. While Chinese authorities could, theoretically provide this permission. Chinese regulators have frequently refused to allow Chinese companies to be audited. 

SEC Chairman Gary Gensler reported in December, 2021 that, although more than 50 foreign jurisdictions have cooperated with the PCAOB, neither Hong Kong nor the PRC has. 

For more than a decade, the inability to verify the audits of Chinese firms has plagued U.S. regulators. The issue came to a head in 2020 because of NYSE-listed Chinese coffee brand, Luckin Coffee. In April 2020, the Chinese coffee chain fired its CEO after discovering that he had fabricated $310 million in sales. Trading was halted, and the firm lost 83% of its value. The company was delisted and later declared bankruptcy. 

The HFCAA specifically addresses disclosure regarding foreign jurisdictions that prevent inspections. Additionally, the act requires companies to disclose if they are owned or controlled by a foreign government. Currently, there are state-owned and state-controlled companies listed on all three major, U.S. exchanges. 

Rules in China are also restricting U.S. listing of Chinese firms, particularly technology companies. The Cyberspace Administration of China requires companies which hold data on more than one million users to seek approval for overseas listing. Additionally, companies in industries which are normally banned from foreign investment must seek a waiver before listing. Once listed, these firms are subjected to national security and cybersecurity reviews. 

Shortly after Chinese ride-hailing app DiDi listed on the NYSE, China's cybersecurity regulator ordered the company's app removed from app stores, citing issues of data security. The company's stock fell by 25%. Shareholders sued on the grounds that the company had failed to disclose the discussions it was having with Chinese authorities. A few days later, DiDi announced that it was delisting from the NYSE, planning to relist in Hong Kong. The company assured investors that the shares would be convertible into freely tradable shares on another stock exchange. 

Another area where US and Chinese regulators are increasing scrutiny is the variable interest entity (VIE). Chinese technology companies and other companies in industries barred from having foreign investors, use a VIE structure to list on U.S. exchanges. A variable interest entity is a shell company, usually registered in the Cayman Islands, which has a contractual agreement with a real company in China, whereby the investment dollars flow through the VIE to the real company in China. And the distribution of profits/dividends flows through the VIE back to the investors. 

The Chinese government is cracking down on internet companies in general and is now tightening rules related to VIEs, as well as overseas listings. The Chinese Securities Regulatory Commission recently issued a statement saying that they were not planning to prohibit the VIE structure. However, there is speculation that the Chinese authorities may prohibit Chinese companies from using VIEs in the future. Banning VIEs would effectively end U.S. listings of Chinese technology firms.

U.S. authorities are also considering taking action against VIEs. Gensler warned in July, 2021 about the risks of investing in VIEs, actually referring to them as "shell companies." Gensler and other opponents of VIEs argue that American investors could lose their money if Chinese regulators outlawed VIEs. Another risk is that if a VIE refused to pay dividends to U.S. shareholders, Chinese courts would not be obligated to enforce the contractual distribution of profits. 

If Chinese or U.S. regulators forced an end to the VIE structure, U.S. investors could lose. Of the more than $700 billion in Chinese stocks held by Americans in 2017, more than half were VIEs. Additionally, delisting VIEs would cause $1.6 trillion of Chinese stock value to disappear from U.S. exchanges. 

The announcement of the Holding Foreign Companies Accountable Act had an immediate impact on stock values, causing the Nasdaq Golden Dragon China Index, which tracks 98 U.S.-listed Chinese firms, to go into decline. Other Chinese companies have canceled or delayed their U.S. IPOs, including LinkDoc Technology Ltd., Hello Inc. and Ximalaya Inc., while RoboSense, Lalamove and Xiaohongshu have chosen to list in Hong Kong instead.

Chinese firms unable to list in the U.S. often list in Hong Kong. Now that the PRC legal system is creeping into Hong Kong, however, the VIE structure may be illegal. Consequently, many Chinese firms could find it impossible to list anywhere. A cessation of VIE listings would negatively impact U.S. financial firms, which have earned $82 billion helping 300 Chinese firms list in the U.S. through VIEs. 

Gensler told staff to hold off new listings of Chinese companies. It remains to be seen what the effects of the HFCAA will be, but the new rules could lead to as many as 200 firms and possibly $200 billion of value being removed from U.S. exchanges.