How Congress lets Chinese stocks thrive in U.S. despite delisting threat

By Kellie Mejdrich

07/09/2020 05:01 AM EDT

President Donald Trump and U.S. lawmakers are threatening to kick Chinese companies off American stock exchanges for refusing to allow federal regulators to review their books.

The trouble is, more and more Chinese companies are continuing to list in the U.S., thanks to a law passed by Congress itself that not only makes it easier for them to sell shares here but also gives them a free pass to withhold key financial information from U.S. regulators for up to five years.

Of the 114 firms from China that filed to sell shares on either the New York Stock Exchange or the Nasdaq from 2017 to 2020, all but six registered with the Securities and Exchange Commission using a special “emerging growth company” designation that Congress created in the 2012 Jumpstart Our Business Startups Act, according to a review of listings at the nation’s two largest exchanges. The JOBS Act was intended to establish a streamlined path to the capital markets for U.S. businesses — although it did not exclude foreign firms. 

Now, in the wake of a series of high-profile cases of Chinese companies accused of engaging in financial fraud, Americans are crying foul.

“The [JOBS Act] was passed to help small businesses in the United States access capital so they could create jobs and grow the American economy, not China’s,” said Chris Iacovella, CEO of the American Securities Association and a former House Financial Services Committee aide.

The administration is exploring executive action to protect U.S. investors “from significant risks” of Chinese companies “flouting American transparency requirements,” Trump said in a June White House memorandum [whitehouse.gov] setting up a presidential working group on the issue. The SEC has scheduled a roundtable on emerging markets to discuss China issues on Thursday.

The Senate in May unanimously passed legislation that would delist Chinese firms that ignore U.S. regulators, S. 945 (116) [subscriber.politicopro.com], and the House is weighing an identical bill, H.R. 7000 (116) [subscriber.politicopro.com]. While the measure would not immediately ensnare all newly listed companies that are exempt from most disclosure requirements under the JOBS Act, it would eventually apply to them.

“We don’t want companies, American or non-American, lying about their profits and defrauding investors,” Sen. John Kennedy [cd.politicopro.com] (R-La.), who sponsored the Senate bill, said in an interview.

But while politicians talk tough, regulators have continued to approve stock exchange listings from China-based companies — more than a dozen in the first half of 2020 alone on Nasdaq and NYSE, records show.

The emerging growth designation in the JOBS Act exempts smaller companies — defined as firms with total annual gross revenue of less than $1.07 billion — for up to five years from the normal disclosure and governance requirements for offering securities to the public. Congress later expanded certain benefits under the emerging growth designation in the 2015 highway bill [govinfo.gov]. 

“If policymakers and regulators agree that investors should be able to rely on their companies’ financials, then they should stop creating loopholes and exemptions to our securities laws — not just for Chinese companies, but for all companies,” said Tyler Gellasch, executive director of the investor advocacy group Healthy Markets Association who also worked on the JOBS Act as a senior Senate aide.

In fact, most companies that have begun to publicly sell shares on U.S. markets in recent years have invoked the emerging growth designation. But for Chinese firms, that benefit takes on new significance because most of them — 110 out of 114 — have incorporated their businesses in the Cayman Islands or British Virgin Islands, according to SEC filings.

Those venues offer generous tax breaks and more lenient corporate governance and disclosure standards than do other countries. That creates further legal hurdles for shareholders seeking to bring lawsuits and gives companies even more room to limit disclosures and restrict access to their financial records. 

On top of that, the Chinese Communist Party enacted a law in March restricting foreign regulatory activity such as audits on Chinese soil, citing national security concerns.

The JOBS Act designation provides a number of breaks related to the listing process: There’s no need to attest to regulators that financial controls are in place to conduct a proper audit; only two fiscal years of audited financial statements are required to go public instead of three; and under Congress’s direction, SEC staff provides confidential reviews of registration statements for these companies before they offer securities to the public, a benefit that was extended to all companies.

An SEC spokesperson said in a statement: “For decades, the Commission has focused on the importance of providing a level playing field for domestic and foreign issuers in our markets, including through the treatment of emerging growth companies as established by Congress.

“The fundamental problem—which creates an unlevel playing field for issuers in certain emerging market jurisdictions, including China—is the practical effects are substantially different, based on the inability of U.S. regulators to inspect for compliance and enforce our laws and regulations in those jurisdictions,” the spokesperson said. “Without the ability to inspect for compliance and enforce laws and regulations, the effectiveness of those laws and regulations (or any new laws and regulations) is severely constrained.”

Recent cases of fraud and suspected fraud related to some of these Chinese companies illustrate the potential risks of the new, more relaxed framework for listing. Some traders, including hedge funds, have even reaped returns by betting against these companies with the expectation that they would eventually get in trouble with regulators and shareholders.

Carson Block, chief investment officer of Muddy Waters Capital, an activist hedge fund that sells company securities short based on questionable accounting practices, bet against a number of U.S.-listed firms from China.

Luckin Coffee [twitter.com], GSX Techedu, [muddywatersresearch.com] and China Internet Nationwide Financial Services [muddywatersresearch.com], which later renamed itself Hudson Capital Inc., all went public using the emerging growth exemption as well as a tax haven jurisdiction for incorporation — and later ended up on the Muddy Waters short list.

Luckin agreed to be delisted last month [subscriber.politicopro.com] after admitting that it fabricated $310 million in transactions in April. GSX was hit with a class action lawsuit [subscriber.politicopro.com] in New Jersey federal court in April alleging securities fraud, a charge the company has denied. And China Internet announced in April [globenewswire.com] that it received a warning from Nasdaq that it was not in compliance with listing standards.

On May 18, Nasdaq also proposed [nasdaq.com] additional initial listing standards for public offerings from what it called “restrictive markets,” including China.

Block said the questionable listings are allowed to go on because certain U.S. entities, including underwriters and stock exchanges, benefit from the arrangement and have pressed to let it continue.

“China has been able to get the most powerful and influential people in America to act in their own self-interest, which are China’s interests. But those are actually detrimental and deleterious to the interests of a wide swath of Americans and the majority of American investors,” Block said. “It’s also deleterious to the long-term interests of the companies and institutions that those American individuals represent.”

A Chinese embassy spokesperson did not respond to a request for comment on details of the China-based U.S. listings.

Sourabh Gupta, a resident senior fellow at the Institute for China-America Studies, a Washington-based nonprofit funded by a foundation in China, said: “The emerging growth company designation is the perversity here, because it allows Chinese companies to benefit from a lighter regulatory touch whose intention was to stimulate firm entry and access to capital and certainly not to shield firms from transparency requirements.”

“So while many U.S. investment banks, which have earned handsome commissions bringing these firms to market will suffer, overall my view is that raising this disclosure bar is the epitome of ‘win-win competition,'” said Gupta, who added that his remarks don’t reflect the views of the institute or the Chinese government. 

Former Rep. Stephen Fincher, a Tennessee Republican who sponsored the JOBS Act legislation, said in an interview, “I don’t think any of us expected or knew the level of what China has been doing and continues to do” in listing companies in the U.S.

“We must take this, get a handle on this, and stop this from being taken advantage of,” Fincher said from his farm, about 50 miles north of Memphis. “It absolutely needs to be revisited.”