Pushing for More Scrutiny of Chinese Stocks Traded in the U.S.

Interior designer Kim Bondy had never heard of Luckin Coffee Inc. when, she says, her financial adviser suggested investing in the fast-growing chain, often referred to as the Starbucks of China. The idea couldn’t have come at a worse time.

Shortly after her purchase of Luckin’s stock, the company disclosed that top executives had fabricated a chunk of its 2019 revenue. The shares, trading on the Nasdaq Stock Market, were subsequently suspended and have dropped almost 90% since April 1, leaving Bondy with an $85,000 loss. “It’s caused horrific financial stress,” says Bondy, who sold her house and vacation home to pay down a credit line.

Like many investors, Bondy assumed that Chinese companies trading on U.S. exchanges and recommended by brokers like hers at Morgan Stanley are subject to the same oversight and regulations as U.S. businesses. That’s not the case, however, especially when it comes to federal protections designed to ensure thorough audits of public companies and prevent frauds like the one being probed at Luckin.

Propelled in part by Luckin’s collapse, but also by the U.S.’s increasing tensions with Beijing, lawmakers and the Trump administration are working to patch loopholes that have given Chinese companies that sell stock on American markets the ability to shield their financial records from U.S. inspections. Yet investor advocates say they remain pessimistic that the political momentum is enough to overturn years of government inaction supported by much of Wall Street, which profits from the lighter regulatory touch and doesn’t want the status quo disrupted. “The problem is that it has been going on for so long,” says Lynn Turner, a former chief accountant at the Securities and Exchange Commission.

The audit issue dates to the 2002 Sarbanes-Oxley Act, passed in the wake of accounting scandals at Enron Corp. and WorldCom Inc. The law ordered publicly traded companies’ accountants to submit to regular inspections from U.S. regulators—reviews that include poring over corporate financial documents. While more than 50 foreign jurisdictions permit the inspections, China has refused, citing strict confidentiality laws. The U.S. government has tried to negotiate a compromise for more than a decade, but it’s allowed Chinese companies to continue tapping American markets.

Pushing for More Scrutiny of Chinese Stocks Traded in the U.S.

For investors chasing the next Baidu Inc. or Alibaba Group Holding Ltd., it’s caveat emptor, a point underscored recently by SEC Chairman Jay Clayton. “If you’re a U.S. investor and you invest in a non-U.S. entity and you’re defrauded, the chances you’re going to get your money back are extremely low,” he says. Clayton has also said that brokers and investment advisers should be aware of such risks when making recommendations.

The SEC has long been part of the acquiescence, routinely signing off on Chinese companies’ requests for initial public offerings even as the agency’s enforcement lawyers continue to file cases against Chinese-based corporations that tanked after accounting irregularities. The regulator also closely supervises U.S. accounting firms, especially PwC, KPMG, EY, and Deloitte—the Big Four that audit most public companies. Their affiliates in China are major holdouts on inspections. The SEC tried to remedy this by suing them in 2012. The case ended in a settlement where the firms agreed to turn over documents to the inspectors. Ultimately the Chinese firms didn’t comply, and the SEC didn’t reopen the case.

Meanwhile, investors’ exposure to Chinese stocks is growing. According to the SEC, more than 150 of the country’s companies, with a combined value of $1.2 trillion, traded on U.S. exchanges as of 2019. IPOs are also continuing apace, with 20 already this year and more expected in the coming months. The agency also points out that not only are individuals buying shares of the Chinese-based companies, but pension funds and mutual funds, both actively managed and indexed, invest in them, too.

The investor protection issue has come to the fore as President Trump has worked to turn China into a focus of his campaign, blaming it for the coronavirus pandemic as he faces questions about his own administration’s handling of the crisis. On Capitol Hill, separate bills have passed the House and Senate that would require stock exchanges to delist Chinese companies that don’t get their audits inspected. A Trump administration committee of top regulators called the President’s Working Group on Financial Markets, which includes Clayton and Treasury Secretary Steven Mnuchin, proposed a similar approach in a report in August.

The legislation and presidential group’s memo show that “Washington is finally serious about protecting America’s mom and pop investors and stopping China’s fraud on our markets,” says Chris Iacovella, head of the American Securities Association, a trade group of midsize brokerage firms that’s been pushing to curtail what it sees as China’s exploitation of U.S. investors. “Enough is enough.”

Still, Iacovella and others involved in the fight are warily watching the opposition. That includes investment banks that take Chinese companies public, stock exchanges that get paid for the listings, and asset management firms that sell popular emerging-market mutual funds. Many finance companies, too, have their own business in China that they don’t want caught up in tit-for-tat warfare between the two governments.

Well aware of most politicians’ sentiments toward China, the Wall Street players aren’t taking public lobbying positions against the delisting plans. They’ve already won an important concession: time. Even if legislation passes, it will take years before any Chinese companies are tossed from U.S. markets. The SEC would also need to write rules governing the delisting process, which will give the industry another chance to influence the policy.

Major companies such as Vanguard Group, New York Stock Exchange, and Nasdaq highlighted some of their opposition during a July meeting held by the SEC that focused on investing in China. Among their biggest concerns is that Chinese companies would move their listings to Hong Kong or countries where investor protections are weaker than in the U.S. American investors, of course, would still be able to purchase the stock. The Trump committee of regulators also pointed out that potential in its report.

Nor is that just speculation. The year’s most-anticipated IPO, China’s Ant Group Co., chose to list on stock exchanges in Hong Kong and Shanghai. Yet in an illustration of how Wall Street benefits even when U.S. markets are bypassed, Citigroup, JPMorgan Chase, and Morgan Stanley were hired as underwriters for the Hong Kong part of the offering.

Although SEC Chairman Clayton has come out in support of the delisting option, the agency continues, as it did under his Democratic and Republican predecessors, to give Chinese companies a green light to sell shares on U.S. exchanges even though it’s widely known they won’t comply with the audit inspection rules. Clayton, who as a deals lawyer helped Alibaba in 2014 when it launched what was then the biggest IPO in history, didn’t signal that cracking down was a major priority for him when he started as SEC chairman three years later. As he settled into the job, agency staff presented him with a report on possible solutions to the audit inspections stalemate with China, but he didn’t take any action, according to a person familiar with the matter.

“Within two months of joining the SEC in 2017, Chairman Clayton was raising these issues directly with Chinese regulators,” says Chandler Smith Costello, a spokesperson for the SEC. “This direct engagement has continued over the entirety of his chairmanship.” Clayton ratcheted up the rhetoric as the Trump administration soured on China. He and William Duhnke, head of the Public Company Accounting Oversight Board, the agency charged with policing auditors, issued strongly worded policy statements in 2018 and 2020 warning investors about the “risks and uncertainties” and stressing that regulators have less visibility into Chinese companies’ books.

China says it would like to reach a deal and is negotiating in good faith—it’s proposed joint inspections by the PCAOB and Chinese regulators. But Duhnke isn’t optimistic about landing an agreement with China to allow audit inspections. In a letter in July, he told the president’s working group that China is the only foreign jurisdiction that has refused “to cooperate meaningfully,” despite efforts including a pilot program and years of talks at many levels of government.

As for Bondy, who took a big hit on the Luckin coffee chain, she’s pursuing an arbitration claim against Morgan Stanley and her broker for allegedly recommending an unsuitable security. Morgan Stanley declined to comment.

The SEC is investigating Luckin, which is just the latest example of a Chinese-based company attracting millions of American investors before cratering in a financial fraud. The list includes well-known companies such as Sino-Forest, Longtop Financial Technologies, and AgFeed Industries.

This hasn’t stopped some investors, including Billy Heanue. The 27-year-old says he lost about $2,000 investing in Luckin. The loss “has made me more cautious to invest in companies in China,” Heanue says, but he still holds shares in IQiyi, the so-called Netflix of China, which he started buying in 2018. In August the company said that the SEC has opened an investigation into its accounting practices. After an initial plunge, its shares have rebounded. —With Ben Bain

©2020 Bloomberg L.P.

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