Chinese Company Listings on U.S. Exchanges: The Beginning of the End?

August 12, 2020

On June 4, President Trump tasked the President’s Working Group on Financial Markets (PWG)—a group of U.S. financial regulators led by the secretary of the treasury—to examine the risks to U.S. investors posed by the lack of access to audit work papers for Chinese companies listed on U.S. exchanges. Last week, the PWG released its report and issued five recommendations, including “Enhancing Listing Standards for Access to Audit Work Papers.” On August 10, Treasury Secretary Mnuchin said the U.S. Securities and Exchange Commission (SEC) would adopt the recommendation, which could lead to the delisting of companies from “Non-Cooperating Jurisdictions” (NCJs), including China, from U.S. exchanges at the end of 2021. The recommendations also call for enhanced risk disclosures by registered funds, focusing on issues “unique to emerging markets,” and greater due diligence on index providers. Taken together, the recommendations focus broadly on investment in Chinese and other emerging market companies, whether traded on U.S., Chinese, or other country exchanges. It remains to be seen whether the PWG recommendations will forestall the need for further action or herald the erosion of financial linkages between the world’s two largest economies. 

Q1: What did the PWG report recommend?

A1: The report makes five recommendations to protect U.S. investors from risks, including those posed by NCJs that do not allow the Public Company Accounting Oversight Board (PCAOB), the U.S. audit regulator, to inspect public accounting firms and audits of public companies:

1. Enhanced Listing Standards for Access to Audit Work Papers. The PWG recommends enhancing listing standards for U.S. exchanges to require PCAOB access to work papers of the principal audit firm for the publicly listed company as a condition to initial and continued exchange listing. If firms are unable to satisfy this requirement, they may alternatively satisfy the requirement via a “co-audit” with a qualified accounting firm as the principal auditor.


2. Enhanced Issuer Disclosures. The PWG recommends establishing enhanced disclosure requirements intended to raise awareness of the risks of investing in NCJs.


3. Enhanced Fund Disclosures. The PWG recommends enhancing risk disclosure and due diligence by registered funds that have exposure to issuers from NCJs in order to increase investor awareness of the risks of investing in such funds.


4. Greater Due Diligence of Indexes and Index Providers. The PWG recommends the SEC consider taking steps to encourage or require SEC-registered funds that track indexes to perform greater due diligence on an index and its index provider prior to the selection of the index.


5. Guidance for Investment Advisers. The PWG recommends the SEC consider issuing guidance to investment advisers with respect to fiduciary obligations when considering investments in NCJs.

The recommendations follow Senate passage of the Holding Foreign Companies Accountable Act of 2020 in May, which, if signed into law, would require the SEC to prohibit trading on U.S. exchanges of companies for which U.S. regulators are unable to inspect their audits for three consecutive years.                                                            

Q2: What motivated the PWG examination?

A2: The PWG examination and subsequent recommendations follow long-standing complaints from the PCAOB over the lack of access to audit work papers of principal audit firms for Chinese-based companies listed on U.S. exchanges. As documented in a letter from the PCAOB chairman to the PWG, China has “refused to cooperate meaningfully with the PCAOB” since 2007, when Chinese and Hong Kong audit firms first refused access to U.S. inspections, citing Chinese restrictions on sharing sensitive information with foreign entities. The PCAOB also faces obstacles to inspect the audit work of firms in Belgium and France but describes these concerns as “distinct” from those related to China and expects “to conclude soon bilateral cooperative agreements” allowing for inspections in each country.

After years of negotiating for access to Chinese firms’ audit papers, the PCAOB, the China Securities Regulatory Commission (CSRC), and China’s Ministry of Finance signed a Memorandum of Understanding in 2013 that was intended to serve as a cooperative framework for the exchange of audit papers. However, the PCAOB claims the Chinese side never agreed to provide access “consistent with [PCAOB] core principles.” The PCAOB argues the latest Chinese proposal from April 2020 falls short as it preserves CSRC veto power over access to specific company audits and scope of investigations, lacks commitment to routine audits, and contains insufficient enforcement mechanisms.

Q3: What is the significance of the PWG recommendations?

A3: The long history of non-compliance begs the question, “Why now?” Increased U.S.-China tensions and the recent Luckin Coffee fraud scandal uncovered this spring, leading to the company’s delisting from Nasdaq, have clearly increased scrutiny over Chinese auditing practices. Yet recommendations #3-#5, which focus on enhanced disclosures by registered funds, greater due diligence of indexes and index providers, and fiduciary obligations of investment advisors, go beyond audits of foreign companies listed on U.S. exchanges. Taken together, the recommendations focus broadly on investment in Chinese and other emerging market companies, whether traded on U.S., Chinese, or other country exchanges. In particular, the report highlights that “the portfolios of U.S. investors have become increasingly exposed to companies that are based in emerging markets” and acknowledges the potential risks to investors resulting from differences in regulatory, accounting, auditing, and financial recordkeeping standards.

The PWG’s report comes amid increasing financial integration between the United States and China. Over the past several years China has eased restrictions on foreign portfolio investment, sought to deepen its capital markets, and courted foreign banks, investment funds, and index providers. As U.S.-China financial ties have developed, Chinese companies have increasingly announced primary or secondary listings on U.S. exchanges. According to data accessed via Bloomberg Terminal, as of August 10, firms based in mainland China and Hong Kong now account for more than one-quarter of foreign-listed firms traded on U.S. exchanges. In terms of market capitalization, these firms account for roughly 20 percent of the value of all foreign listed firms ($2.1 trillion of $10.9 trillion). Despite rising U.S.-China tensions, Chinese and Hong Kong-based companies accounted for well over half of foreign company initial public offerings (IPOs) launched on U.S. exchanges—25 of 39—in the year to date and represent almost 20 percent of the total number of IPOs launched this year on U.S. exchanges (25 out of 128).

The PWG report acknowledges that its recommendations may result in Chinese companies relisting on exchanges outside the United States, such as in London, Hong Kong, or Shanghai. In recent months, Chinese authorities have streamlined the listing approval process and loosened daily trading restrictions for the ChiNext board on the Shenzhen Exchange and expanded the relatively liberal rules of Shanghai’s nascent STAR Market. Despite Beijing’s recent crackdown on Hong Kong’s autonomy, Chinese officials have tried to preserve the city’s status as an international financial hub by pledging to ease restrictions on capital transfers with the mainland. Chinese exchanges have grown in the past couple years, and as of June, the combined market capitalization of the Hong Kong, Shanghai, and Shenzhen exchanges had reached $14.1 trillion, up from $10.1 billion in 2018. By comparison, the total market cap of Nasdaq and the New York Stock Exchanges combined was $35.7 trillion as of June. According to data compiled by Bloomberg, the three exchanges have launched 283 IPOs so far in 2020, with both the Shanghai and Shenzhen exchanges exceeding their full-year 2019 figures. 

Q4: What comes next?

A4: On August 10, Secretary Mnuchin said the SEC was expected to adopt the PWG recommendations; it then is up to the SEC to draft precise implementing rules. The enhanced listing standards (recommendation #1) would provide a transition period until January 1, 2022, for currently listed companies from NCJs to come into compliance. For new listings, the enhanced standards would apply immediately once implemented. Failure to meet the enhanced listing standards would result in the company’s eventual delisting from U.S. exchanges. However, the alternative of “co-audit” compliance for companies unable to provide PCAOB access to audit work papers raises questions about the circumstances under which Chinese authorities would allow access to audit work papers.

China is unlikely to directly retaliate to delisting threats and may well support any action that leads Chinese companies to relist on domestic exchanges. Chinese authorities have shown continued willingness to discuss regulatory issues, and on August 8 the CRSC revealed that it had already sent a new proposal to the PCAOB on audit cooperation. CRSC did not elaborate further on what the new proposal contains, and it has not been made public.

In addition, recommendations #3-#5, which concern enhanced disclosures for registered funds, greater due diligence of indexes and index providers, and guidance for investment advisors, may well be as consequential over the medium term, especially if they have the effect of improving investor protections and/or deterring investment in China and other emerging markets by U.S. investors.

Stephanie Segal is a senior fellow with the Economics Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Dylan Gerstel is a research assistant with the CSIS Economics Program. Olivia Negus is a research intern with the CSIS Economics Program

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