It looks like the Chinese invasion is over. A few years ago, anything China was white-hot as investors and journalists endlessly pushed variations on the "China is the superpower of the 21st century, so you must get in today" theme. But as seems to always be the case, what starts with gold ends with dross and the China bubble has petered out as investors have been forced to consider issues like fraud, disclosure and the fact that China's economy isn't actually Shangri-La. Unfortunately, the Chinese government has elected not to cooperate with efforts to improve disclosure and transparency. There is a major disagreement going on now between U.S. regulators, like the SEC, and the Chinese government over the desire of U.S. regulators to have greater oversight over the auditing process of accounting firms in China. China has not only started to restrict access to domestic financial filings, but has also claimed that audits fall within the State Secrets Law, making it illegal for the Chinese firms to comply with the requests of U.S. regulators. What's more, the China Development Bank has been reportedly providing capital (approximately $1 billion in loans) to assist companies in departing the U.S. financial markets.
The question for investors now is whether the sudden efflux of listed Chinese companies is really a problem, and what the near-term future holds for United States-listed Chinese.
A Quick J-Turn
Like the hero of a generic 1980s cop show, the trend in Chinese listings on U.S. stock markets has suddenly reversed and started accelerating in the opposite direction. The flood of Chinese listings that began about five years ago has clearly ended; from 42 initial public offerings (IPOs) in 2010, the number has dropped to just one IPO in the first half of 2012.
At the same time, more and more companies are leaving. There were three delistings in 2010, but there have been 23 delistings to date. While there will almost always be a certain amount of legitimate delistings (mostly companies being acquired), clearly things have changed. In the wake of repeated accounting fraud scandals and growing skepticism about the quality of Chinese accounting and auditing standards, valuations have plummeted and Chinese companies are increasingly looking to pull their listings from U.S. markets.
Revolution or Evolution?
Any discussion of mass Chinese delistings has to be examined in the context of what the world's financial markets offer companies. Until very recently, stock markets in China were built for the benefit of the Chinese government, formerly state-owned enterprises and large corporations in general. It was difficult for small companies to list on these exchanges and there really wasn't a Chinese version of the Nasdaq to cater to small companies.
Consequently, Chinese companies had to look at U.S. exchanges to raise equity. At the same time, there was a certain prestige in listing on U.S. exchanges; it was a sign to many that the company was legitimate and playing in the big leagues.
As time has gone on, the Chinese markets have matured and are increasingly accessible to smaller local companies. What's more, many Chinese companies and investors are becoming more self-confident in their own markets; companies no longer need a foreign seal of approval to look good in the eyes of employees, competitors or investors.
Transparency and Turf Wars
There are much darker overtones to this development as well, though.
It's important to note that many of the Chinese companies that are listed on U.S. exchanges never went through the IPO process and the scrutiny it carries. Instead, these companies attained publicly traded status by executing reverse mergers - basically buying dead "shell" companies and taking advantage of their listings to become public. This process is faster and cheaper, but involves less oversight and disclosure. Consequently, more than a few companies went public that likely could not have completed a conventional IPO.
It is also the case that disclosures, accounting fraud and auditing have become major issues with Chinese companies. Chinese companies have been found playing fast and loose with their financial reports, with problems ranging from overstating profits, claiming assets that don't exist and giving sweetheart benefits to company insiders. While not all of the accusations made against Chinese companies have held water, there has been enough fire beneath the smoke to create serious concern for many investors.
While there hasn't been much in the financial media about this yet, this issue could explode. If the U.S. decides to play hardball, it is possible that there will be mass forced delistings of Chinese companies, possibly including large and generally well-regarded firms like PetroChina (NYSE:PTR) and China Mobile (NYSE:CHL). Common sense will likely prevail, with protracted negotiations relieving the immediate threat of mass delistings, but this issue is not going to go away.
Integrity Pays in the Long Run
Quite frankly, if the Chinese government does not see the need for U.S. investors to have access to timely and accurate information on companies listed on U.S. exchanges, then some would suggest the response on the part of U.S. investors ought to be "good riddance." There's simply no way to make informed investing decisions without accurate financial information.
What's more, China needs to wake up to the long-term realities of how financial markets work. American and European markets are by no means perfect, but if China is seen as an opponent to fair disclosure and transparent financial disclosure, it seems unlikely that Shanghai will ever emerge as a major financial hub for any but Chinese financial firms and those multinationals that need a foothold in China.
To be fair, not all of these delistings are terrible companies or bad decisions. Many of these listed companies are tiny, with no coverage, minimal volume and few prospects for ever attracting attention. In those cases, there's little point in incurring the expense of staying listed on U.S. exchanges. Other delistings seem more petulant, with companies basically saying "well, if you won't just take our word for it and give us a rich valuation, we're going home."
The Bottom Line
I've written before on the ongoing trend of foreign companies abandoning or deprioritizing their listings on U.S. exchanges. In some cases, these are money-saving measures for companies that don't need U.S. market exposure, while others have found that the growing liquidity of local exchanges means they no longer have to tolerate U.S. regulations and disclosure rules in order to access adequate capital. All in all, while I have understood the reasoning of the companies, I have lamented how the process is by and large bad for investors.
In the case of Chinese companies, though, I don't see that U.S. investors will miss out on much. Many of these companies should have never been public in the first place, and as I said before, U.S. investors should not lament the disappearance of companies that don't want (or are not allowed) to comply with GAAP and transparent disclosure policies. While I do hope that China sees reason and defuses the situation with moves towards greater oversight transparency, investors should appreciate that investing in Chinese companies could become more challenging if this controversy escalates.
Unfortunately, the Chinese government has elected not to cooperate with efforts to improve disclosure and transparency. There is a major disagreement going on now between U.S. regulators, like the SEC, and the Chinese government over the desire of U.S. regulators to have greater oversight over the auditing process of accounting firms in China. China has not only started to restrict access to domestic financial filings, but has also claimed that audits fall within the State Secrets Law, making it illegal for the Chinese firms to comply with the requests of U.S. regulators. What's more, the China Development Bank has been reportedly providing capital (approximately $1 billion in loans) to assist companies in departing the U.S. financial markets.
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