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E-MailJesse Fried is the Dane Professor of Law at Harvard Law School and Matthew J. Schoenfeld is a Portfolio Manager based in Chicago. This post was authored by Professor Fried and Mr. Schoenfeld.
In May, the Senate unanimously passed a bill—the Holding Foreign Companies Accountable Act—designed to improve financial reporting by China-based firms trading on U.S. exchanges. Fraud at these firms—including most recently Luckin Coffee—has cost American investors tens of billions of dollars over the last decade. The bill thus targets a real problem. Unfortunately, its remedy is likely to hurt—not help— the American shareholders of these firms.
To reduce fraud, the Sarbanes-Oxley Act of 2002 requires audits of every U.S.-traded firm to be inspected by the Public Company Accounting Oversight Board. But U.S.-traded firms based in China, whose market capitalizations collectively exceed $1 trillion, refuse to comply. They and Beijing say PCAOB inspection of China-based audit records would violate state-secrecy laws. Why hide these records from the PCAOB? Inspections would likely turn up improper payments to officials, putting them at risk and embarrassing the Chinese Communist Party.
The Senate bill requires the Securities and Exchange Commission to ban trading in the shares of any firm whose audits go three consecutive years without PCAOB inspection. If the ban is not lifted, the firm will be forced to delist. The bill’s apparent goal is to force China to agree to inspections, which would make it harder for insiders of China-based firms to defraud American investors. And if China does not agree, future American investors in these companies cannot be defrauded—because the trading ban and subsequent delisting will ensure there are no such investors.
But if the proposed legislation becomes law, its cure could be worse than the disease. Both Chinese controlling shareholders and the Chinese government are likely to exploit such a trading ban to further their own objectives, at the expense of Americans holding shares in these firms.
Over the last decade, controlling shareholders of more than 90 China-based U.S.-traded firms have arranged low-ball “take private” transactions. The goal is to delist U.S. shares at a depressed buyout price and then relist in China at a much loftier valuation. The poster child for this maneuver is Qihoo 360, an internet security firm. Founders squeezed out U.S. shareholders in mid-2016 at a valuation of $9.3 billion. In February 2018, they relisted Qihoo on the Shanghai Stock Exchange at a valuation exceeding $60 billion, a 550% return. Qihoo’s chairman personally made $12 billion, more than the entire company was claimed to be worth 18 months earlier.
Investors in U.S.-listed Chinese companies are much more vulnerable to an unfair take-private than investors in publicly-traded American firms. Not only are financial statements unreliable, but most China-based firms—including Luckin Coffee—incorporate in the Cayman Islands. This jurisdiction affords investors much less protection than Delaware, home to most U.S. companies. Neither U.S. nor Cayman court judgments can be enforced in China, where insiders and assets are based. And, when American investors are hurt, the same state-secrecy laws make it difficult for shareholders and regulators to collect litigation-critical information.
But the trading ban could make things even worse for shareholders of these firms. Consider a Chinese controller who plans a cheap take-private, but is willing to bide her time if that enables an even lower price. If China continues to bar PCAOB inspections, the SEC will eventually announce a trading ban for the controller’s firm, causing a rout in the stock as investors dump shares before the ban takes effect. The controller can then use a take-private to cash out investors at a rock-bottom price, all while blaming the delisting on the SEC. The legislation will have handed the controller a gift on a silver platter: a means to conduct a take-private on even more confiscatory terms.
For its part, China is unlikely to cave on PCAOB inspections. It dislikes the idea of foreigners—especially Americans—probing and questioning domestic commercial transactions that may involve Party officials. Moreover, Beijing can actually use the trading ban to advance its objective of moving its large tech companies home. Beijing is unhappy that its largest and most famous tech firms—such as Alibaba and Baidu—trade in the United States and not in China.
China wants its crown jewels back. Bringing them home would enable local retail investors to participate in their future growth. And it would boost the prestige of Chinese exchanges. Several years ago, Beijing launched a program to try to induce large overseas-traded Chinese firms to list shares at home while remaining listed abroad. So far, there have been no takers.
But if the Senate bill becomes law, China can force all of these tech firms to leave the United States. By simply continuing to refuse PCAOB access, China can trigger trading bans that would lead to delistings. If the firms then list in China, the legislation will have helped China achieve what its own inducements so far could not. Some controllers might have preferred to keep their firms on U.S. exchanges. But, faced with a trading ban, they will arrange take-privates that enrich themselves at the expense of American investors.
The Senate bill is well intentioned. But Beijing is unlikely to back down, leading to a tsunami of delistings and cheap take-privates that hurt current investors in China-based firms. True, future American investors in these firms cannot be defrauded. But that is only because such investors will not exist. Unfortunately, there is no appealing policy option for protecting current investors in China-based firms trading here.
What can be done? Congress should consider barring future listings from countries that impede PCAOB inspections or otherwise frustrate the pursuit of cross-border wrongdoers. Had this step been taken years ago, we would not be stuck between a rock and a hard place today. Such a forward-looking bar would come too late to help investors in already-listed China-based firms, but it would at least limit the amount of future expropriation.
