The Problem with Foreign Issuers

Alissa Kole Amico is the Managing Director of GOVERN. This post is based on a GOVERN memorandum by Ms. Amico.

A common denominator

What is the common denominator between a Chinese company listed in the United States and an Emirati company listed in the United Kingdom? Both are foreign issuers currently embroiled in massive governance scandals, the details of which are creating fascinating corporate dramas, spilling all over front pages of financial media. Both companies are presently in the process of being delisted, following a whistleblower campaign initiated by Muddy Watters, an American investment research firm, as it announced its short positions.

The parallels between Luckin Coffee, a Chinese company listed on NASDAQ, and NMC Health, an Emirati company listed on the London Stock Exchange are, indeed, remarkable. Both were founded by reputed, established entrepreneurs, backed by prominent sovereign and private investors and creditors, and held leading positions in their respective industries. Fast-forward to today, both are subject to investigations of flagrant fraud: in the case of Luckin Coffee, of $310 million of fictitious sales, and in the case of NMC of over $4 billion of undisclosed debt.

And flagrant it was: consider the accounting gimmicks required to fabricate revenues from millions of non-existent coffee cups, amounting to almost half of its total sales, as in the Luckin Coffee case or a shareholder registry where the ownership of the three largest shareholders turns out to be a Sherlock Holmes mystery as in the NMC case. A few weeks later, and to no surprise, the CEOs of both firms have been dismissed and new boards have been marshaled in to navigate these companies through the ensuing distress.

Changes in governance

Yet, these governance changes to their executive and boards arrive, arguably, too late: Luckin and NMC have already gravely affected the reputation of their investors, creditors as well as their home and host markets. As a result of these incidents, Credit Swiss, the bank that backed Luckin Coffee IPO in 2009, increased its loan loss provisions five-fold for its Asian operations, while the Abu Dhabi Commercial Bank (ADCB), NMC’s large creditor, risks to forfeit $1 billion USD credit, representing 80% of its 2019 profit.

Both companies are currently in the process of being delisted from their respective home exchanges, in the case of Luckin by the exchange itself and in the case of the NMC by a decision of the new board of directors, brought in after the firm was put under administration by a UK court on request of the ADCB. While important disparities between the two cases remain—naturally, given the difference in their jurisdictions and sectors—the two have much more in common than having their bluff called by Muddy Waters.

As Luckin and NMC unraveled—in a spectacularly similar fashion—in the world’s two arguably most prestigious markets, they have prompted a fundamental soul-searching among investors and the public as to whether a listing on a premium exchange does indeed translate into a doctor’s clean bill of governance health during the offering process and appropriate surveillance after.

Rules for secondary listings

In other words, are the rules of the game addressing capital raising by foreign issuers in premium markets sufficient to protect investors? These rules, typically set by securities regulators and—to a lesser extent—by stock exchanges, establish certain obligations intended to render foreign issuer governance equivalent to domestic issuers, with a view to offer investor protections expected of major international marketplaces.

Existing regulatory frameworks for primary listings, listings of foreign companies not previously listed in their home jurisdiction, and for secondary or dual listings, when a foreign listing follows a primary listing at home, are naturally different. Both are of importance since almost 8,000 companies worldwide have raised a total of USD 1.4 trillion on foreign equity markets between 1995 and 2018, estimates the OECD.

The billion-dollar question is whether current regulatory frameworks are creating “governance equivalency” between foreign and domestic issuers. This question remains unanswered for a number of reasons. First, capital raising by foreign issuers may be subject to exemptions. Second, foreign stocks can trade on premium exchanges without an underlying listing through Global Depository Receipts (GDRs) or American Depository Receipts (ADRs).

Third, securities regulators have introduced “mutual recognition” agreements, allowing already listed issuers to be admitted to second market based on compliance with domestic standards. Already a decade ago, a report I authored for the OECD warned that that these agreements “raise the possibility that companies from weak governance regimes might list on exchanges with stronger governance regimes.”

Supervisory challenges

Even when firms are not listed domestically first—and mutual recognition concerns are not relevant—foreign issuers may still represent risks to investors. Indeed, neither Luckin nor NMC had a primary domestic listing, only a foreign premium listing. As such, the “buck” for monitoring their governance stopped fully with the Securities and Exchange Commission (SEC) and the Financial Conduct Authority (FCA), respectively. Yet, by their own admission, they may not be up to the task.

The challenges faced by securities regulators in supervising foreign issuers were underscored by the recent statement of Jay Clayton, SEC’s Chair, when he highlighted that “the SEC, U.S. Department of Justice and other authorities often have substantial difficulties in bringing and enforcing actions against non-U.S. companies and non-U.S. persons, including company directors and officers, in certain emerging markets, including China.”

If so, the question that begs itself is how do these foreign issuers make it to premium markets, the gold standard for global institutional investors? And how do these glitches escape the attention of index providers whose very raison être is to review and admit markets to the prestigious club of “developed” exchanges?

Competition among exchanges

At least in part, the answer to this question lies in the ever-growing competition for listings between the now self-listed exchange groups. As initial public offerings by non-financial corporations have declined by half over the past decade, exchanges have arguably less incentives to impose strict listing and governance rules, lest they lose a listing to a foreign competitor.

This pressure was on display, as I highlighted in an earlier analysis when the potential listing of Saudi Aramco shares, now the world’s largest company by market capitalisation, prompted the London Stock Exchange to propose a relaxation of its listing standards for sovereign issuers on the premium listing tier, an idea that was met with by investor outcry and ultimately abandoned.

Political pressures

The tide on foreign listings is starting to turn. Alas, this is not necessarily happening as a result of recent governance scandals such as Luckin Coffee and NMC Health. In the US—the largest public equity market globally—market dynamics today appear to be dictated by political prerogatives of engagement with China. This was on display last week as the Trump administration tried to pressure a $600 billion USD federal government pension to divest its Chinese stocks.

This unprecedented move demonstrates that US sovereign investors can potentially be compelled not only to avoid foreign securities listed in the US: they can be asked to actively carve out stocks of specific jurisdictions even if they are not listed in the US. The logic of this move is, unfortunately, not specifically related to stewardship or ESG, as it was for example when Norges, Norway’s SWF, decided to divest from coal in 2019.

The same pressure now appears to be applied to NASDAQ as it announced last week, with no prior warning, a tightening of its listing requirements for companies from countries with “secrecy laws”, clearly aimed at Chinese issuers without explicitly naming that elephant in the room. Certainly, the consequence of this announcement may ultimately prove positive for the integrity of US markets as Luckin Coffee is not the first US-listed Chinese company to have imploded due to a governance scandal.

Towards investor rights?

Yet, in the context of the ongoing Sino-American confrontation, one can question if this move can be interpreted as a broader trend of exchanges taking a harder look at governance of foreign issuers. If so, this move may prove as consequential for equity markets as the Volcker rule was for investment banks. For large markets such as NASDAQ or the LSE, losing foreign listings can introduce a non-negligible dent to their revenues.

At this early juncture, the judge is still out as to whether such moves will advance investor rights. As a French writer Francois de la Rochefoucauld once held, “however glorious an action in itself, it ought not to pass for great if it be not the effect of wisdom and intention”. Until exchanges, regulators and investors decide to concern themselves with governance risks of foreign issuers, the NMC and Luckin Coffee stories may be followed by a parade of others.

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