Analysis

Crackdown On Chinese Cos. Could Be A Double-Edged Sword

By Tom Zanki
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Law360 (June 5, 2020, 7:48 PM EDT) -- More Chinese public companies are considering listing their shares abroad as they mull alternatives before a looming crackdown by U.S. policymakers concerned that Chinese issuers have long dodged transparency requirements governing U.S.-listed companies.

Notably, the U.S. Senate last month unanimously approved a bill that would delist foreign companies that block U.S. regulators from inspecting their audits for three straight years. The bill addresses a sticking point raised for years by U.S. audit inspectors, who have expressed frustration over their inability to examine the books of Chinese issuers that trade in the U.S.

At the same time, Nasdaq wants to tighten its listing standards to ensure that foreign issuers including Chinese companies increase their compliance with U.S. regulatory oversight. These efforts follow notable accounting scandals involving high-profile U.S. IPOs of Chinese companies such as Luckin Coffee, which is being sued for allegedly fabricating sales.

Lawyers and compliance experts say the U.S.' desire to get Chinese companies to play by rules applicable to other foreign issuers has been mounting for years. Tensions are coming to a head now against the backdrop of continued trade war disputes, plus political blowback from some senators and the Trump administration over China's withholding information about the novel coronavirus.

"Those things combined are making it more politically easy and maybe even popular for Congress to appear strong on China," said Robert Weber of Sheppard Mullin Richter & Hampton LLP.

But Weber, who advises Asian clients on SEC enforcement actions as part of the firm's business trial practice group, noted that U.S. investors benefit from opportunities to invest in companies like Alibaba Group Holdings Ltd. The Chinese e-commerce giant's value has more than doubled after it chose to list in the U.S. instead of Hong Kong when it went public in 2014.

Weber acknowledged that many smaller Chinese companies have far to go in terms of improving their corporate governance to meet U.S. expectations, but cautioned that delisting them could reduce their incentives to do so and prompt them to consider alternative venues.

"Absolutely, it would be a good thing to have more transparency into these companies," Weber said. "Delisting them from U.S. exchanges isn't going to promote that."

U.S.-listed Chinese companies have been paying attention to developments. Some have launched plans to add listings on overseas exchanges, which can broaden a company's investor base while also providing a Plan B from U.S. exchanges for companies looking to hedge their bets.

Mobile-gaming group NetEase Inc., which trades on the Nasdaq, reportedly priced a roughly $2.7 billion initial public offering on the Hong Kong Stock Exchange this week. NetEase referred to the recent Senate legislation in an SEC disclosure, saying the bill "could cause investor uncertainty for affected issuers," hurt the company's share price and result in a delisting from Nasdaq.

Chinese search engine Baidu and e-commerce giant JD.com, both of which also trade on Nasdaq, are also reportedly considering secondary listings in Hong Kong. Such companies could follow Alibaba, which last November priced a $13 billion secondary listing in Hong Kong. Baidu and JD.com did not respond to requests for comment.

The speculation comes while Hong Kong seeks to make its venue more competitive globally in a bid to capture more mainland Chinese companies that might otherwise list in the U.S. Hong Kong has recently eased rules on dual-class shares that provide company founders with outsize voting power, which are common among fast-growing technology and biotech startups.

Given questions about the direction of U.S policy, lawyers say London and Singapore are other potential venues for Chinese issuers looking to access international markets outside their immediate home. Mayer Brown LLP partner Anna Pinedo said increased competition for listings could "sway companies to those other non-U.S. exchanges, at least while there is uncertainty."

The Senate bill, known as the Holding Foreign Companies Accountable Act, on its face applies to issuers from any country, though the legislation expressly requires companies to disclose ties to the Chinese Communist Party. The bill's main thrust is that it would delist issuers that block their financial audits from being inspected for three straight years by the U.S. Public Company Accounting Oversight Board, a watchdog that routinely reviews audits of U.S.-listed companies.

SEC Chairman Jay Clayton and PCAOB chairman William Duhnke have previously warned that Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and audit papers. The chairmen reupped their warnings in an April 21 statement that also cautioned investors of Chinese companies that regulators' ability to pursue compensation for fraud is limited because of jurisdictional obstacles.

Chinese regulators have blasted the Senate legislation for mainly targeting China and accused the U.S. of politicizing securities regulation. The Chinese Securities Regulatory Commission, in a statement posted on its website, cautions that the bill would undermine ongoing dialogue between U.S. and Chinese regulators to improve cooperation regarding audits.

"The bill will cause harm to the interests of both parties," the CSRC said on May 24. "It will not only prevent foreign companies from going public in the United States, but will also weaken the confidence of global investors in the U.S. capital market and their international status."

The Senate bill, sponsored by Sens. John Kennedy, R-La., and Chris Van Hollen, D-Md., would require the SEC to establish rulemaking to carry out its provisions. A companion bill in the House of Representatives was introduced May 22 by Rep. Brad Sherman, D-Calif.

The SEC declined to comment on the bill. SEC Chairman Jay Clayton in a June 2 television interview called the bill a "sensible piece of legislation" that levels the playing field for investors and provides issuers adequate time to address a problem that has "gone on for too long."

"This is a very sensible way to approach a problem that has been around a while," Clayton said in a Bloomberg interview.

The SEC has scheduled a July 9 roundtable with regulators and market participants to discuss the risks of investing in emerging markets, including China. 

Himamauli Das, a senior vice president who handles legal matters at investigations and compliance firm K2 Intelligence, said the frustration of U.S. regulators with what they see as the noncompliance of Chinese firms is understandable. He pointed out that domestic regulators have sought greater transparency into Chinese companies' books since about 2011, after a wave of fraud involving Chinese issuers that listed in the U.S. through reverse mergers.

That said, Das noted that newer Chinese companies may be less inclined to undertake the time and expense of listening on a U.S. exchange if they risk getting kicked off after a few years. Those listings also benefit U.S. market participants, specifically financial institutions and exchanges.

"It isn't a black or white issue," Das said. "It's an issue that falls into the area of gray."

Despite uncertainty over what shape U.S. legislation will finally take, assuming congressional approval, it is not clear yet that Chinese companies will cease to pursue initial listings in the United States, which is a magnet for foreign issuers given its role as the world's largest capital market.

Companies based in China regularly account for a steady subset of U.S. IPOs, though many are small technology-oriented issuers that go public without fanfare. Chinese-based issuers have generated 12 of this year's 64 U.S. IPOs, or nearly a fifth, raising $1.4 billion total, according to Dealogic.

Several companies have moved forward on existing IPO plans since the Senate bill passed, even as they are unaware of how the bill will pan out.

Shanghai-based delivery firm Dada Nexus Ltd. on Monday launched plans for an IPO that could raise $264 million. Like NetEase, Dada acknowledged the risk in its SEC disclosure, saying that the bill "could cause investor uncertainty for affected issuers" and could result in its delisting.

Dada Nexus was otherwise optimistic about its prospects in its SEC registration statement, citing growing consumer demand for online commerce, which is the lifeblood of its business. Chinese mobile-gaming company Playtika Ltd. is also reportedly considering an estimated $1 billion IPO.

For Chinese companies that go forward in the current environment, Pinedo said their decision could signal confidence about the quality of the financial reporting and the audit work.

"I could see it shaping up so that the very best or strongest companies list here," Pinedo said.

--Editing by Rebecca Flanagan and Alanna Weissman.

For a reprint of this article, please contact reprints@law360.com.

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