On Booting Chinese Firms Off U.S. Exchanges

Amid the many executive orders and memoranda President Trump has ballyhooed lately, let’s not forget this sneaky little number: a proposal that Chinese businesses listed on U.S. stock exchanges must submit to U.S. auditing standards. 

Right now, Chinese firms don’t have to do that. Rather, they can publish financial statements audited by Chinese audit firms; but investors here in the United States have no idea whether those audits meet serious standards of rigor. China won’t let U.S. audit regulators inspect those Chinese audit firms’ work.

Then come accounting frauds such as Luckin Coffee, the Chinese competitor to Starbucks recently accused of concocting more than $300 million in revenue from thin air. Luckin’s CEO and COO have been fired, and its share price is now worth less than a small regular at Dunkin Donuts. 

Spectacles like that make people wonder whether the financial statements for lots of Chinese firms are a pile of phooey. So without a rigorous audit from an accounting firm that meets U.S. standards, the argument goes, those companies should be booted off the NYSE and Nasdaq. 

At least, that’s the recommendation from the Treasury Department, which released a proposal last week to tighten listing standards for U.S. stock exchanges. Either the PCAOB gets access to the work papers of a company’s principal audit firm — something currently against the law in China — or the company gets a “co-audit” from an audit firm that can provide its work papers to the PCAOB. Or else the company can’t trade on U.S. exchanges. 

To that extent, the Trump Administration’s proposal is sensible. The Obama Administration danced around this problem for years, sometimes coming close to forcing Chinese firms off U.S. exchanges but never following through. Trump, wanting to look tough on China to boost his re-election campaign, has more reason to follow through.

My question is this: Why are we getting more tough on the auditing of Chinese firms, while simultaneously getting less tough on the auditing of U.S. firms? 

There’s an inconsistency here worth exploring. Hear me out.

To Disclose, or to Safeguard?

I keep going back to the Sarbanes-Oxley Act — specifically Section 404(b) of the law, which requires publicly traded companies to get an external audit of their internal controls over financial reporting.

Republicans hate 404(b), and have tried to expand the number of firms exempt from 404(b) compliance for years. Their most recent success came in March, when the SEC voted to exempt firms with less than $100 million in annual revenue from compliance. That’s in addition to Emerging Growth Companies, exempted from 404(b) in 2012; and non-accelerated filers, which the SEC never got around to including under 404(b) in the first place. 

When regulators repeal Section 404(b) requirements for an audit of financial controls, investors are forced to shoulder more risk. That’s fine under federal securities law, so long as companies clearly disclose that fact: “Our auditors don’t offer an opinion on the effectiveness of financial controls! Invest at your own risk!”

Well, how is the investment risk with a Chinese company substantively different? By that same logic, the Chinese firm could just scrawl, “Our audit might be worthless, invest at your own risk!” across the first page of the 10-Q, and be done with it. 

If disclosure to investors is enough to depart from 404(b) audits, then by that logic it should be enough to depart from other audit requirements, too — including the expectation that audits meet U.S. auditing standards. No Republican commissioner at the SEC would put the point so bluntly, but that is where their logic takes us. 

Hester Peirce, resident libertarian theorist on the SEC, kinda sorta came close to that point when speaking at a conference last year. Someone asked her about expanding Section 404(b) exemptions for even more firms, and she said, “If I were king or queen for a day, I would say make it optional for everyone.” 

Instead of forcing companies to spend cash on audit fees, Peirce often argues, companies should be able to spend that money on business operations. Let them disclose that decision to investors, and then let the market decide whether or not to reward those companies with investment dollars.

Fair enough, if that’s what you believe — but then why stop at Section 404(b)? Why not repeal the management assertions about internal controls in Section 404(a), or the need for audited financial statements entirely? 

Back to China

To be clear, I do support tighter listing standards that will force Chinese companies to toe a more rigorous line — but that’s because I support strong investor protections generally, including Section 404(b) audits. Sometimes simply disclosing the risk to investors isn’t the right path; a regulatory authority should draw a firm line that says, “Nope, this risk isn’t allowed, period.” 

That’s especially true for subtle, nuanced risks beyond the expertise of most retail investors. The quality of audits from Chinese audit firms is one example; the reliability of ICFR is another. Chinese do firms pose more risk to investors than firms skipping 404(b) audits, but only as a matter of degree. The risk is substantively the same for both groups.

The Trump Administration is correct to say this headache with Chinese firms has lingered far too long. Those firms should have been exiled from U.S. exchanges years ago, and prior SEC leadership never had the gumption to do it. 

Then again, SEC leadership also includes current chairman Jay Clayton, who hasn’t done anything about this problem in the first three years of his tenure either. He released a wishy-washy statement in 2018 lamenting the poor state of affairs, but that’s not action. That’s telegraphing to investors that Chinese companies are sketchy. 

So will the SEC act against China now? Will that action be driven by a sincere desire to protect investors — or a desire to protect Trump’s re-election prospects? (Let’s not forget, Clayton also needs Trump’s support for that New York prosecutor job Clayton wants in a possible Trump second term.) We’ll see.

Perhaps the Trump Administration is doing the right thing for the wrong reasons. That’s better than nothing, but let’s not have any illusions about the forces really at work here.