Key Takeaways:
- Having reached a tentative deal that could remove the delisting threat for U.S.-traded Chinese stocks, China and the U.S. will conduct a trial period through the end of this year
- Different interpretations on reciprocity and cooperation could become stumbling blocks that ultimately derail the deal – following the failure of two previous agreements
By Doug Young
Will the third time be the charm?
That’s the question on everyone’s minds these last few days, or at least everyone from the world of U.S.-listed Chinese stocks, including ourselves at Bamboo Works, as well as the more than 200 Chinese companies listed in New York and their many investors. Following months of negotiations, the U.S. and China on Friday announced a breakthrough agreement allowing U.S. regulators to inspect the working papers of the China-based auditors for New York-listed Chinese firms.
The actual terms of the agreement are quite complex and weren’t disclosed. Instead the two sides each put out its own announcement, including a brief statement and Q&A from the China Securities Regulatory Commission(CSRC); and a statement from the Public Company Accounting Oversight Board (PCAOB), the body that works with the U.S. Securities and Regulatory Commission (SEC) on auditing U.S.-listed companies.
This isn’t the first time the U.S. and China have reached an agreement, which the CSRC pointed out in its statement, and which shows how long this issue has dragged on. That’s why we asked whether the third time might be the charm at the start of this piece, and why we’re far from optimistic that this latest deal will really succeed where the other two failed.
But before we go into that, we’ll quickly review the historical context for this deal, as well as what’s happened over the last few days.
All of this dates back roughly two decades to the start of the millennium, when a group of Chinese companies, unable to list on their own domestic stock markets for a number of reasons, chose to pursue U.S. listings instead. But the SEC and PCAOB quickly discovered they couldn’t investigate those companies because China considered any information held by their China-based auditors as “state secrets.”
A series of accounting scandals about a decade ago prompted the U.S. and China to negotiate a memorandum of understanding (MOU) on enforcement cooperation in 2013; and another memorandum of cooperation on pilot inspection three years later in 2016. But the U.S. basically abandoned both deals after determining it couldn’t get access to the information it wanted.
The U.S. finally said “enough” and passed the Holding Foreign Companies Accountable Act (HFCAA) in late 2020, giving China three years to change its position and make the audit records for U.S.-listed Chinese companies available to the PCAOB. That touched off a Wall Street panic that has seen most U.S.-listed Chinese stocks plummet since early 2021, wiping out billions of dollars in value as investors dumped shares over concerns that Chinese companies would be forcibly delisted for failing to comply with the HFCAA.
That brings us to the present, which saw a slight rally in China ETFs such as the iShares MSCI China ETF (NASDAQ:MCHI) and the Invesco China Technology ETF (NYSE:CQQQ), which both rose about 4% on Thursday when word of the deal first leaked out in U.S. media reports. But both rallies are quite minor compared to the huge selloff of the last year and a half.
Reciprocity and cooperation
With all that background in mind, we’ll spend the second half of this review looking at the actual statements from both sides, and why we’re not extremely optimistic that this “breakthrough” deal will ultimately satisfy either.
First, we should note that the SEC and PCAOB have been extremely skeptical throughout this process, most likely due to the failure of the previous two deals. Accordingly, the PCAOB pointed out that it will now mobilize a team to test the agreement and determine by December whether it’s working. Reflecting its skepticism, the PCAOB pointed out several times in its statement that the latest agreement is just a “first step” towards solving the impasse.
While there are quite a few points that could ultimately sink this latest deal, the two that stick out the most involve the ideas of reciprocity and to what extent the two sides will cooperate.
We’ll begin with reciprocity, which is mentioned three times in the two CSRC statements. “The agreement is equally binding on both sides,” the CSRC says in its Q&A document. “Regulators from both China and the U.S. can conduct inspections and investigations of relevant audit firms in the other’s jurisdiction pursuant to their statutory mandates.”
We can look at the reciprocity issue in two ways. At one level this looks like face-saving language, basically the CSRC’s way of saying it’s also gaining new access it previously didn’t have. But at the same time, the Chinese regulator could actually try to exercise its new access, for example by requesting to see U.S.-based accounting records of Chinese firms, or records on U.S. firms’ Chinese operations. In both instances, the PCAOB and SEC may lack the authority to provide such access, and might not give it even if they did without strong justification.
Then there’s the issue of cooperation. The PCAOB says it expects “complete access to the audit work papers, audit personnel, and other information we need to inspect and investigate any firm we choose, with no loopholes and no exceptions.”
But the CSRC says the agreement should involve cooperation throughout the process. “The two sides willcommunicate and coordinate in advance to plan for inspections and investigations,” it says. “The Chinese side will also take part in and assist in the interviews and testimonies of relevant personnel of audit firms requested by the U.S. side.”
While those two statements aren’t necessarily contradictory, they do leave quite a bit of room for disagreement. The PCAOB seems to be saying “we will do things our way, and you will make sure we get what we want.” That’s a bit different from the CSRC’s attitude, which seems to be “all decisions must be based on joint discussions, including which companies are targeted and how they are inspected.”
At the end of the day there are no overt contradictions in the two sides’ stances, which is why they could actually sign an agreement. But execution could be far more difficult based on different assumptions each side is bringing to this new deal. That makes us skeptical that the PCAOB will give an unconditional “thumbs up” when it makes its determination at the end of the trial period in December.
