One exchange’s trash is another’s treasure
Trust – the basis of all finance
It’s generally accepted that in financial transactions there should not be fraud, and there is a presumption of trust while making them. However, from time to time, this trust is broken. To ensure that people trust the financial system and a lack of trust does not cause financial activity to stop, regulators and the participants in the system themselves have certain rules to ensure that there is trust in the system.
One important rule is that all financials presented must be audited by an outside expert when presented to shareholders at a stock exchange. The purpose of this rule is that investors can trust the financials of the companies they invest in. Before this rule was in place stock markets were full of fraud, and there was considerable information asymmetry in the market. The company executive selling the stock knew a lot more about the stock than the investor buying the stock. This is true even with audits, but the amount of the asymmetry has reduced with them.
Corporate auditing is a vast field and you can live your life happily without knowing its details. But the purpose of it is to ensure that investors (and other stakeholders like employees and customers) can to a large extent believe the numbers presented. The idea behind this is that if the auditor has signed off the numbers, they must be true.
Can we trust the auditors?
But like all assumptions, this is also on shaky ground. Auditors do make mistakes, and sometimes they are influenced by the management itself to intentionally put false numbers. This was particularly prevalent in the largest corporate fraud of all time – Enron.
Enron was an energy trading company which faked its numbers to an order of around $50 billion. They said they had around $2.4 billion in revenue but they actually had only $1.7 billion. This led the stock to crash from $70 billion in market cap to zero in the span of less than a year. The auditors at Enron did not check it as they had a conflict of interest. They were the auditors, but they also had consulting relationships with the company which made them turn a blind eye to some of the shady practices going on at Enron.
This experience left a bad taste in investors’ and regulators’ mouths and so a new rule was born to regain the trust of investors in the financial markets. The United States Congress passed a law – the Sarbanes-Oxley Act – which among other things established the Public Company Accounting Board which was supposed to regulate the auditors.
The China problem
The PCAOB was established in 2001 when most companies in American markets were American. China, the other large economy today had not yet reached its stature and had just joined the WTO.
But as China grew and Chinese companies grew too, they started to list on American stock exchanges and raise money there. That was a problem for the PCAOB.
Normally if a foreign company say Vodafone (a British company) listed in the American stock markets, their auditors (let’s say KPMG UK) have to submit to investigations by the PCAOB. This applies to every company that lists on American exchanges – foreign or not.
But Chinese companies have been immune to such requirements largely due to a lack of co-operation from Chinese authorities themselves. From the PCAOB’s website
“The PCAOB spent significant time and resources negotiating a Memorandum of Understanding (MOU) with the Chinese authorities for enforcement cooperation. Unfortunately, since signing the MOU in 2013, Chinese cooperation has not been sufficient for the PCAOB to obtain timely access to relevant documents and testimony necessary to carry out our mission consistent with the core principles identified above, nor have consultations undertaken through the MOU resulted in improvements.”
[1]
For example, in April, short selling company MuddyWaters Research released a report showing evidence of widespread fraud and sales fabrication of nearly a quarter of Luckin’ Coffee – a Chinese coffeehouse chain’s sales. The company was delisted from the Nasdaq on May 20th and is currently under investigation by Chinese authorities.
More recently the same firm announced that it had evidence that the Chinese education company GSX had “at least 70%” of its users. Along with that Carson Block, the CEO of MuddyWaters has maintained for years that Chinese auditing practices are questionable and not to the standards of American companies.
Amidst rising US-China tensions, American lawmakers became increasingly concerned that Chinese companies were not playing by the same rules as the rest of American companies in the US. In October of 2019, Sen. Rubio and Sen. Gillibrand tabled a bill in the Senate to pass a law that would delist firms which did not comply with PCAOB regulations.
Just in May 2020, a similar law was passed in the Senate that required all companies that could not be audited by the PCAOB for three consecutive years to be delisted from American exchanges. The bill has not yet been passed in the House which is the next step in making it law.
For economic reasons or otherwise, American senators were sending a strong message that the Chinese companies could not be trusted.
New York’s loss is Hong Kong’s gain
Seeing the possibility of delisting on the horizon, Chinese companies have moved quickly to change the exchange their stocks trade on. For example, JD.com – the Chinese e-commerce company – said that its stock would be listed in Hong Kong rather New York.
Hong Kong is picked because of its deep financial markets and closeness to the Mainland’s financial systems. In 2016, the Hong Kong Shenzhen Stock Connect was launched making the city closer to Mainland China. Now, with the prospect of their stocks being kicked out from the United States this is the new alternative.
This is likely to drive a large increase in revenue for the Hong Kong stock exchange – HKEX – in 2020. HKEX had a slow year in 2019 when it lost its no. 1 spot for listings, and the company was looking to do better this year.
And so, they welcomed the rejected Chinese companies from America with open arms. HKEX expects almost a trillion dollars of market value from these companies.
What do we take from this?
On one hand, you can draw a conclusion that skepticism is good and more countries should banish suspected frauds as they come. Another equally good lesson you can take from this is that the American senators were too conservative and caught up in a power struggle with China that they did not see the broader picture.
But what I got from this was different. It was that the value of signalling that your markets are safe, are far greater than the markets being safe or not. Regardless of whether the Chinese to-be-delisted companies are actually fraudulent, the American regulators sent a message to the rest of the world, and to investors in their own capital markets that they would not tolerate even the slightest suspicion of fraud. [2]
[1] https://pcaobus.org/International/Pages/China-Related-Access-Challenges.aspx
[2] The other message is towards China that Americans would not tolerate Chinese fraud specifically