US equity market tightens noose on Chinese listings

In January, tensions between the US and China appeared to be subsiding when the world's two largest economies seemingly put an end to the trade war with the so-called Phase 1 deal. However, these incredible times are acting as something of a veil as the tête-à-tête between the rivals worsens, rather than improves.

A huge part of this escalation is centered on the financial markets and the economy: trade, for one, plays an enormous role. The capital markets, too, have top billing. Recent legislation and restrictions from the US Senate and New York-based stock exchange Nasdaq have dealt something of a killer blow in the equities space. The days of US-listed Chinese firms may be numbered.

"You can pile the blame on the geopolitical tensions. The dollar and all of the attention the US and China is getting accelerates people to act. But a lot of US-Chinese companies know that the outlook for them is pretty gloomy," said Samson Lo, head of Asia M&A at UBS in Hong Kong SAR. "Valuations would be quite challenging. That's why most companies are contemplating delisting."

"It's just a convenient headline for them to say that because of the political tension it makes a lot more sense to be relisting in Hong Kong SAR."

The hangman is coming  

Nasdaq has announced new restrictions on initial public offerings (IPOs) below $25 million on the exchange – or 25% of market cap – which it is thought will directly impact smaller Chinese firms looking to list. Although a Nasdaq spokesman confirmed that the listings rules changes "apply to any and all companies, regardless of country of origin", market logic suggests that the impact of this move will be greatest for the Chinese.

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The rules would make it significantly more difficult for firms to list without allowing an audit from the SEC and the Public Company Accounting Oversight Board (PCAOB): something that is currently not permitted by the Chinese government. "The broader issue though is that of disclosure and PCAOB oversight of the audit firms, and I think that's an issue for the SEC to address," said Adana Friedman, Nasdaq CEO at Piper Sandler's Global Exchange & FinTech Conference on June 4.

On May 20, the Senate passed a bipartisan bill legislating for similar measures that would prevent any Chinese company from listing that did not meet US auditing standards. It must pass the other two levels of government before becoming law.

"Nasdaq's new rule and the bill passed by the Senate, if ultimately also passed by House and signed by the president, will make it harder for some Chinese companies to list in the US and others that are already listed to potentially delist," said Ashok Lalwani, Asia-Pacific chair of Baker McKenzie's international capital markets practice.

"There has always been some tension within the SEC and the US stock exchanges with regard to the black and white requirements imposed by Sarbanes-Oxley and the desire to make the US markets more accessible for Chinese companies."

Sarbanes-Oxley arose out of accounting scandals following the dotcom bust and some of the current proposals have similar genesis, albeit with a potential hint of politics. The intended benefit of the new rules is to strengthen corporate governance, though this may lead to some companies seeking listings elsewhere.

The legislation proposed by the Senate would make the US public markets unavailable to Chinese companies unless the PCAOB can conduct their audit and have access to work papers. If passed and signed, these companies will need to list elsewhere unless the US and China come to some sort of an agreement again on this issue.

US Secretary of State Mike Pompeo issued a press statement on June 4 applauding the move from Nasdaq, writing that "the announcement is particularly important given a pattern of fraudulent accounting practices in China-based companies" and that "American investors should not be subjected to hidden and undue risks associated with companies that do not abide by the same rules as US firms".

"Nasdaq’s action should serve as a model for other exchanges in the United States and around the world," he added.

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Welcome clarity

Sources agreed that this action was expected. "A friend of mine who runs an investment bank that specialised in Chinese listings has been asking me when this would happen," said Bob Greifeld, former Nasdaq CEO. "Shockingly, he was actually very happy with the Nasdaq move in that there is clarity and a bright line that he has to shoot for with respect to listings."

"Whether it hits the number of listings or not, at least it takes him out of the great unknown," he added. "The complaint was that he was selling listings into Nasdaq and it was opaque, while the exchange was contemplating these new rules all approvals slowed down."

"To be clear, he does agree that there is going to be a reduction in the number of new listings per se, but this is the most upbeat he has been in years."

Dan McClory, head of equity capital markets and head of China at Boustead Securities, agreed with the sentiment. "It is incredibly refreshing that Nasdaq has now codified and has taken the subjective to the objective, and has actually laid out what firms need to do with these proposed new rules if they want to list from one of the restricted markets," he said.

Previously, Nasdaq had used the broad discretion in the listing qualification department to give feedback to issuers via comment letters. Seventy percent of Boustead Securities' underwriting clients in 2019 were Chinese, and these concerns have never showed up on any list of requirements. "You couldn't find it under the qualification standards, but they would use their subjectivity to say that here still should be US nexus, and they should raise more money they should have a greater float and independent directors from the US," he added. The feedback was never codified, but now, if you want to list, there are stated restrictions. "No more $5 million IPOs. No more $10 million deals with a $500 million market cap company."

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This has resulted in actual changes to in-process deals, because companies are willing to do what it takes to get listed – within reason. "All of this banter about not wanting Chinese companies, about stopping Chinese companies or delisting Chinese companies has been mischaracterised because of the political environment," added McClory. "It's easy to fall into that trap."

Not adding up

The catalyst for the move is likely Luckin Coffee, the fast-growing Chinese coffee chain that created a network of fake employees and customers that enabled it to grossly fabricate its revenues. Only eight months after going public – on Nasdaq's exchange – the company's valuation had doubled to $12 billion. News of the doctored numbers caused stock to fall by as much as 75% overnight.

"After decades of working in China intensively on financial accounting, there is not a single state-owned enterprise I've worked on that I can think of that abided by international accounting standards," said Harry Broadman, partner and managing director of the emerging markets practice at Berkeley Research Group. "Some of these firms are now listed on the US markets. I've not examined those firms' recent financial accounts, but even if we were given their upstream numbers, the source and integrity of those numbers has always been, in my mind, very dubious."

"I am surprised that it has taken this long, just in terms of the sheer due diligence and regulatory integrity check. I wasn't aware of exactly how many of those Chinese firms were listed on US markets, but I'm actually quite shocked there were that many," he added, "That's not a comment about the Chinese, but about US regulators."

"Anybody who understands how  state owned Chinese firms keep accounts, even some of the more privately oriented of them, knows they are just not completely grounded in international accounting standards, like a US firm or a British firm," he said. "Anyone who thinks that is quite myopic."

Delisting, relisting

"When companies consider listing venues they look at a variety of factors including valuation, liquidity, comparable companies also listed on the same exchange, prestige of the exchange, strength of the economy of the listing country, among others," said Lalwani. "On balance, Nasdaq's proposal with regard to a minimum float of $25 million or 25% of the market cap may lead some companies to turn to other exchanges, but these issuers will have to keep in mind that most exchanges have a minimum float requirement and consider the other goals of the listing."

If there was an exodus of Chinese listed firms from the Nasdaq exchange, the natural winners would include the Hong Kong Stock Exchange, potentially the STAR Market of the Shanghai Stock Exchange, and other listing venues in ASEAN countries such as Singapore and Taiwan. "Many issuers look for certainty and stability, which does not necessarily mean that they are any less qualified to list in one jurisdiction than in another," said Ivy Wong, partner at Baker McKenzie in Hong Kong SAR. "We are already seeing a growing number of issuers and potential issuers on these other stock markets in recent years, particularly where some have reformed to facilitate listings of new technology and new economy companies, which have experienced exponential growth in demand and valuation over the past years."

"We may also see potential secondary listings by these companies listed in the US which may want to have a back-up listing venue in the midst of regulatory turbulence and escalated risks," she added. "We have yet to see if there will be any reshuffling of companies on different listing venues or how these reshufflings would be, as any regulatory changes and restructuring of companies will take time."

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