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Time to prepare for a PCAOB no-deal
With the recent decision by numerous large Chinese SOEs to effectively end their time on the US markets, the writing seems to be on the wall for a deal between the PCAOB and their Chinese counterparts to reach a deal on audit inspections. Thus likely pushing US-listed Chinese companies off the US exchanges, and setting in motion a sea-change in the landscape for investors in Chinese equities.
The PCAOB vs China audit dispute has been ongoing since the early 2010’s, and throughout the entire time it has been characterised by being a seemingly very solvable problem, that simply never finds a solution. Throughout the history of the dispute it has often looked like a dance between two parties where one is unwilling to engage, and for the last few years the actual mechanics of what a deal would look like have mattered less than the politics driving both sides.
At some level I suspect that one of the key issues is that the government ministry negotiating on the Chinese side (the CSRC) is not the one likely to have the most objections to the deal, but they wouldn’t have been able to drive any deal through the other ministries involved in regulating these companies. The already wide definition of what constitutes national security matters in China have also somewhat widened in the last few years, which always meant any deal on audit inspections would have harsher seas to navigate.
Increasing reluctance on the US side to accept any compromise from their Chinese counterparts was likely the final straw, although it’s always hard to know how much of these things are simply negotiating positioning, and what constitutes actual red lines. It’s been fairly obvious that the driving force for finding a deal switched from the PCAOB - who did a lot of the work early on - to the Chinese side over the past few years.
Still, here we now are, with a deal looking very unlikely, and Chinese SOEs voluntarily delisting from the US exchanges. So it’s high time to in earnest start preparing for the fallout of a no-deal scenario.
For some fun reading, and a reminder of what has and hasn’t changed on this I recommend starting by reading this post from Professor Paul Gillis speculating on the effects of no audit deal, in 2011.
Luckily, many Chinese companies have already started this preparation with a secondary listing in HK, and I expect this to pick up some real speed now. I’ve long said not getting a secondary listing already is verging on negligence from the management of these companies.
As the majority of the bigger private companies affected by this are using VIE structures for parts of their business the only viable mainland exchange where they could list is the STAR market. However, it seems unlikely the STAR market can handle this type of migration, so a switch to HK, or potentially using the new deal to cross-list over to Singapore seem like the most viable alternatives.
This is bad news for investors since they’ll lose a lot of insights into how these companies are using their VIE structures, which will impact risk assessments going forward. At present I’d say it’s virtually impossible to do an accurate VIE risk assessment based only on HK filings. Hopefully this will add pressure on HK to adopt US-style VIE disclosures in order to cater to US investors, but I somewhat doubt it.
Another potential issue is auditing international companies with large China operations, since foreign auditors can’t come in, and the audit papers can’t go out. This feels like a situation where we could see the actual mechanics of what a solution to the impasse would have looked like, since it has all of the same problems, but virtually none of the politics involved.
Overall, I think the only real potential winner here is HK, and they could really use a win right now. They are likely to be very aggressive in courting these companies, and will use this as their opportunity to become the exposure point to international capital for Chinese companies. Some of them will likely also choose a secondary listing on the local STAR market, in the same way that Ant financial was planning to do before their IPO was scrapped.
For investors though, it means getting used to new capital market rules, worse disclosures, and likely more focus on individual due diligence work in a country that is as closed off to foreign visitors as it has been since… a good wee while.
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