By Jesse Fried From Financial Times

Controlling shareholders and Beijing are likely to exploit a ban to further their objectives

Last month, the US Senate unanimously passed a bill aimed at improving the reliability of financial statements by China-based companies trading in the US.

The legislation focuses on a real problem with these businesses, whose total market capitalisation is about $1tn. Over the past decade, alleged fraud at China-based, US-traded companies — including most recently Luckin Coffee — has cost American investors billions of dollars. Unfortunately, the bill’s remedy may end up making them worse off.

To reduce fraud, the Sarbanes-Oxley Act of 2002 requires audits of every US-traded company to be inspected by the Public Company Accounting Oversight Board. But those based in China refuse to comply. They, and the Chinese government, say PCAOB inspection of China-based audit records would violate state-secrecy laws. Why block PCAOB access? Inspections might well reveal bribes to high-ranking officials, embarrassing the Chinese Communist party.

The US bill requires the Securities and Exchange Commission to prohibit trading in the stock of any company that goes three consecutive years without PCAOB inspection. Its apparent goal is to force China to agree to inspections. If the strategy succeeds, it should be harder for insiders of China-based companies to defraud American investors. The bill has bipartisan support in the House of Representatives.

But the cure could be worse than the disease. Both Chinese controlling shareholders and Beijing are likely to exploit the ban to further their own objectives, at American investors’ expense.

Over the past decade, controlling shareholders of more than 90 China-based, US-traded firms have arranged confiscatory “take-private” transactions. The goal: delist US shares at a low buyout price and then relist in China at a much higher valuation. The poster child is Qihoo 360, an internet security firm that was taken private in 2016. Founders squeezed out US shareholders at a valuation of $9.3bn. In February 2018, Qihoo relisted on the Shanghai Stock Exchange at a valuation of more than $60bn. Qihoo’s chairman made $12bn — more than the whole company claimed to be worth 18 months before.

Investors in US-listed Chinese companies are more vulnerable to this tactic than investors in public US companies. Financial statements are unreliable and most companies — including Luckin Coffee — incorporate in the Cayman Islands. This jurisdiction affords investors less protection than Delaware, home to most US companies. Neither US nor Cayman court judgments can be enforced in China, where insiders and assets are based. When American investors are hurt, the same state-secrecy laws invoked to shield audit papers from the PCAOB make it difficult for shareholders and regulators to get to the bottom of things.

The proposed trading ban could make things even worse for shareholders. Assuming Beijing continues to bar inspections, the SEC will announce a ban, causing a rout in a barred company’s stock as investors dump shares before they become non-tradeable. The Chinese controller can then use a take-private to cash out investors at rock-bottom, while blaming the delisting on the US government. The trading ban will play straight into the controller’s hands.

China is unlikely to cave on inspections, as it dislikes the idea of foreigners probing domestic commercial transactions involving party officials. In fact, Beijing could use a trading ban to further its long-held objective of moving its large technology companies home. Beijing is unhappy that its biggest and most famous tech giants — such as Alibaba and Baidu — trade in the US and not at home. It wants its crown jewels back.

Several years ago, Beijing began trying to induce large overseas-traded Chinese firms to list at home. So far there have been no takers. But, by not allowing inspections, China can then trigger a ban and force its companies to leave the US. Some may then return home. Of course, exits would be arranged by Chinese controllers to enrich themselves at public investors’ expense.

While the US legislation is well intentioned, it probably will not open China to inspections. Sadly, there is no easy way to protect investors from any fraud by China-based companies trading now in the US. Good money has been paid for stock that may come to be worth very little.

If Congress wishes to protect American investors, it should consider barring new listings from countries that refuse inspections or otherwise frustrate the pursuit of cross-border wrongdoers. True, that would come too late to help current investors, but it would at least protect future investments.

The writer is the Dane professor at Harvard Law School

For more on this story go to: https://www.ft.com/content/7bb80406-a0c6-11ea-ba68-3d5500196c30