CSRC signals open to international cooperation on inspections
For years I have heard a familiar refrain from American investors: They would love to be able to participate in China’s economic growth, if only they could trust the accuracy of the accounting. Unfortunately, episodic blowups of listed Chinese companies have sown doubts about the reliability of their financial reporting and governance practices. In cases when serious problems emerged, there was limited recourse available to hold management accountable or secure compensation.
Frustration with a lack of Chinese cooperation in enforcing U.S. securities laws led to a joint statement by the SEC and the PCAOB in late April regarding the significant risks of investing in emerging markets. A month later, the Senate passed the Holding Foreign Companies Accountable Act on May 20th, which could potentially put Chinese companies with a market value of $1.8 trillion at risk of delisting from the U.S. markets if their auditors did not comply with PCAOB inspection requirements.
Last week China’s primary securities regulator, the China Securities Regulatory Commission (CSRC), appeared to launch a public relations campaign to show that it was getting serious about accounting and governance reform. The CSRC revealed that they had in fact provided the SEC with access to audit papers of 14 U.S.-listed Chinese companies already, and had “proactively sought to build a mutually acceptable mechanism for inspection.” In an interview with Caixin Global, CSRC Chairman Yi Huiman reportedly said: “As long as the U.S. side is willing to solve the problem, we can definitely find a way for China and the U.S. to cooperate on audit regulation." At a financial forum the same week, he went on to say that China’s top priority was to help market confidence recover following the COVID-19 crisis and that there would be “zero tolerance” towards financial fraud.
These statements come as the Chinese government has started to make the integrity of public company accounting and governance a priority on its domestic stock markets. The changes are driven by the evolution of China’s capital markets and economic strategy, creating a potential alignment with the type of reforms international investors have been clamoring for.
The CSRC Steps Up Enforcement
The CSRC is China’s equivalent of the SEC, with broad oversight of domestically listed companies and gatekeepers such as investment banks and accounting firms. In late April, the CSRC announced that it has been stepping up enforcement actions, launching 22 investigations since 2019, resulting in administrative penalties in 18 cases and criminal referrals in 6 cases. The CSRC noted that these cases involved sizable amounts of money and a "high level of concealment and complexity." Violations included inaccurate financial disclosures, misuse of company funds by insiders, and failures of due diligence by gatekeepers.
Recent revisions to China's securities law have increased the penalties for disclosure violations 16-times to $1.44 million while opening the door to class-action lawsuits. The CSRC has said it will roll out new rules this year, requiring companies with fraudulent IPO disclosures to repurchase shares issued from the market. The new securities law gives the Chinese government the power to take action when securities are issued overseas if a company's deceptive practices harm domestic investors. Given that most U.S. IPOs of Chinese companies in the past two years have included significant participation by local strategic investors, this would appear to open the door to an enforcement role for the CSRC that it lacked in the past.
The CSRC has an even more potent sway over investment banks and auditors. An investigation into one of China’s top audit firms in July of 2019 led to the suspension of planned IPOs by 28 of its clients. The message to other capital markets participants was clear: Step up your due diligence game or your business could vanish overnight.
From Shiny Adornment to Strategic Necessity
Why is China paying more attention to the accuracy of financial disclosure issues now?
First, the country has more at stake in having functioning equity markets today than in the past, given the growth of its capital markets. Shanghai took the top spot for global IPOs in the first quarter of 2020 despite being in the midst of the COVID-19 outbreak, raising more funds than the NYSE, NASDAQ, or Hong Kong. The new Shanghai STAR market for high technology listings launched last July with the explicit backing of President Xi Jinping and has already seen 112 companies list. The city of Shanghai has identified 1,000 high-growth companies with the potential to list on what is being billed as “China’s NASDAQ,” and the success of the project is a matter of national prestige. More broadly, China would like to make its equity and debt markets more attractive to overseas capital, building on its growing weight in the MSCI and other global indexes. A reputation for dodgy accounts undermines its brand with investors.
Second, China is in the midst of a transition from an approval-based system of listings where the CSRC carefully vets each company to a disclosure-based system in which investors and market forces determine which companies can list and IPO pricing. Following the success of the STAR market, China recently expanded the market-based listing reforms to Shenzhen’s ChiNext board for smaller growth companies and then plans to roll them out on the main boards in Shanghai and Shenzhen.
A disclosure-based system without reliable financial data is doomed to fail, since investors rely on this information to make their assessments of a company's viability and earnings prospects. China is betting that these reforms will enable its domestic stock markets to capture the next wave of IPOs by high-growth companies that listed overseas in the past. But if the IPO bloom is rife with fraud, it will put the stock markets in bad odor for years.
Finally, having vibrant capital markets and attracting overseas investors is a lynchpin to China’s economic strategy going forward. In the past, the stock market was a speculative outlet for retail investors; large state-owned enterprises (SOEs) relied on bank loans as their primary source of capital to power the industrial, infrastructure, and property sectors.
The innovation economy does not offer the kind of assets and cash flows required to secure debt financing. Public equity markets, with their tolerance for risk and potential for outsized gains, are essential to spur post-COVID 19 economic recovery. The stock market has gone from a shiny adornment to a strategic necessity.
Will Reforms Be Sustained?
China’s officials are fast to mobilize once an issue becomes a national priority. And they have powerful tools to exert leverage on both management and gatekeepers. If the government follows through on recent statements and rule changes with a series of highly visible enforcement actions, that message will resonate throughout the capital markets, both domestically and abroad. International investors may finally have a more level playing field when investing in Chinese companies.
China has made the leap to a global economic power and has staked its future on building a leading position in a range of next-generation technologies and industries. If this bet is to pay off, operating its capital markets to “emerging markets” standards is a liability it can no longer afford.