The risk lies in Beijing’s refusal to allow U.S. regulators to do their jobs and verify that Chinese companies are in compliance with U.S. laws. Chinese companies’ systematic use of irregular investment structures to do business on U.S. exchanges without real financial transparency has been going on for more than a decade. Public awareness rose after this year’s release of the documentary “The China Hustle,” which chronicled the efforts of Wall Street whistleblowers to call attention to the huge scope and scale of the problem.
Despite years of negotiations, U.S. regulatory institutions charged with ensuring that these firms are properly audited have failed to persuade Beijing to cooperate. Now, Washington is beginning to connect the issue to the broader Chinese strategy of transferring huge amounts of wealth from the United States to China.
“It’s outrageous that the Chinese government shields China-based companies operating in the United States from complying with American laws,” Sen. Marco Rubio (R-Fla.), chairman of the Congressional-Executive Commission on China, told me. “If China-based companies want to list on stock exchanges or access capital markets in the United States, we should make them comply with American laws. If they will not, we should delist China-based companies from American stock exchanges.”
Rubio will soon introduce legislation to enforce that idea. Congressional action is needed because the U.S. Securities and Exchange Commission has failed to secure Beijing’s agreement to allow the real oversight of Chinese firms that U.S. companies must by law submit to.
According to the U.S.-China Economic and Security Review Commission’s 2017 report, China’s opaque financial system makes it impossible to verify Chinese companies’ financial disclosures and auditing reports. Through fraud schemes alone, Chinese issuers have stolen billions from U.S. investors with no fear of punishment inside China.
But the larger, looming threat is that huge Chinese companies, especially in the technology sector, are using a variety of creative investment structures to trade large volumes of shares on U.S. exchanges. More than 130 Chinese companies are listed on major U.S. exchanges, including Chinese Internet giants Alibaba, Tencent and Baidu, the commission reported, with a combined valuation of more than $1 trillion.
“The complex legal structures of these U.S. listings, as well as China’s state secrecy laws and opaque auditing practices allow some Chinese companies to shield themselves from U.S. legal and regulatory jurisdiction,” the commission wrote. “As a result, these listings could pose significant risks for unsuspecting U.S. investors who buy into U.S.-listed Chinese companies.”
Beijing uses state security laws to prevent American regulators from obtaining information on Chinese firms needed to verify their audits and disclosures. The Public Company Accounting Oversight Board, which was created under the Sarbanes-Oxley Act of 2002, lists foreign companies that deny it the ability to inspect their audits. More than 200 firms based in China or Hong Kong are listed.
There’s broad skepticism in the China expert community that the Trump administration is going to address this issue if left to its own devices. For one, the SEC decided to replace the leadership of the Public Company Accounting Oversight Board last year, removing Chairman James Doty, who had been pushing this issue with Beijing.
Trump also last year appointed Jay Clayton, a lawyer who helped Alibaba launch its massive 2014 initial public offering, to be the new chair of the SEC. Considering that the SEC is investigating Alibaba’s accounting practices, it’s no surprise the company’s stock jumped at the announcement. Alibaba Executive Chairman Jack Ma is close to the Trump family and has even dined with Ivanka Trump.
Some business leaders and Wall Street lobbyists will argue the concern is overblown. The market is self-correcting and the added risk is baked into the stock price of Chinese assets, some say. But in reality, the true risk is unknown, which is the entire point. And when U.S. investors get swindled, they have no legal recourse in China. Meanwhile, American financial services companies that help Chinese firms work the system get paid on both ends.
“We’re bending our laws again for the Chinese for the sake of making money,” said Paul Gillis, professor at Peking University’s Guanghua School of Management. “Ordinary Americans are not aware they have a rising exposure to firms that are not adhering to U.S. laws.”
Trump is waging a trade war with China to force Beijing to play by the rules. Enforcing real inspections of Chinese firms that raise money in the United States is a key part of that fight. The producers of “The China Hustle” also produced “Enron: The Smartest Guys in the Room.” If Alibaba is allowed to outsmart U.S. regulators like Enron did, the results could be just as catastrophic.