Nowadays, one of the few issues that can unite Republicans and Democrats in Congress is the effort to hold Communist China accountable. In early December, the U.S. House of Representatives unanimously passed legislation that would ban trading shares of Chinese companies whose audit papers aren’t inspected by U.S. regulators for three consecutive years. The same legislation was approved with bipartisan support in the U.S. Senate in May and President Trump is likely to sign it into law in the coming days.
This effort is long overdue. Chinese companies have enjoyed open access to U.S. capital markets for years and collectively raised billions of dollars from international and American investors. Capital from global investors helped fuel product innovations, and market share expansions for these companies helped to mint many Chinese millionaires and billionaires. There are currently more than 250 U.S.-listed Chinese companies with a combined market capitalization of more than $2 trillion.
According to U.S. securities laws, work done by auditors of all publicly traded companies in the United States must be subject to supervision and routine examination of U.S. regulators such as the Security and Exchange Commission and the Public Company Accounting Oversight Board. Yet by invoking national security concerns Beijing has prevented U.S. regulators from inspecting the financial records as well as auditors’ reports of Chinese companies. This is a gross violation of investor protection.
Turning a Blind Eye
It is widely known that the financial statements of Chinese companies are not always reliable. The Wall Street Journal reported that in 2018 alone, auditors declined to endorse 219 annual reports prepared by Chinese companies, meaning these auditors either found serious issues with those reports or had expressed concern about the likelihood of survival for these companies.
Some of China’s home-grown accounting firms are just as unreliable as their corporate clients. Rather than acting as gatekeepers, these firms have turned a blind eye to their clients’ fabricated financial statements. For example, in 2019, a Chinese regulator found that GP, a Chinese accounting firm, failed to disclose in its audit report that one of its corporate clients inflated its cash holdings by $4 billion.
Unfortunately, when a bad thing happens in China, it rarely stays in China. With the assistance of Wall Street, some of these Chinese firms with questionable, or even fraudulent, accounting practices have made it into the U.S. stock markets. Based largely on Wall Street’s rosy forecasts that these companies are the next best things, international investors bought shares.
Exposing China’s Billion-Dollar Lies
Ironically, it took a pandemic originating in China to expose the billion-dollar lies sold to international investors. April saw two big accounting scandals from two U.S.-listed Chinese companies. One was Luckin Coffee, a startup chain in China.
Three Wall Street firms — Credit Suisse, Goldman Sachs, and Morgan Stanley — made millions by underwriting Luckin’s 2019 initial public offering. Luckin’s IPO on the NASDAQ stock exchange granted enormous credibility to what was then a one-year-old company and enabled it to raise $645 million from investors based on a promise that Luckin would soon overtake Starbucks to become the largest coffee chain in the world. At the beginning of 2020, Luckin was worth $5 billion with a share price of $51.
Luckin’s luck ran out, however, under the weight of a two-month coronavirus lockdown in China. On April 2, after denying accusations of accounting fraud by U.S. short-sellers, the company finally admitted that its chief operating officer and several close employees fabricated 2019 sales by about 2.2 billion yuan ($310 million), meaning 75 percent of Luckin’s reported 2019 sales were fake.
Luckin’s stock price plummeted more than 80 percent that day, wiping out more than $2 billion of its market value. Four days later, Goldman Sachs disclosed that Luckin’s Chairman Charles Zhengyao Lu defaulted on a $518 million loan. While NASDAQ ultimately delisted Luckin stock, hundreds and thousands of investors, including many Americans, had already suffered significant losses.
In the same month, TAL Education Group, another U.S.-listed Chinese company and one of the largest education providers in China, revealed one of its employees had inflated the company’s sales by “forging contracts and other documentation.” The share price of TAL dropped 23 percent in one day and reduced the company’s valuation by $1.8 billion.
Had Wall Street firms done due diligence before underwriting the public offerings of these companies, and had the Chinese government allowed U.S. regulators to examine their books from the beginning, these two companies might never have been able to list on any U.S. exchange and international investors would have been protected.
An End to the Stonewalling
The legislation President Trump is expected to sign into law serves an ultimatum to the Chinese government: either allow U.S. regulators to inspect the relevant financial books of Chinese companies and audit reports, or delist these companies and lose access to the most important capital market in the world. Rep. Brad Sherman, D-Calif., told The Wall Street Journal, “Without this bill, the Chinese have been just stonewalling us, and we certainly shouldn’t make it easier for a Chinese company to get American capital than an American company.”
Wall Street is not happy with the bill. They are concerned that rather than complying with U.S. requirements, the Chinese government will persuade Chinese firms to take their listings to Hong Kong or Shanghai stock exchanges. This may mean Wall Street gets fewer lucrative underwriting deals for Chinese companies in the future.
More importantly, Beijing may retaliate by shutting Wall Street out of the biggest prize they have been seeking for years: access to the financial market in China. Yet Beijing has promised to open up China’s financial sector to foreign financial firms since the 1990s, and has never done so.
Instead, the Journal reports the Chinese Communist Party makes sure that Chinese financial institutions it controls “thoroughly dominate every sector in finance, from commercial and investment banking to private equity and asset management.” Consequently, Wall Street firms have a very limited presence in China and little name recognition among average Chinese consumers even to this day.
Still, driven by the hope to eventually gain a significant share of the China market, Wall Street remains the loudest cheerleader of China in the United States. Indeed, during U.S.-China trade negotiations, Beijing has often relied on leaders of Wall Street — such as Stephen Schwarzman of Blackstone Group and Hank Paulson of Goldman Sachs — as “go-betweens” with the Trump administration.
Wall Street Regret May Come Too Late
Wall Street firms not only often lobby the U.S. government on behalf of the Chinese government but also eagerly endorse the Chinese government’s controversial policies to please Beijing. For example, between 2016 and 2017, more than 30 Hong Kong-traded Chinese companies required their boards to seek advice on major decisions from Communist Party committees.
Even though this would enhance the CCP’s control of these corporations at the expense of reducing shareholder influence, U.S.-based BlackRock funds — the largest asset manager in the world and the self-appointed champion of corporate governance — voted in favor of the change, as did many other Wall Street firms. For Wall Street, it appears that as long as they get to make money, it doesn’t matter too deeply if the world is run by an authoritarian regime. They should care, however, because ultimately, their own future is at stake.
Recently, the CCP’s party Secretary Xi Jinping personally decided to suspend the $40 billion Hong Kong and Shanghai dual listing of Ant Financial, an affiliate of China’s Internet giant Alibaba. The move came after Alibaba’s founder Jack Ma, the richest man in China and a long time supporter of the CCP, voiced his concern about China’s speed of innovation being slowed by financial regulations. The listing suspension cost investment banks including J.P. Morgan and Citibank more than $400 million in fee income and, as many either borrowed money or invested their life savings in Ant Financials’s IPO, putting hundreds of thousands of small investors in a dire financial situation.
In essence, the CCP used the suspension to fire a warning shot: it will never allow any private corporation, domestic or foreign, to dominate a sector, especially the financial sector, in China. No matter how much Wall Street firms kowtow to the CCP, they will never gain the kind of market access they desire. Instead, someday, they may be crushed by the authoritarian regime they have so enthusiastically and foolishly enriched.