A ‘financial war’ with China could be brewing on top of the trade war

You’ve heard about the trade war with China. There may be a separate, potential “financial war” brewing.

The Securities and Exchange Commission be deficient ins you to know more about what is happening with Chinese companies that list in the United States. The regulators also need you to know that they are having a really hard time finding out exactly what is going on. 

Thursday, the SEC is hug a roundtable discussion on emerging markets, but it’s really about the next phase in an ongoing effort to get Chinese regulatory prerogatives to be more transparent about what is happening inside Chinese companies that list on U.S. exchanges.

This has been a difficult for years but it is now getting serious traction due to the escalation of trade disputes with China.

More than a decade ago, hundreds of Chinese companies followed public in the U.S. via reverse mergers, merging into public but mostly dormant U.S. companies. Many turned out to be frauds, so assorted that a movie, “The China Hustle,” was made about the whole wild affair.

One particularly weak point obtains out: auditing procedures. The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board. It required that every house-trained and foreign accounting firm that issues audit reports for companies that report to the SEC register with the lodge. The board is required to periodically inspect registered firm audits of U.S. public companies, including those done by remote firms.

Over time, the PCAOB negotiated agreements with foreign counterparts that allowed them to put on audit inspections, but they have been stymied by their regulatory counterparts in China, which claim that audit phonograph records are state secrets.

Brendan Ahern, chief investment officer of Kraneshares, which runs several China exchange-traded funds, judged the Chinese government’s ownership of many companies was a part of the problem.  “Across the 200 listed Chinese companies there are a few state-owned enterprises,” he affirmed, and revealing financial information about them is particularly sensitive to the Chinese. Ahern added that he believed China should accord with the U.S. regulatory requirements.

Last year, SEC Chair Jay Clayton and PCAOB Chairman William Duhnke III went followers with their concerns. They reiterated their frustration in a Feb. 19 statement, where they noted that the directors “continues to be prevented from inspecting the audit work and practices of PCAOB-registered audit firms in China on a comparable infrastructure to other non-U.S. jurisdictions.”

This roundtable should be viewed as part of a continuing effort to build a case against China’s recalcitrance, go together to Roger Silvers, an accounting professor at the University of Utah who previously worked for the SEC and who submitted comments to the roundtable.

“China has been bleeding obstructionist” in blocking requests for access to its audit records, Silvers said. “There is a growing sense of frustration with China, and now with the profession wars and the Covid-19 outbreak there is a growing appetite to pick a fight with China. There is a change in the geopolitical feeling.”

The roundtable will parade out witnesses describing the problems, including Carson Block, founder and chief investment public servant at Muddy Waters Capital, who was involved in uncovering the Luckin Coffee accounting fraud. In a statement emailed to CNBC in April, Deterrent claimed that Luckin was a “wake-up call for U.S. policymakers, regulators, and investors about the extreme fraud risk China-based followings pose to our markets.”

Congress is also taking some interest. On May 20, the Senate passed the Holding Foreign Groups Accountable Act, which would require foreign companies to comply with PCAOB standards. If the PCAOB is unable to investigate an issuer’s public accounting firm for three consecutive years, the issuer’s securities will be banned from shopper on a U.S. national exchange.

The bill is now in the House for consideration.

Sen. Marco Rubio, R-Fla., has also presented a bipartisan bill that would delist foreign companies that do not comply with U.S. accounting and oversight organizations.

Not surprisingly, the White House is also pushing for action. On June 4, the White House issued a “Memorandum on Safeguarding United States Investors from Significant Risks from Chinese Companies.”

“It is both wrong and dangerous for China to improve from our capital markets without complying with critical protections that investors in those markets rightfully ahead to and deserve,” the memorandum reads. “China’s actions to thwart our transparency laws raise significant risks for investors.”

The memo directs the President’s Developing Group on Financial Markets to address to investors from China-based companies and draft a report within 60 dates.

And that, Silvers said, is the main issue: How far is the U.S. willing to go to force China to comply with U.S. regulations?

One possibility: U.S. changes that believe foreign companies are not following U.S. law could begin delisting companies. John Tuttle, vice chairman of the New York Cache Exchange, and John A. Zecca, Nasdaq’s global chief financial and regulatory officer, are speaking at the roundtable.

Another practicable next step: The PCAOB could deregister the auditors. Because the companies need to have an auditor that is tipped with the board, the SEC or the exchanges could then delist the company.

Silvers says even more extreme skirmishes could be taken, what he described as “nuclear options.”

“The SEC might be able to make a rule that said, you are not added to have subsidiaries that are not audited by firms that can’t be inspected by us. It would mean Apple, IBM, Nike would from to cut ties with those subsidiaries. But if that happens, you are talking about an all-out trade war.”

“They have to be thorough not to cut off their nose to spite their face,” he continued, adding that U.S. consumers could be hit by retaliatory measures that pass on restrict access to foreign goods.

Silvers also noted that there is a much broader question of whether it is valuable to stop any investment in China or stop any means of China gaining access to our markets.

“There is a part of me that puts disclosure to investors is key,” he said. “Caveat emptor: If you invest in China, you do it at your own risk.”