Denying Chinese Companies Access to U.S. Exchanges?
Posted on Oct 23, 2019In the past month, news broke that the White House narrowed down the measures contemplated to restrict U.S. investors’ capital flows into China, including delisting Chinese companies from U.S. stock exchanges.[1] Motivations behind such restrictions vary from protecting U.S. investors from excessive risk due to lack of regulatory compliance by Chinese businesses, to addressing national and economic security concerns associated with the Chinese government’s influence over private companies.
When the possibility of delisting U.S.-listed Chinese companies was raised, the U.S. stock market sank despite the fact that forced delisting for geopolitical reasons would be very unusual.[2] There are about 160 Chinese companies with a collective market capitalization of more than $1 trillion traded on the Nasdaq and the New York Stock Exchange (“NYSE”).[3] While the mechanism for the implementation of the White House’s plan has not been mapped out, there are a few ways through which the measure could be legally effectuated.
One potential way to implement the plan is through exchange-initiated delisting. A stock exchange can delist a company that has violated its exchange rules by filing an application to the SEC.[4] However, the SEC may disagree with the exchange and determine that the application contravenes the rules set by the exchange.[5] Absent violation of relevant regulations, the exchanges may have insufficient grounds to delist for geopolitical reasons, which seem to fall outside existing exchange rules and securities laws.
With approval from the SEC, stock exchanges can also amend their own rules, which may affect all Chinese issuers as a class. For example, Nasdaq implemented a revised set of listing rules this August based on changes proposed in October 2018. The new rules will require, for instance, that at least 50% of a company’s shareholders must each hold shares with a market value of at least $2,500 in an IPO.[6] Although this example is purportedly separate from the recent restraints considered by the White House, some believe that the change has tightened restrictions and slowed down the approval of IPOs of small Chinese companies,[7] which tend to have relatively concentrated ownership structure.
However, the stock exchanges are unlikely to revise their rules on mere geopolitical grounds. Such a move conflicts with the statutory obligation of U.S. exchanges to ensure a free and open market and forbid unfair discrimination between issuers.[8] As business entities operating separately from the federal government, the Nasdaq (owned by Nasdaq, Inc.) and the NYSE (owned by Intercontinental Exchange), may also decide that the market has been and can continue taking risks on Chinese firms. Further, banning Chinese companies runs afoul of the exchanges’ own interests, as more IPOs will go to competitors such as the Hong Kong Stock Exchange, the STAR Market (a new Nasdaq-styled exchange in Shanghai), or the London Stock Exchange.
The SEC can also promulgate rules that “govern the grounds and procedures for the delisting of the security.”[9] In light of the long-simmering fight for inspection of audits of U.S.-listed Chinese companies,[10] the SEC may well identify certain common deficiencies and adopt rules applicable to all Chinese companies, effectively limiting U.S. capital flows to China. Last December, the SEC and the Public Company Accounting Oversight Board (“PCAOB”) issued a statement warning investors about the difficulties U.S. regulators faced during accounting investigations and inspections of China-based auditors.[11] The obstacles persist even after Chinese authorities agreed to cooperate with U.S. regulators in a memorandum signed in 2013.[12] Given the unsuccessful regulatory cooperation with Chinese authorities and prolonged lack of transparency of Chinese companies,[13] it would not be surprising if the SEC decides to tighten its checks on Chinese issuers to protect U.S. investors. Yet it remains to be seen whether the SEC, an independent agency, will adopt more restrictive rules when pressed by other executive bodies like the National Security Council.[14]
Rather than exert influence on the stock exchanges or push the SEC to change its rules, the administration may push for legislation demanding tightened rules for Chinese issuers. In June, a bipartisan group of U.S. lawmakers introduced the Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges (“EQUITABLE”) Act, which requires Chinese companies listed on American stock exchanges to submit to heightened regulatory oversight, including providing access to audits. The Act requires the SEC to amend regulations to strengthen oversight and review of Chinese companies listed on U.S. exchanges.[15] The Act also adds provisions to Section 6(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(b)), including delisting foreign companies that fail to comply with U.S. accounting and oversight regulations from American exchanges (subject to a grandfather provision).[16] The Act requires the national securities exchanges to file such proposed changes to the rules of the exchange with the SEC.
Another mechanism to implement the measure is through the President’s emergency power. Under the International Emergency Economic Powers Act of 1977 (“IEEPA”), the White House may declare that funds flowing to Chinese firms pose a threat to U.S. national security. Ray Dalio, the founder of the hedge fund Bridgewater, argues that judicial precedent and congressional inaction (the Congress has never overturned a presidential emergency[17]) suggest that the President “could wield IEEPA with great force,” which would include “delisting Chinese companies on U.S. stock exchanges.”[18] Once declared, terminating the emergency would require either a successful court challenge or a joint resolution passed by simple majorities of both houses of Congress. An attempt to nullify the emergency declaration may rest upon the fact that only 11 of the 156 Chinese companies listed in the U.S. are state-owned,[19] despite the blurred demarcation between state-owned and private firms.
With investor protection and security consideration cited for the proposed measures of limiting U.S. funds flowing to the Chinese market, delisting U.S.-listed Chinese companies can be a legally feasible path forward. But if rolled out, such measures may not only hurt the real economy as a new flashpoint in the prolonged trade dispute but also “harm the U.S.’s role as a conduit for international capital.”[20]
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[1] Jenny Leonard, White House Focuses on China Stock Limits in Retirement Fund, Bloomberg (Oct 8, 2019, 7:00 AM EDT), https://www.bloomberg.com/news/articles/2019-10-08/white-house-zeroes-in-on-limit-to-chinese-stocks-in-pension-fund.
[2] Id.
[3] The US-China Economic and Security Review Commission, Chinese Companies Listed on Major U.S. Stock Exchanges, https://www.uscc.gov/chinese-companies-listed-major-us-stock-exchanges.
[4] 79A C.J.S. Securities Regulation § 127 (2009).
[5] Removal From Listing and Registration of Securities Pursuant to Section 12(d) of the Securities Exchange Act of 1934, Exch. Act Rel. No. 34-52029, 70 Fed. Reg. 42456-01, 2005 WL 1696142, at *3 (July 22, 2005).
[6] SEC, Self-Regulatory Organizations; The Nasdaq Stock Market LLC; Notice of Filing of Proposed Rule Change to Revise the Exchange’s Initial Listing Standards Related to Liquidity, April 3, 2019, at 17, https://www.sec.gov/rules/sro/nasdaq/2019/34-85503.pdf; see also Nasdaq, Initial Listing Guide Aug 2019, at 8, https://listingcenter.nasdaq.com/assets/initialguide.pdf.
[7] Echo Wang & Joshua Franklin, Exclusive: Nasdaq Cracks Down on IPOs of Small Chinese Companies, Reuters (Sep 29, 2019, 2:03 PM), https://www.reuters.com/article/us-usa-china-ipos-nasdaq-exclusive/exclusive-nasdaq-cracks-down-on-ipos-of-small-chinese-companies-idUSKBN1WE0P5.
[8] Securities Exchange Act of 1934 § 6(b)(5), 15 U.S.C. § 78f(b)(5) (2012).
[9] 79A C.J.S. Securities Regulation § 127 (2009).
[10] Dave Michaels & Michael Rapoport, SEC Revives Fight Over Inability to Inspect Chinese Auditors of Alibaba, Baidu, Wall St. J. (Dec 7, 2018, 7:44PM ET), https://www.wsj.com/articles/sec-revives-fight-over-inability-to-inspect-chinese-auditors-of-alibaba-baidu-1544229843.
[11] Jay Clayton, Wes Bricker, & William D. Duhnke III, Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally—Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China, S.E.C., Dec. 7, 2018, https://www.sec.gov/news/public-statement/statement-vital-role-audit-quality-and-regulatory-access-audit-and-other.
[12] Memorandum of Understanding on Enforcement Cooperation, https://pcaobus.org//International/Documents/MOU_China.pdf.
[13] Marco Rubio, You Can’t Trust a Chinese Audit, Wall St. J., https://www.wsj.com/articles/you-cant-trust-a-chinese-audit-11559687739.
[14] Alan Rappeport & Ana Swanson, China Trade Talks Restart and White House Weighs Escalation Options, N.Y. Times (Oct. 10, 2019, Updated 10:36 a.m. ET), https://www.nytimes.com/2019/10/10/us/politics/trump-china-trade.html.
[15] Marco Rubio, You Can’t Trust a Chinese Audit, Wall St. J., https://www.wsj.com/articles/you-cant-trust-a-chinese-audit-11559687739 (stating that the Act was introduced in response to the problem that Chinese companies have not been subject to U.S. rules and regulatory oversight).
[16] ‘‘Ensuring Quality Information and Transparency for Abroad-Based Listings 6 on our Exchanges’’ (the ‘‘EQUITABLE Act’’) (2019), https://www.rubio.senate.gov/public/_cache/files/c2630968-1e66-44d4-bebf-458a86188e7b/2A963878FD61C08209B01D9DA41D1FDB.equitable-act-legislative-text.pdf.
[17] Erica Werner, House Prepares to Vote on Overturning Trump’s Emergency Declaration, Wash. Post (Feb. 25, 2019, 8:23 PM EST), https://www.washingtonpost.com/politics/house-prepares-to-vote-to-overturn-trumps-emergency-declaration/2019/02/25/343657f2-3918-11e9-b10b-f05a22e75865_story.html.
[18] Ray Dalio, The Threat to Limit Capital Flows to China and Pending Impeachment Conflict: Next Logical Steps in a Classic Dangerous Journey? The 1935-45 Analogue, Linkedin (October 1, 2019), https://www.linkedin.com/pulse/threat-limit-capital-flows-china-pending-impeachment-conflict-dalio.
[19] The US-China Economic and Security Review Commission, Chinese Companies Listed on Major U.S. Stock Exchanges, https://www.uscc.gov/chinese-companies-listed-major-us-stock-exchanges.
[20] John Ruwitch & Alun John, Explainer: What delisting Chinese Firms from U.S. Stock Markets Could Mean, Reuters (Sep 30, 2019, 7:52 AM), https://www.reuters.com/article/us-usa-china-listings-explainer/explainer-what-delisting-chinese-firms-from-us-stock-markets-could-mean-idUSKBN1WF17S.