As part of the Holding Foreign Companies Accountable Act (HFCAA), the U.S. government recently closed an accounting/auditing loophole that could result in the delisting of most Chinese-listed ADRs from American exchanges by the year 2024—or even as soon as 2023, if current legislation is enacted. 

Recent steps taken by the U.S. government assure that a slew of Chinese companies will be delisted from American exchanges by the year 2024.

Superficially, that may sound like a major development in the ongoing U.S.-China trade dispute, but the move more accurately represents the closing of a legal loophole—a loophole that has been consistently exploited by companies headquartered in China.

So while the infamous “trade war” may have triggered the necessary political will for action, this particular development boils down to better protecting American investors, as opposed to punitive action against China.

Background

Accounting fraud has always been a risk for investors and traders in the financial markets. Since stocks were first listed on U.S. exchanges, companies have attempted to “cook the books” in order to artificially inflate their share prices.

The worst instances in recent history—Enron and WorldCom—resulted in catastrophic losses for investors. But those scandals also catalyzed the strengthening of auditing requirements with the intent of better protecting investors.

In 2002, the Sarbanes-Oxley Act was passed by Congress to help ensure that publicly traded companies adhere to strict accounting standards. It also mandated that senior officers personally certify the veracity of corporate financial records. Executives that knowingly sign off on inaccurate financial information are now subject to criminal penalties, including prison time.

The implementation of Sarbanes-Oxley is one reason that financial markets in the U.S. are among the most trusted and liquid in the world.

China Loophole

Foreign companies listed on U.S. exchanges have been required to adhere to U.S. auditing standards since Sarbanes-Oxley was enacted in 2002.

Perplexingly, however, Chinese companies listed on American exchanges have somehow managed to sidestep the stringent accounting and auditing standards mandated by Sarbanes-Oxley.

Given the lack of oversight, it’s no great surprise that many recent instances of accounting fraud—amongst overseas entities—have involved Chinese companies.

Case in point, the American-listed shares of Luckin Coffee (LKNCY) cratered during the summer of 2020 after it was discovered the company had reported hundreds of millions in fake sales. Luckin Coffee—the Chinese equivalent of Starbucks (SBUX)—was subsequently delisted by the Nasdaq, but not before irreparable damage was done to American investors.

Weak enforcement of stringent auditing rules amongst foreign entities continues to this day, and according to the Securities Exchange Commission (SEC), almost all of those companies are located in mainland China and Hong Kong.

Loophole Closed

In order to close the loophole, the U.S. Congress passed the Holding Foreign Companies Accountable Act (HFCAA) in 2020. Under the law, foreign companies listed on American exchanges will henceforth be delisted if they fail to turn over audit results for three consecutive years.

Currently, this topic is in the news because the Public Company Accounting Oversight Board (PCAOB) in the U.S. recently adopted a mechanism for enforcing the rules outlined by the HFCAA—essentially designating the violating companies “non-compliant,” and subject to punitive delisting.

In short, that means foreign companies failing to turn over audit results for the next three years will be delisted—with limited exceptions. Accordingly, a slew of Chinese delistings is expected to materialize in 2024. It’s estimated that about 270 companies, and associated listings, could be affected.

Investors and traders should note that Congress is even considering moving up the timeline from three years to two years, as part of the Accelerating the Holding Foreign Companies Accountable Act. The passage of that legislation would instantly change the critical date on the calendar from 2024 to 2023.

Ramifications

It’s entirely possible that the U.S. and China find a way to resolve their differences on this issue before the period of non-compliance is enforced.

In Europe, China was able to negotiate an arrangement known as “regulatory equivalence,” which means European regulators accept the work of Chinese regulators as if they had done the auditing work on their own.

But that resolution isn’t likely to be accepted in the U.S., especially considering the recent implosion of Luckin Coffee.

It’s also possible that Chinese companies listed in the U.S. start complying with the necessary requirements. But that scenario is considered a long shot because it would require Chinese companies to hand over data and materials viewed as critical to national security by the Chinese government.

As a result of the continuing impasse, some market participants have already set the wheels in motion to get ahead of the projected delistings.

In late 2020, WisdomTree investments swapped the American depository receipts (ADRs) of Alibaba (BABA) for shares listed in Hong Kong in many of the company’s exchange-traded funds (ETFs).

Likewise, an asset manager in the Netherlands—Robeco—is reported to have swapped out all its American-listed shares of Chinese companies in favor of Hong-Kong-listed shares, where possible (not all companies are listed in both regions).

So-called “homecoming listings,” in which a foreign-listed Chinese company offers shares in a secondary market (most often Hong Kong) have also picked up recently—likely as a direct consequence of the HFCAA.

Alibaba made headlines in 2019 when it listed secondary shares in Hong Kong, and roughly 15 other Chinese companies have followed suit since that time.

Investors and traders should keep in mind that a delisting from a major exchange in the U.S. doesn’t necessarily mean a company’s shares stop trading altogether. For example, in the case of Luckin Coffee (LKNCY), the shares continue to trade over-the-counter (OTC) in the U.S., even though they were delisted from the Nasdaq last summer.

But in terms of visibility, liquidity, and interest, an OTC listing isn’t viewed that favorably compared to a “big board” listing—which is likely why some market participants are already swapping American-listed shares for those listed elsewhere.

Retail investors and traders in the United States also have the option to sell out of Chinese ADRs and invest directly in the Hong Kong-listed shares—although access varies by broker.

Typically, a broker will require an investor/trader to convert U.S. dollars to Hong Kong dollars in order to purchase Hong Kong-listed shares. Or, transactions such as these are also sometimes executed using margin, which involves a broker lending Hong Kong dollars to the investor or trader for use in the transaction.

Obviously, the currency component introduces a new element of risk to the transaction. So market participants should thoroughly vet such transactions before moving forward (additional fees and commissions also will likely apply).

Alternatively, investors and traders can utilize China-focused ETFs to access exposure to the region. Many country-focused ETFs already invest directly in shares listed in Hong Kong (H-shares) or mainland China (A-shares). That means those ETFs would theoretically be unaffected by a potential delisting tidal wave, when (or if) it arrives.

Along those lines, the Xtrackers Harvest CSI 300 China A-Shares ETF (ASHR), the KraneShares Bosera MSCI China A ETF (KBA), and the iShares MSCI China A (CNYA) all exclusively invest in stocks listed on mainland exchanges. And the iShares China Large-Cap (FXI) holds Hong Kong–listed shares only. The SPDR S&P China (GXC) offers a combination of mainland and Hong Kong listings.

To learn more about recent developments related to China, readers may want to review this previous episode of Options Jive on the tastytrade financial network.

For timely insights on everything moving the markets, readers can also tune into TASTYTRADE LIVE—weekdays from 7 a.m. to 4 p.m. CST—at their convenience.

Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to support@luckboxmagazine.com.