Implications of the Equitable Act for American Investors

As a new “silicon curtain” crashes down between the technological infrastructure of America and some of its allies and China and the countries in its sphere of influence, there has begun to be talk about restricting flows of capital as well as goods between the two nations. Some have fretted that China might dump its holdings of US treasuries in retaliation for escalating tariffs. Other analysts have speculated that U.S. financial institutions might soon be prohibited from investing in securities in mainland China’s state-owned enterprises. And now Senator Marco Rubio has put the nuclear option on the table with a bill and editorial in the Wall Street Journal, “You Can’t Trust a Chinese Audit,” proposing to potentially boot hundreds of Chinese companies off of U.S. stock markets.

Rubio’s proposed “Equitable Act” (short for “Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges”) seeks to break the long-standing impasse between the Public Company Accounting Oversight Board (PCAOB) and the Chinese government over the inspection of Chinese audits. The PCAOB, the accounting watchdog created by the Sarbanes-Oxley Act, is mandated to inspect every auditor for U.S.-listed companies.

However, China has continued to insist that no foreign entity be given access to the working papers from the audits of Chinese companies as it would put “state secrets” at risk. Given the heavy overlap between government and private interests in China, Beijing’s view of what constitutes a “state secret” is quite expansive. The Chinese affiliates of Big Four auditors have been caught in a no-win situation, where they face potential loss of their licenses if they refuse the PCAOB and even less savory civil and criminal penalties in China if they cooperate.

As currently written, the Equitable Act would impose draconian sanctions, including:

• An immediate prohibition of any new listings of companies audited by auditors who had not been subject to PCAOB inspection
• A three-year period for existing Chinese companies to have their auditors comply with the audit inspection regime or be delisted from the American markets
• A requirement that all listed companies disclose the percentage ownership interest and any controlling ownership by an arm of the Chinese government (which would presumably include all State-Owned Enterprises)
• Requirement to disclose the names of any member of the Chinese Communist Party on the Board of the public company or its Chinese operating entity

These provisions appear to be a direct challenge to the authority of China’s government to direct the affairs of any enterprise that is listed on American markets, which is likely to be viewed as an affront to Chinese sovereignty by the other side.

Implications of this High Stakes Standoff

The stakes of the fraught standoff are high. Rubio identifies 156 Chinese companies worth a collective $1.2 trillion that could potentially lose their listing status. A report by Morgan Stanley estimated that more than 800 Chinese securities could be impacted by the bill. [1] China has been a notable bright spot in new IPOs for U.S. stock markets in the past few years, generating hundreds of millions of fees for bankers and advisors and enabling American investors to have exposure to innovative companies from the world’s second largest economy.

Should the Equitable Act become law, absent any substantive negotiations, the likely results could include:

• Mass outflow of strong Chinese companies to the Hong Kong Stock Exchange, where U.S. investors have substantially lower access to disclosure, less convenient trading, and likely dislocations in equity pricing due to changing shareholder base.
• The NYSE and NASDAQ could become less relevant as global listing venues.
• Smaller Chinese companies might choose to simply delist or go dark, vaporizing the savings of American shareholders.

Therefore, there could be a ripple down effect on American retail investors who would have limited access to Chinese companies. Of the 300 unicorn companies in the world, more than 180 come from China, so this could be a disappointment to investors who wish to invest in market disruptive businesses.

Prompt a More Focused Conversation

There could be a number of changes made before the law as written becomes law (there is already a parallel bill in the House.) Given the range of issues addresses, the existence of the proposed Equitable Act may serve as a positive catalyst for more meaningful dialogue about rebalancing the market to better protect American investors.  

It is self-evident that the current situation, in which China is the leading source of overseas IPOs in the United States, but the only major country that has not agreed to comply with audit inspections, is unsustainable. It may also be time to revisit a host of areas in which overseas companies that list in the U.S., known as “foreign private issuers,” get a free pass on many governance requirements, including reporting insider stock sales, board independence rules, and shareholder votes on executive compensation.

There are a number of common-sense solutions to the issues of “state secrets” and China’s legitimate national security concerns. These can include having Chinese lawyers redact sensitive documents for non-economic data that has security implications prior to auditors doing work or papers being inspected. It can also include imposing a much higher standard of due diligence on underwriters that a company’s business model does not involve technology used for state security or military purposes that would prevent the issuer from providing accurate disclosures to investors. Doing business in China involves a constant balancing act to determine when a particular company is suitable for global investors and when it is best to walk away.

The key now is that we have a piece of legislation that shed lights on a range of issues and will hopefully bring both sides to the negotiation table, rather than scrambling for shiny red buttons to push.

[1] In a Statement in December of 2018, the PCAOB referenced 224 U.S-listed companies with $1.8 trillion in combined market capitalization where the PCAOB faces obstacles in inspecting the principal auditor's work and “another 207 U.S.-listed companies where the PCAOB can inspect some —although not all—of the auditor's work,” noting that the PCAOB and SEC have “not made satisfactory progress” in gaining cooperation from Chinese counterparts.