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Therese Poletti

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July 24, 2021, 9:33 a.m. EDT

This is your final warning — Chinese stocks listed in the U.S. are dangerous to hold

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By Therese Poletti

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But now, since the U.S. passed the legislation sponsored by Sen. John Kennedy (R, Louisiana) late last year requiring foreign companies that went public in the U.S. to allow audit inspections in the next three years, the clock is ticking. It also represents an opportunity for U.S. investors to get out while they can.

“Since the Kennedy bill has passed, there is this other clock ticking,” said Lynn Turner, a senior adviser at Hemming Morse LLP and former chief accountant at the Securities and Exchange Commission. The Holding Foreign Companies Accountable Act will require the SEC to prohibit trading of securities of foreign companies in the U.S. markets after three consecutive years of non-inspection, if the Public Company Accounting Oversight Board (PCAOB) determines it cannot inspect a company’s audit work papers. That, though, is the worst-case scenario that many don’t expect.

“There are unlikely to be any de-listings of China-based issuers until 2025, with 2022 to be deemed the first non-inspection year,” said Shaswat Das, a lawyer at King & Spalding in Washington, D.C. who was chief negotiator for the PCAOB with the Chinese regulators from 2011-2015, in an email. “Despite the escalating tension between the U.S. and China in a number of areas, the passage of the legislation and its implementation by the SEC and the PCAOB may actually bring both parties…back to the bargaining table once again. There is too much to lose on both sides.”

But China’s ultimate goal appears to be twofold: to have the stocks of the big important growth companies trading back at home, under the watch of the Communist Party, and to better regulate or anticipate sketchy companies or frauds like Luckin Coffee LKNCY that went public here.

Opinion: Luckin Coffee shows how risky Chinese IPOs can be, but investors are just not listening

At some point in the future, Fried believes, “The Chinese government will stop letting the PCAOB inspect, or come up with another plan to herd all these companies back to China, once China’s own capital markets are sufficiently developed.”

He noted that if the Chinese government does refuse to cooperate with the PCAOB, some companies will probably go private and then probably relist elsewhere, like on the exchanges in Singapore, Hong Kong or London.

While many retail investors have been excited about the Chinese market and the potential in these stocks, passive investors could also get hurt, since China is an important emerging market for many fund managers.

“We have always identified that there are risks out there with these companies that some accountants don’t understand, that some regulators don’t understand and that some investors don’t understand,” said Jeff Mahoney, general counsel of the Council for Institutional Investors, or CII. “Our members are largely passively invested. For the most part they invest in companies through index investing.” CII issued a white paper explaining the risks to investors in the structures of Chinese companies going public in the U.S. in 2017.

Turner noted that the CII has been warning investors about the issues with these companies for years, but because of the huge returns, large asset managers aren’t too concerned about the risks.

“I talked to some of the largest ones, and asked them why are you investing in these things, sooner or later the chicken is going to come home to roost,” he said. “Their view is until that happens, and we are making enough money, we will continue to do it. We will make a lot of fees on it, and when it goes upside-down, it won’t be our problem.”

Turner said he believes most major investment funds have exposures to Chinese listings in the U.S., from Fidelity Investments to Vanguard. “Those funds need to be pressed very hard on what their strategy is for getting out of the Chinese companies that face delisting, if things don’t change,” he said.

While passive investors face risks, the real hurt could be reserved for retail investors who bet big on momentum stocks like Pinduoduo, NIO Inc. /zigman2/quotes/204905836/composite NIO -3.31% or a whole host of other Chinese companies. Some investors may already be starting to get nervous. So far this year, as of last week, Dealogic said the aftermarket performance of Chinese IPOs is down 2.76%, compared with a gain of 13.5% last year.

Turner believes there is too much risk for investors in this area. “I think American investors would be wise to hold back and not invest in any new Chinese companies, until we see this develop more in the next few years.”

With the new U.S. law in effect, and the potential threat of delisting looming, investors may have up to three years to examine their portfolios and take their profits. But even if the Chinese and the U.S. come to an agreement where auditors are able to look at the books of U.S.-listed companies, it isn’t necessarily going to stop the next Luckin Coffee from happening. The wisest move may be to get out while you still can.

/zigman2/quotes/204905836/composite
US : U.S.: NYSE
$ 38.65
-1.33 -3.31%
Volume: 22.81M
Oct. 22, 2021 2:56p
P/E Ratio
N/A
Dividend Yield
N/A
Market Cap
$65.49 billion
Rev. per Employee
N/A
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About Therese Poletti

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Therese Poletti chronicles the machinations of the technology industry for MarketWatch in the Tech Tales column. Before joining MarketWatch, Poletti covered...

Therese Poletti chronicles the machinations of the technology industry for MarketWatch in the Tech Tales column. Before joining MarketWatch, Poletti covered some of the biggest companies in Silicon Valley for the San Jose Mercury News. Previously, she spent over a decade at Reuters, covering a range of beats, from spot news and Wall Street to biotech and technology. Poletti was also the lead reporter on teams at the Mercury News that won two Society of American Business Editors and Writers awards for breaking news and two Society of Professional Journalist awards. She was also a finalist for the Gerald Loeb Awards in the deadline writing category. Poletti is also the author of "Art Deco San Francisco: The Architecture of Timothy Pflueger," published by Princeton Architectural Press.

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