Delisting Chinese Companies Could Be Bad for Investors. But It’s the Right Thing to Do

Most larger investors, including fund managers that own U.S.-listed Chinese stocks, should be able to maneuver through the various ways delisting could play out. But smaller retail investors who own individual shares could have a harder time.

The SEC requires all listed companies be registered with the Public Company Accounting Oversight Board, which must verify the accuracy of company audits. But the Chinese government doesn’t allow foreign oversight of audit documentation without its permission, and the U.S.-listed Chinese companies haven’t adhered to this standard. That hasn’t kept investors from buying these companies, which account for $2 trillion in market value. Alibaba Group Holding (ticker: BABA) makes up the biggest chunk, but there are more than 200 companies on U.S. exchanges.

Many policy watchers and fund managers expect the two nations to reach some type of compromise, perhaps with co-audits. In the interim, widely owned Chinese companies such as Alibaba, JD.com (JD), and NetEase (NTES) have already sought secondary listings closer to home. Others, like JD Health International (6618.HongKong), the health care unit of JD.com, are staying local for their public debuts. That trend will accelerate, especially if delisting grows more likely. Over time, these companies’ multiples could even benefit by going home as they tap domestic investors more familiar with their businesses.

Currently, more than 100 U.S.-listed Chinese companies—including Baidu (BIDU) and Pinduoduo (PDD), and Chinese electric-vehicle stocks like Nio (NIO) and Xpeng (XPEV)—don’t have a secondary listing. If regulators don’t come to an agreement on auditing oversight, fund managers expect China will ease requirements so a vast majority of these companies can list on the Hong Kong or Shanghai exchange.

The bill comes at a time investors are grappling with a fraught U.S.-China relationship, even as strategists and larger institutional investors are advocating increasing exposure to China. The appeal of investing in China has grown steadily, especially this year, as the nation heals faster from the pandemic and its stocks outpace their U.S. counterparts. The MSCI China index is up roughly 25% this year.

In an opinion piece this past week, former Treasury Secretary Hank Paulson wrote that “efforts to delist legitimate Chinese companies” come with serious risks. He warned about China becoming a bigger challenger to the U.S. in financial markets, and the dangers of making it harder for U.S. investors to own Chinese stocks while global investors were benefiting from doing just that.

For institutional investors, the cost of switching between a U.S. and Hong Kong listing is small, and many have already swapped out their holdings. Others are monitoring the situation. If the three-year clock to delisting starts ticking, the KraneShares CSI China Internet ETF (KWEB), for instance, would likely convert its holdings and ask its index provider to do the same, says Brendan Ahern, chief investment officer of China-focused Krane Funds Advisors.

That isn’t a great development for the New York Stock Exchange ( ICE ) or Nasdaq (NDAQ), though it helps Hong Kong Exchanges and Clearing (388.HongKong), which has seen its stock rise 52% this year.

Retail investors who own individual Chinese stocks have fewer options. While some brokerages, like Fidelity and Interactive Brokers, allow clients to invest on foreign exchanges relatively easily, Schwab requires a global account, and Vanguard and Robinhood don’t allow trading on foreign exchanges at all. Investors could always transfer their shares to a firm that does, but that comes with costs. Owning foreign securities also brings its own extra paperwork at tax time.

Other risks arise if the situation isn’t resolved neatly, if some smaller companies can’t list elsewhere, or if there’s a compromise that doesn’t include Chinese state-owned enterprises. Some of these companies could go private, which could hurt shareholders based on the price offered. Others could be delisted and homeless.

Typically, companies are delisted because of fraud, financial trouble, or developments that put them at odds with listing requirements. These companies can often still trade over the counter, albeit with less liquidity.

But this bill applies to Chinese companies that trade over the counter as well. The three-year window makes it unlikely that liquidity will dry up overnight, and larger investors will help smooth any delisting process, says Roger Silvers, a former SEC senior economist who is now an assistant professor of accounting at the University of Utah and who consults with foreign regulators. Earlier this month, The Wall Street Journal reported that the SEC was considering a proposal that would let Chinese companies comply by using an accounting firm that would have to accept liability, and be based somewhere that allowed auditors to open their books to the PCAOB..

Retail investors often bear the brunt of changes such as these—one reason experts recommend individual investors use funds or ETFs instead of buying individual stocks, says Barbara Roper, director of investor protection at the Consumer Federation of America. “I sympathize with those who are harmed by the loss of liquidity or drop in valuations, but the policy is still the right one,” she says. “Investors are best served by investing in companies that comply with basic laws designed to ensure that their financial disclosures are reliable.”

Given the potential scenarios, it might be easier for retail investors to reconsider how they get China exposure. Leaving the logistical challenges created by the bill and the task of ferreting out the best opportunities amid the disruption to the asset managers may be the less taxing option.

Write to Reshma Kapadia at [email protected]