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Investors should be aware of risk of stocks from China

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Many investors assumed that companies from China trading on U.S. exchanges and recommended by brokers have the same oversight and regulation as American businesses. But companies from China can shield their financial records from inspection. This reduces federal protections from audits that were intended to prevent securities fraud and protect investors.

American law

The 2002 Sarbanes-Oxley Act requires publicly traded companies to undergo regular inspections by U.S. regulators. These include close reviews of corporate financial documents.

Over 50 jurisdictions allow these inspections. The Chinese government cited its strict confidentiality laws and refused this oversight. The U.S. government tried negotiating a compromise for over 10 years but during this period still allowed Chinese companies to enter American markets.

Beware of the risks

American investors who invest in a foreign entity have little chance of getting their money back if they are defrauded. The Securities and Exchange Commission has continuously allowed Chinese companies’ requests for initial public offerings even while its enforcement attorneys filed cases against Chinese-based companies that dissolved after accounting irregularities.

The Big Four U.S. accounting firms audit most public companies, but their affiliates in China have not engaged in inspections. The SEC tried to address this in 2012. That case settled when the firms agreed to submit documents to inspectors. However, these firms did not comply, and the SEC has not reopened this case.

Exposure to Chinese stocks has grown. Over 150 of companies based in China, with a combined value of $1.2 trillion, traded on American exchanges in 2019. There have been 20 IPOs in 2020, and more are expected later this year. In addition to individual purchases, actively managed and indexed pension and mutual funds are investing in Chinese firms.

Is new legislation on the horizon?

The federal government and Congress are attempting to address the lack of transparency in Chinese based companies trading in the US markets and the risk it poses to the investing public.  Separate bills passed the House and Senate that would require stock exchanges to delist Chinese companies if their audits are not inspected. The president’s working group on financial markets issued a report in August that recommended a similar proposal.

Even if this legislation passes, however, it will be years before any Chinese companies are removed from American markets. The SEC must also draft regulations governing delisting, which may be influenced by this industry.

The current SEC chairman supports these proposals but has allowed Chinese companies to sell their shares on American exchanges even though these companies do not comply with audit rules. The SEC, however, issued policy statements in 2018 and 2019 containing investor warnings about the risks and uncertainties of these investments and that regulators have less access to the records of Chinese companies.