Dissecting the "Great Delisting"

Last December, I wrote a rather provocative post called “Let the ‘Great Delisting’ Begin”. That was when the SEC released its final specifications to implement the accounting compliance requirements outlined in the Holding Foreign Companies Accountable Act (HFCAA). Back then, and right on cue, every Chinese company’s stock price dropped like dead flies, whether they were listed in the US, Hong Kong, or both.

Last week, the SEC announced the first five companies it deemed questionable on the provisional list of its so-called “Commission-Identified Issuers” – what I call the “naughty list”. It is provisional because these companies – BeiGene, Yum China, Zai Lab, ACM Research, HUTCHMED (China) – have 15 business days (so until March 29) to push back on the SEC’s  “public shaming”.

Again, right on cue, every Chinese company under the sun collapsed further, like a melting avalanche, even though these five companies are relatively insignificant as far as market caps or influence is considered (except for maybe Yum China; KFC’s and Pizza Huts are still a big deal in China). In particular, the Internet sector saw the largest drawdown – this vomit-inducing picture says it all.

With so many reasons to feel jittery about the market, it’s worth taking a step back to see if there is any quality information we can dissect to see through the fog and not let fear and confusion take over our brains.

Luckily, there is.

Dissecting the PCAOB Database

The SEC said last December it had identified a total of 273 companies that could be on the “naughty list”, but did not disclose any names back then. Simply go to this database on the PCAOB’s website and you will find them all!

The PCAOB (Public Companies Accounting Oversight Board) is the central regulatory actor within the SEC that determines who is “naughty” and who is “nice”. It is the auditor of all auditors. This responsibility was enshrined in the Sarbanes-Oxley Act of 2002, long before the HFCAA was even a thing.

Because of the political subtext of the HFCAA, there has been a common misconception that the PCAOB is after all Chinese companies. Not true. It is after public companies where their accounting and financial auditing practices occur in places where the PCAOB are not allowed to do inspections, regardless of whether you hire one of the Big Four accounting firms or a boutique. That’s why this database is described (rather verbosely) as a “database of PCAOB-registered firms located where non-U.S. authorities impede the PCAOB’s ability to conduct oversight activities.”

Even if a company was born in the US, thus an “American” company, if its accounting is done in a non-US region where the PCAOB is not allowed to conduct its inspection – like Mainland China or Hong Kong – then it could end up on the “naughty list”. In fact, as Liqian Ren of Wisdom Tree ETFs pointed out, ACM Research, a semiconductor packaging company that started in California and one of the five companies named, is such an example.

Thus, it’s not about the “national origin” of the companies themselves nor the prestige or expertise of the accounting firms they hire. It’s all about the jurisdiction of the places where the accounting happens and whether these jurisdictions like each other or not.

That’s how you end up in this PCAOB database, and in effect, the “naughty list”.

It’s All About Nation-States

When the provisional list was first unveiled, sending shockwaves throughout the market, my initial reaction was there are two doors a company on the list can walk through to get itself off of it:

1. Change to a more reputable auditor;

2. Make auditing happen in a jurisdiction where the PCAOB is allowed to inspect.

Upon further thinking, only door 2 is viable. Door 1 is irrelevant. Despite how interconnected our world is, with the pervasiveness of the internet, global trade, and the international financial system, the question of whether a company gets delisted or not in 2022 comes down to a concept born out of the Treaty of Westphalia in 1648: nation-states.

What matters now is how two particular nation-states, People’s Republic of China (plus Hong Kong in this matter) and the United States of America, decide to deal with this matter, among all the other matters they need to worry about. The two relevant regulators are the China Securities Regulatory Commission (CSRC) and the SEC’s PCAOB. Everything else – no matter how large your market cap is, how cutting edge your product or technology is, how much AUM you have in your fund – is irrelevant.

While this picture may look gloomy, regulators can be reasonable problem solvers. There are signs that reasonableness and compromise may win the day between the CSRC and PCAOB, as current discussions between the two sides are described as “proceeding smoothly”.

Where these discussions could fall apart is if the CSRC views this matter as more of a national security issue, while the PCAOB views it as simply a financial one. That outcome would lead to a long-term impasse, inaction, and the “Great Delisting”.

If this worst-case scenario becomes reality, do we have a Plan B? If we dig into the PCAOB database, there are clues suggesting that a third nation-state (well, more of the city-state) may step up to save the day.

Pay Attention to Singapore

If you type in “Alibaba” into the PCAOB database, this is what you see:

As early as 2017, when the PCAOB first started requiring registered auditors to file the so-called Form AP to indicate which of their branches that are off-limits to the PCAOB are working for a US-listed public company, Alibaba’s auditor, PwC, started filing right away. These Form AP’s are what populate this database.

As you can see, over the last 4-5 years, Alibaba began diversifying its auditing location from being 100% in Hong Kong to Mainland China, but more interestingly, also to Singapore. In its latest 2021 filing, its auditing location distribution is 30%-40% in Mainland China, 5%-10% in Singapore, and the rest presumably still in Hong Kong.

The diversification to Singapore may be partly to serve real business expansion needs. All of Alibaba’s main product lines – e-commerce, fintech, cloud computing – are growing in Southeast Asia. But being the largest Chinese tech company listed in the US, it has always drawn the most attention and had the biggest “delisting” target on its back. It also has the most resources to hire the most creative lawyers and accountants to come up with a Plan B.

Will Singapore become this “compromise location” between the PCAOB and CSRC – a strategic position of neutrality it often serves in so many thorny geopolitical matters? (Remember, the meeting between Trump and Kim Jung-Un in 2018? That was dubbed the “Singapore Summit.” It does not get thornier than that.)

We will know the answer to this question soon enough. In fact, we may have gotten a hint of it already from one of the best investors alive and Alibaba’s newest fan: Charlie Munger.

It’s old news at this point that Alibaba is now the 3rd largest holding of the Munger-controlled Daily Journal. With $BABA stock price now lower than its 2014 IPO opening day price, Poor Charlie may be adding to his position this quarter, if he lives by his partner Warren Buffett’s investing creed: “be fearful when others are greedy, and greedy when others are fearful.”

Last month, when asked about the risk of owning Alibaba ADRs during the Daily Journal shareholders meeting, his response was:

“Assuming there is a reasonable honor among civilized nations, that risk doesn't seem all that big to me.”

I might be over-dissecting his response here, but the language he used was extremely precise – “a reasonable honor among civilized nations”, not between the US and China. The word “among” implies more than two.

He may be relying on Singapore to save the day (and his Alibaba holding) too.