Let the “Great Delisting” Begin

Last week, the SEC dropped the final “regulatory shoe” by specifying the rules and procedures that will implement the accounting compliance requirements outlined in the Holding Foreign Companies Accountable Act (HFCAA) on foreign companies listed on US stock exchanges. Right on cue, every Chinese company currently listed in the US promptly plummeted on the news. Invesco’s Golden Dragon China ETF, which tracks the NASDAQ’s Golden Dragon China Index, dropped close to 10% last Friday.

The designation that the SEC will use on companies to be scrutinized is called “Commission-Identified Issuers” (aka Santa’s “naughty list”). To be clear, these auditing standards have been around since the Sarbanes-Oxley Act of 2002. They are just poorly enforced by the Public Company Accounting Oversight Board (PCAOB) when it comes to Chinese companies, likely because helping these companies IPO in the US has been so profitable for Wall Street.

In the coming weeks and months, we will find out which company will end up on the “naughty list” on this SEC webpage. In the meantime, I see three paths that these US-listed Chinese companies will take: secondary to primary, dual-primary listing, and total exit.

Path 1: HKEX Secondary to Primary (Alibaba)

Ever since the HFCAA started gaining momentum in the US Congress two years ago, Chinese tech companies have been looking for a Plan B. Alibaba led the way by doing a secondary listing on the Hong Kong Stock Exchange (HKEX) in November 2019. Many other tech companies -- Netease, Baidu, BiliBili, etc. -- followed suit.

There are a few aspects of the HKEX secondary listing option (aka Path 1) that makes it a natural offramp from the US, especially for large Chinese tech companies.

First, this option is only available to companies who’ve already listed for more than two years on the NYSE, NASDAQ, or the premium listing on the London Stock Exchange, which by proxy shows these companies have met a high standard of compliance and disclosure. Thus, the required paperwork to execute a secondary listing on HKEX is much less than a primary listing (aka Path 2, see below). The timeline is also shorter -- approximately 90 days for a secondary listing versus 180-200 days on average for a primary listing. Alibaba, Netease, and Baidu obviously qualify, given their size and age. BiliBili, a relatively newcomer, filed for HKEX secondary listing as soon as it qualified -- its NASDAQ debut was March 2018 and its HKEX secondary started trading in March 2021.

Second, the HKEX changed its rules in April 2018 to allow a dual-class share structure, which is common among tech companies. It was one of the main reasons why Alibaba decided not to go public in Hong Kong back in 2014. Companies who have this structure, called weighted voting rights (WVR) in HKEX parlance, also have to meet a certain revenue threshold. Given this “new and improved” HKEX, tech companies like Alibaba no longer have to compromise on its corporate structure.

Third, and perhaps least well-known, if the trading volume of a company via its HKEX secondary listing exceeds 55% of its global volume, Hong Kong automatically becomes the company’s primary regulator, not Uncle Sam’s SEC. Thus, for example, if the SEC puts Alibaba on the “naughty list” as a Commission-Identified Issuer, and Alibaba decides to either not comply or fail to meet the PCAOB’s standards, its trading volume in the US would fall sharply while its Hong Kong volume would grow. By then, it’s just a matter of time when the 55% threshold is reached in Hong Kong, and Alibaba naturally leaves the SEC’s jurisdiction with Hong Kong’s Securities and Futures Commission (SFC) becoming its primary regulator.

This Path 1 -- HKEX Secondary to Primary -- is not available to every company. For the ones who do qualify, it’s the cheapest and quickest way to build a Plan B from the US.

Path 2: Dual-Primary Listing (XPeng)

For companies who cannot, or don’t want to, pursue Path 1, another path forward is a dual-primary listing on both an American exchange and the HKEX. XPeng, a leading Chinese electric vehicle (EV) maker, paved this path in July by IPOing on the HKEX less than one year after its IPO on the NYSE. Li Auto, an XPeng competitor, followed suit in August. NIO, another Chinese EV maker, also attempted to follow but its Hong Kong listing is delayed until 2022.

There are some advantages to pursuing a HKEX primary listing, the most important of which is access to Mainland Chinese investors via the stock connect that links Hong Kong to investors trading in Shanghai and Shenzhen.

There are some drawbacks as well. First, the company can’t piggyback off of the work already done for its US public listing in its HKEX primary listing application. Hong Kong’s SFC is a compliance-oriented regulatory regime, which is quite different from the SEC’s disclosure-oriented regime. Second, the timeline is also longer, as I noted above. Third, the ongoing filing, auditing, and compliance cost to make two primary regulators happy is no chump change.

However, for Chinese tech companies who want to maintain exposure to the US public capital market and don’t qualify for HKEX secondary listing, Path 2 -- a dual-primary listing -- may be their only option. Luckily, XPeng has built some prior art for others to copy. And for certain types of tech products that need a growth story beyond China, EVs being a good example, keeping a US listing and complying with the SEC is still worth the trouble.

Path 3: Total Exit (Didi)

Path 1 and 2 are both hedges against a forced delisting. I believe companies who’ve chosen these two paths still intend to work with the SEC to comply and hopefully stay listed in the US. Path 3 is a total exit, which is appealing for companies that have no business prospects or ambition in the US anyways, and dealing with the SEC is a waste of time.

Didi is one good example and has already begun the process to delist. While Didi has some international ambition in Latin America, as I’ve documented during my travels there, it has no prospect in the US. I can see companies like Pinduoduo, Beke, TAL Education, and Lufax doing the same. Leaving the US will likely be followed by a primary listing on the HKEX. However, compliance does not necessarily get easier for these companies with a Hong Kong listing. Didi chose to IPO on the NYSE and went against Chinese regulators’ wishes partly because it would have to do a lot more work to change its business structure and model to meet HKEX’s requirements. Ironically, with the HFCAA and the SEC’s new rules, Didi can no longer escape Hong Kong.

As the SEC works through its process, there will be plenty of Chinese companies on the “naughty list” and many of them will simply choose Path 3, leaving the US once and for all. What may be more interesting to speculate on is which company will pass the SEC’s compliance gauntlet and end up on the “nice list”! Out of the more than 200 US-listed Chinese companies, there ought to be at least a few companies who do follow solid accounting practices and are not owned by the Party or anyone the US government deems questionable characters. These companies would be the true unicorns!

Regardless of which company ends on which list, the “great delisting” will keep plenty of accountants, lawyers, and of course bankers busy and gainfully employed.