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Read This Before Selling All Your U.S.-Listed Chinese Stocks

The U.S. Senate recently passed a bill that could cause many Chinese companies to delist their stocks from American exchanges. The bill requires companies to certify they're not "owned or controlled by a foreign government," and requires the Securities and Exchange Commission to bar companies that haven't opened their books to the Public Company Accounting Oversight Board (PCAOB) for three consecutive years.

The PCAOB is a non-profit watchdog that oversees the audits of public companies. Unlike most foreign companies that list in the U.S., Chinese companies don't allow the PCAOB to oversee their audits. The bill still needs to pass a House vote and be signed into law by President Trump, but it currently enjoys bipartisan support.

The unexpected passage of the Senate bill raises red flags for investors in U.S.-listed Chinese stocks like Baidu (NASDAQ: BIDU), Alibaba (NYSE: BABA), and JD.com (NASDAQ: JD). However, investors should consider a few key points before blindly dumping all their Chinese stocks.

Image source: Getty Images.

Chinese stocks aren't technically Chinese

China's government restricts direct foreign investments in certain sectors, including internet and online education companies. To bypass those restrictions, Chinese companies usually open holding companies called variable interest entities (VIEs) in countries like the Cayman Islands.

VIEs are headquartered in the new country but owned by Chinese citizens. These companies own private shares of the underlying company, then sell stakes to foreign investors via IPOs. This arrangement grants foreign investors exposure to the company's growth, but it doesn't grant them any direct voting rights.

However, most Chinese companies still consider a VIE stake to be equivalent to a direct stake. For example, SINA (NASDAQ: SINA) faced an activist challenge in 2017 from U.S. hedge fund Aristeia Capital, which owned a 4% stake in the VIE. SINA allowed its shareholders to vote on Aristeia's proposals, since ignoring them would likely have undermined the entire VIE system.

If the PCAOB forces Chinese companies to open their books, the audits could merely reveal the balance sheets of the VIEs instead of the underlying companies. In other words, the opaque VIE structure could create loopholes and trip up U.S. regulators and auditors.

Voluntary delistings won't wipe out U.S. shareholders

If Chinese companies delist their stocks, they'll likely do so in one of two ways. First, they could simply change their symbols and move to the OTC market. If this happens, American investors' stocks would simply be renamed and transferred to an OTC exchange. Many major Chinese stocks, including Tencent (OTC: TCEHY), currently trade on OTC exchanges.

Image source: Getty Images.

However, OTC exchanges have less liquidity than the NYSE and NASDAQ, which could make it harder to buy and sell shares. Smaller trading platforms like Robinhood also don't offer access to OTC exchanges, and investors using those platforms would be forced to liquidate their shares once they're delisted.

The second possibility is a buyout. A company could make a tender offer for its outstanding U.S. shares, take itself private, then relist its stock on another exchange. Chinese companies like Qihoo 360, Mindray Medical, and Wuxi Pharmatech all initially raised cash through U.S. IPOs, delisted their shares by going private, then filed new IPOs in Chinese markets at several times their U.S. valuations.

This outcome could hurt U.S. investors, since a tender offer could significantly undervalue the company. Many Chinese companies, including JD and Alibaba, employ a dual-class share system that grants the management an outsized majority stake in the company -- so any foreign resistance to a lowball go-private offer could be futile.

But that outcome is arguably less likely, since it requires lots of cash to buy out existing investors. Instead, it's easier for besieged Chinese companies to shift their U.S. shares to OTC exchanges and launch secondary listings in Hong Kong to raise fresh capital.

Expect resistance from U.S. companies and funds

The proposed crackdown on Chinese stocks will likely spark fierce protests from American companies, funds, and exchanges.

For example, Alphabet's Google and Walmart both own big stakes in JD.com. Investment juggernauts Blackrock and Vanguard are among Alibaba and Baidu's top shareholders. Over 150 Chinese companies trade on U.S. exchanges, and their listing fees likely generate significant revenues for the New York Stock Exchange and NASDAQ.

A mass exodus of Chinese stocks from U.S. exchanges could hurt all those companies and their investors. Therefore, it wouldn't be surprising if the U.S. government significantly tones down the bill before it's passed into law.

Don't panic and sell all your Chinese stocks

Investors should keep tabs on the bill's progress, but they shouldn't expect major companies like Baidu, Alibaba, or JD to abruptly delist their shares. Baidu CEO Robin Li already shot down rumors that the company would delist its shares in the U.S., but left the door open for a secondary listing in Hong Kong.

For now, investors should welcome tighter oversight of Chinese stocks after the collapse of Luckin Coffee. These new rules might rattle the market, but they could also shake out the frauds.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Leo Sun owns shares of Baidu, JD.com, Sina, and Tencent Holdings. The Motley Fool owns shares of and recommends Alibaba Group Holding Ltd., Alphabet (A shares), Alphabet (C shares), Baidu, JD.com, Luckin Coffee Inc., and Tencent Holdings. The Motley Fool recommends Sina. The Motley Fool has a disclosure policy.


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