China ADR Stock Delistings: What you need to know

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Difficulty: Advanced

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We recently read a Goldman Sachs Research report titled “China Musings: More FAQs on potential Chinese ADR de-listing from the US” (published 2 June 2020). It was incredibly useful in helping us understand the potential impact of the China ADR delisting.

1) The US Senate passed a bill to delist Chinese companies from US stock exchanges

The bill still requires approval from the US House of Representatives, followed by President Trump before it is passed as law.

2) The bill will impact 233 Chinese ADRs, with an aggregate market value of $1.03 trillion

China ADRs will be delisted if they fail to comply with US regulatory audits for three consecutive years. As Chinese regulators forbid the sharing of such audit data as per Chinese law, the ADRs are left in a bind and will most likely just fail the audit.

3) Some commonly asked questions that we will answer

• When is the delisting deadline?
• Are delistings good or bad for the ADR stock prices?
• If a stock is dual-listed in US and HK, should investors buy the HK shares to avoid US regulatory uncertainty?
• Which Chinese ADRs can potentially execute a secondary listing in HK?
• Aside from a secondary listing in HK, what other alternatives do the ADRs have?
• If the Bill is passed as law, how much forced selling of ADRs should we expect from US investors?
• If ADRs have a secondary listing in Hong Kong, will mainland China investors be able to invest in them?
• What is the expected buying demand into the ADR secondary listings?

4) So should you buy Alibaba, given the possible US delisting?

The InvestQuest’s View: Assuming the bill passes, we expect price volatility in the short-term. However, for stocks that are listed or can list on the HK stock exchange (including Alibaba), we believe that the price will primarily be affected by fundamentals (i.e. earnings) over the longer term. This is because most institutional investors (in our understanding) are indifferent to where the company is listed, especially since HK dollars are pegged to the USD.

Importantly, since Alibaba is currently listed on the HK Stock Exchange, investors can currently exchange the US ADR share to the HK share, and vice versa with no loss. Note that both the ADR share price and HK share price move closely in tandem.

5) In conclusion, stick with the BIG US ADRs

The InvestQuest’s View: We have already seen some of the “blue chip” Chinese ADRs like Alibaba, Netease and JD.com opening a secondary listing in Hong Kong. Potential eligibility of these shares into the Hang Seng Indices and HK-China Stock Connect will provide the buying support needed offset any negative US investor sentiment. The bigger concern would be on the smaller cap ADRs, which have fewer options to raise capital.

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Introduction

On 21st May, headlines on Bloomberg read: “Senate Passes Bill to Delist Chinese Companies From Exchanges”. The news triggered a -6.5% sell off to the S&P/BNY China Select ADR Index (which tracks 48 of the largest China ADRs), on the day and day after the new broke.

Investors who held investments in stocks like Alibaba, JD.com and Baidu started to question the longer-term investment implications.

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What exactly is written in the Senate Bill?

The actual name of the Bill is the Holding Foreign Companies Accountable Act. According to the official press release, the Bill acts to “protect American investors and their retirement savings from foreign companies that have been operating on U.S. stock exchanges while flouting Securities and Exchange Commission (SEC) oversight.”. The proposed bill states that the SEC shall delist foreign companies from US stock exchanges, if these companies fail to comply with the country’s regulatory audits for three consecutive years.

Do note that the above Bill has not yet been passed as law, as it still requires approval from the US House of Representatives, followed by President Trump.

What next? The House of Representatives may take one of three steps: 1) accept the Bill in its current form, 2) make amendments (the Bill then goes back to the Senate for approval), 3) reject the bill.

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Answering the most commonly asked questions

Q: How many Chinese ADRs will be impacted if the Bill is passed?

Goldman Sachs estimates that there are 233 Chinese ADRs with an aggregate market value of $1.03 trillion, representing 3.3% of total U.S. equity market valuation.

Q: Foreign companies will be delisted if they fail to comply with US regulatory audits for three consecutive years. When do those three years start?

The three year period is not retrospective, so the countdown starts only from the date of enactment of the Act.

Q: Are delistings good or bad for the ADR stock prices?

It depends. Voluntary ADR delistings tend to be associated with positive stock performance leading up to delisting, while Forced/Involuntary delistings tend to be associated with negative stock price performance. This is logical as voluntary delistings are often due to the company being acquired or taken private, while forced/involuntary delistings are often due to a failure in compliance/disclosures. We list the ADR delistings that have taken place in the past three years below, with involuntary delistings highlighted in red. The results do support the above conclusion.

Q: If a stock is dual-listed in US and HK, should investors buy the HK shares to avoid US regulatory uncertainty?

It will make no difference. Using Alibaba as an example, the company is dual-listed across both US and HK exchanges currently. As the US-listed shares can be directly converted to HK-listed shares at a ratio of 1:8 and vice versa, it makes no difference between buying the US or HK listed shares. As you can see from the chart below, Alibaba’s ADR and HK-listed shares trade closely with each other, with deviations mainly due to the different trading timezones. Netease and JD.com are both aiming to launch their secondary HK-listings on 11 and 18 June respectively, using a similar structure to Alibaba.

Q: Which other Chinese ADRs can potentially execute a secondary listing in HK?

Companies have to fulfill certain requirements for eligibility to list a secondary share issue on the HK Exchange:

1. Minimum two-year track record of good regulatory compliance on a Qualifying Stock Exchange (New York Stock Exchange and Nasdaq both qualify)
2. Market capitalization requirements
   • If the company has equal-weighted share voting rights, it needs to have an expected market capitalisation of at least HK$10 billion.
   • All other companies must satisfy one of the following:
     • a market capitalisation of at least HK$40 billion at the time of listing; or
     • a market capitalisation of at least HK$10 billion at the time of listing and revenue of at least HK$1 billion for the most recent audited financial year
3. If the company does not meet some of these requirements, the HK Exchange has leeway to waive their requirements for that particular company, where they see fit. The listing requirements are also not static and may change over time.

Goldman Sachs estimates that up to 41 of the 233 Chinese ADRs could qualify for secondary listing in HK (tables below).

Q: Aside from a secondary listing in HK, what other alternatives do the ADRs have?

ADRs can consider delisting themselves from the US Exchange and elect for a primary share issuance in a different market. One likely avenue is China’s Star Market, a stock exchange primarily catering to China’s tech start ups.

Q: If the Bill is passed as law, how much forced selling of ADRs should we expect from US investors?

According to Goldman Sachs, the forced selling is likely insignificant. Currently, approximately 41% of US investors’ current China exposure is held via H-shares, so investing in China companies via their HK-listings could substitute US-listed ADR holdings, assuming shares are dual-listed.

Q: If ADRs have a secondary listing in Hong Kong, will mainland China investors be able to invest in them?

Yes, but only if the secondary HK listings are eligible for trading via the HK-Shanghai/Shenzhen Stock Connect.

Relevant eligibility criteria for inclusion into the HK-Shanghai/Shenzhen Stock includes the following:

1. The stock is a Hang Seng Composite Index (HSCI) constituent (pretty easy requirement). Note that HSCI is a more inclusive Index than the more commonly followed Hang Seng Index (HSI). The HSCI comprises of 476 stocks, totaling c.95% of the total market cap listed on the HK Exchange Main Board. Meanwhile, HSI comprises of just 50 stocks.
2. Listing history of longer than 6 months and 20 trading days. This criteria requires further clarification by the HK Exchange to confirm if it also applies to secondary stock listings.
3. Approval by China Securities Regulatory Commission (CSRC) and mainland China exchange operators

Q: What is the expected buying demand into the ADR secondary listings?

Expected buying demands will depend on two key factors, which includes:

1. The stock’s weightage in the Hang Seng Index (HSI) and Hang Seng China Enterprises Index (HSCEI). This will determine the buying demand from ETF/Funds tracking the various indices. For Alibaba’s HK listing, Goldman Sachs estimates that HSI/HSCEI index inclusion will result in US$1.1 billion of index-related buying demand.
2. Whether the stock is eligible for trading on the HK-Shanghai/Shenzhen Stock Connect. According to Goldman Sachs, mainland China investors currently own 5%, 7% and 10% of the HK-listed shares of Tencent, Meituan Dianping and Xiaomi via the Stock Connect.
   • Applying these ownership percentages to Alibaba, whose HK-listed shares are not yet tradable via the Stock Connect, would result in incremental US$2 billion to US$4 billion in buying demand from mainland China investors.
   • In addition, the upcoming HK secondary listings of Netease and JD.com are aiming to raise between US$5.8 bilion to US$7 billion. The same assumptions would imply incremental US$290 million to US$700 million buying demand from mainland China investors on these shares.

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So should we buy Alibaba, given the possible US delisting?

The InvestQuest’s View: Assuming the bill passes, we expect price volatility in the short-term. However, for stocks that are listed or can list on the HK stock exchange (including Alibaba), we believe that the price will be primarily affected by fundamentals (i.e. earnings) over the longer term. This is because most institutional investors (in our understanding) are indifferent to where the company is listed, especially since HK dollars are pegged to the USD.

Importantly, since Alibaba is currently listed on the HK Stock Exchange, investors can currently exchange the US ADR share to the HK share, and vice versa with no loss. Note that both the ADR share price and HK share price move closely in tandem.

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In conclusion, we prefer sticking with the BIG US ADRs

If the Senate Bill is finalized and made into law, we will surely see an acceleration of ADR delistings ahead of the three year deadline. Under such a scenario, our preference will be the “blue chip” ADRs as they have more options on where to relist, be it in Hong Kong or otherwise.

The InvestQuest’s View: We have already seen some of the “blue chip” Chinese ADRs like Alibaba, Netease and JD.com opening a secondary listing in Hong Kong. Potential eligibility of these shares into the Hang Seng Indices and HK-China Stock Connect will provide the buying support needed offset any negative US investor sentiment. The bigger concern would be on the smaller cap ADRs, which have fewer venue options to raise capital.