The U.S. Senate approved the Holding Foreign Companies Accountable Act (HFCAA) on Wednesday, sweeping legislation that could result in non-U.S. companies that fail to meet a number of strict criteria being barred from trading on U.S. stock exchanges. The bill was approved without objection. 

One of the key provisions of the legislation is that companies would be required to certify that "they are not owned or controlled by a foreign government." Lawmakers would also require that these statements be backed up by an audit conducted by the Public Company Accounting Oversight Board (PCAOB). 

The legislation would still need to pass the House of Representatives before being sent to President Trump for final approval. If passed, though, the law could have far-reaching effects on foreign companies already listed on U.S. exchanges, especially those from China.

Representations of flags from the U.S. and China in fire and smoke

Image source: Getty Images.

On the chopping block?

Last year, a U.S. government regulator compiled a list of 165 Chinese companies whose stocks were listed on U.S. exchanges and that could ultimately be affected by the legislation. Among those are a number of relatively high-profile companies from China that are popular with U.S. investors.

These include Chinese search engine leader Baidu (NASDAQ:BIDU), which has frequently been called the "Google of China" after its search counterpart owned by Alphabet; e-commerce and cloud computing titan Alibaba (NYSE:BABA); and e-commerce platform JD.com (NASDAQ:JD). Other companies that could potentially be affected by the legislation include video game and social media giant Tencent (OTC:TCEHY); New Oriental Educational & Technology Group (NYSE:EDU), which specializes in tutoring and test-prep services; and of course Luckin Coffee (NASDAQ:LK).

Luckin Coffee's recent troubles may have been the final straw that resulted in the draft legislation. The Chinese coffee company announced in early April that an internal investigation found evidence of fraud on a massive scale in its financial statements, including a significant number of fabricated transactions. Trading shares of the nascent company were halted on the Nasdaq in early April. Shares have since resumed trading, but the Nasdaq is now preparing to delist the company. Luckin has since fired its COO and CEO as the result of the scandal.

Meaningful oversight

The PCAOB, which falls under the purview of the Securities and Exchange Commission (SEC), is a nonprofit organization charged with overseeing audits of all U.S. companies that aspire to raise capital and be listed on the U.S. stock market. It was established by Congress in 2002 in the wake of several high-profile accounting scandals, including Enron and WorldCom. Foreign companies would be forced to submit to oversight by the PCAOB, which also reviews the audits of U.S. companies.  

While the requirements would apply equally to any foreign company listed in the U.S., the new regulations appear to be focused on China, which has refused to submit the work of its auditors for outside review, arguing that Chinese law forbids the necessary documents from leaving the country.

U.S. lawmakers have a less forgiving view. Sen. John Kennedy (R-Louisiana) sponsored the bill, which is aimed at strengthening disclosure requirements and transparency regarding foreign companies.

"The Chinese Communist Party cheats, and the Holding Foreign Companies Accountable Act would stop them from cheating on U.S. stock exchanges," Kennedy wrote in a post on Twitter. "We can't let foreign threats to Americans' retirement funds take root in our exchanges." 

This follows a warning by the SEC last month that companies not answerable to U.S. oversight could subject investors to a greater potential for loss. "In many emerging markets, including China, there is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse, in comparison to U.S. domestic companies," the SEC said in a press release. 

A man checking figures on a balance sheet while using a calculator

Image source: Getty Images.

A ripple effect

The potential for increased regulation is already sending ripples across Wall Street. Baidu is considering delisting from the Nasdaq and listing on a stock exchange closer to its native China, according to a story first reported by Reuters. The company believes its stock is being undervalued on U.S. markets. 

Baidu's CEO and co-founder Robin Li said the company is considering its options carefully in a statement made to the state-controlled China Daily newspaper. "For a good company, there are many choices of destinations for listing, not limited to the U.S.," Li said in a statement.

This could be the first of many Chinese companies to desert U.S. markets in advance of the stricter regulations, and it could also prevent the listing of new companies from the Middle Kingdom. This could result in these companies being traded only on over-the-counter markets rather than the major exchanges, or even be barred from trading in the U.S. at all. 

Stay tuned.