Another strike for biotech: China

Use of an auditor that cannot be inspected by the US regulator takes centre stage as Chinese biotech stocks fall.

Already reeling from general waning investor sentiment, biotech now has another problem. China-based companies traded on US exchanges are coming under pressure over the perceived risk that they might be delisted because of a rule recently implemented by the SEC.

The issue relates to the accountancy firm that each company uses to audit financials; where such a firm is based in China it typically cannot be inspected by the US regulator – and this could be grounds for delisting. Though the risk is theoretical and just five companies have so far been identified the fear is that the list will grow as annual reports are filed, and that the SEC cuts its grace period for non-compliers.

At present this grace period is three years. This means that biotechs the SEC has identified as non-compliers when they filed their 2021 accounts – currently Beigene, Zai Lab and Hutchmed – would only be delisted from Nasdaq if the regulator was also unable to inspect the firms that audited their 2022 and 2023 financials.

However, in a statement today Hutchmed cautioned: “Legislation is being considered in the US to shorten the number of non-inspection years from three years to two.”

Holding companies accountable

How did this all come about? The problem had been brewing since December 2020, when the US Holding Foreign Companies Accountable Act came into law.

This requires the SEC to identify US-listed companies that are audited by firms located in a foreign jurisdiction that makes it impossible for them to be inspected by the Public Company Accounting Oversight Board (PCAOB). The statute is part of a US push to access information protected by national law, especially China’s.

What happened this week was that the SEC published its list of the first five non-compliant companies. Purely by dint of being the first to file annual reports, Beigene, Zai and Hutchmed featured as the first three biotechs to be identified as non-compliant.

But there was investor selling across the board, and the Loncar China Biopharma exchange-traded fund closed down 3% yesterday. Curiously, the fallers included Lianbio, off 10%; Lanbio today issued a statement stressing that it was compliant with the new law, and that it had a US-based auditor that is currently inspected by the PCAOB.

Moreover, the audits involved are understood not to be especially onerous. “There’s a moderate to high probability that this gets worked out in the year ahead,” Brad Loncar, chief executive of Loncar Investments, told Evaluate Vantage, adding that it was not in China’s interest to allow its companies to be delisted from the US.

“Ironically, I think the way the stocks have plunged will bring China and the US closer to the table to work it out, so [the selloff] yesterday might end up being productive in some ways,” he said.

Trading in selected US-listed Chinese companies on March 10, 2022
Company Share price chg On SEC's provisional non-compliance list? Statement
I-Mab -13.8% No None
Lianbio -10.1% No Says principal auditor is located in New York, and inspected by PCAOB
Zai Lab -9.0% Yes Confirms auditor cannot be inspected by PCAOB; working to engage independent auditor that satisfies PCAOB requirements
Connect Biopharma -8.7% No None
Hutchmed -6.5% Yes Confirms potential delisting in 2024, unless PCAOB can conduct full inspection of auditor; notes US might shorten allowed non-inspection period from 3 to 2 years
Beigene -5.9% Yes None
Legend Biotech -3.7% No None
Gracell -1.7% No None
Adagene -1.6% No None
Sinovac None* No None
China Pharma Holdings Unchanged No None
Universe Pharmaceuticals +0.8% No None
Genetron +1.4% No None
Note: *trading in Sinovac stock has been halted since 2019. Source: stock exchange & company information.

For its part, China’s securities regulator said it respected the SEC’s strengthened supervision of “relevant accounting firms to improve the quality of listed company financial information", but strongly opposed what it called "the politicisation of securities supervision”.

“We are willing to solve the problem ... through regulatory cooperation. China’s Securities Regulatory Commission and Ministry of Finance have continued to communicate with the PCAOB and have made positive progress,” it said.

Still, given the cautious biotech investment climate, many will want to know what the worst-case scenario is. Importantly, Beigene, Zai and Hutchmed have secondary listings, so their stock can be converted between each listing, and cancellation of shares on Nasdaq would not erase holders’ ownership, no matter how bad the optics of such a move would be.

“I expect others like I-Mab, which don’t yet have a secondary listing, to [secure one] ASAP as an insurance policy,” said Mr Loncar. “The fact that I-Mab doesn’t yet have one is the reason why its stock was hit the hardest yesterday.”

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