Over the past decade, waves of Chinese companies flocked to U.S. and other North American stock exchanges in search of much-needed capital to support their burgeoning businesses and economy. Chinese companies were met with an insatiable appetite by U.S. investors to tap into the nearly untouched array of Chinese businesses that were becoming accessible on a regular basis.
Many of the Chinese companies gaining access to U.S. exchanges did so through various techniques, including reverse mergers and variable interest entities, which enabled them to evade much of the normal scrutiny that companies must typically undergo when listing on a stock exchange through the initial public offering process. However, because all companies listed on U.S. financial markets, including those headquartered in China, are subject to financial reporting rules in accordance with the regulations of the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB), a clash has arisen between Chinese and U.S. regulators surrounding the extent to which U.S. regulators can demand audit work papers and supporting documentation.
Financial reporting regulation for public companies in the U.S. is handled primarily by the SEC, which oversees companies listed on financial markets with the objective to protect investors and provide transparent, reliable financial information. Simply put, public companies are required to submit forms to the SEC (e.g., Form 10-K, Form 10-Q, Form 8-K, etc.). Some are required to be certified by an independent auditor to opine that the financial condition of the company is being accurately presented and that required disclosures are made.
Following financial accounting scandals at companies like Enron, Congress established the PCAOB, a nonprofit corporation that acts to oversee audits and auditors specifically. The PCAOB reports to the SEC and the two organizations work in tandem.
Regulatory Dispute and Wave of Short Sellers
On the heels of the influx of Chinese companies listing on U.S. exchanges, a regulatory clash has arisen surrounding the PCAOB’s ability to inspect audits of Chinese companies performed in China. The Chinese Securities Regulatory Commission (CSRC) is the regulatory body responsible for overseeing Chinese public companies and their financial reporting. The conflict between regulators boils down to an issue of sovereignty, as the CSRC does not want a foreign regulator– namely the PCAOB or the SEC– inspecting Chinese auditors or audit work papers.
Every U.S. Big 4 accounting firm has operations in China and audit companies listed on U.S. exchanges through joint ventures with local Chinese auditing firms. However, due to the clash between Chinese and U.S. regulators, the PCAOB has yet to gain access to inspect the audit work papers of the companies listed on U.S. stock markets, despite the fact that they are audited by U.S.-based accounting firms. The lack of transparency and familiarity with local auditors has fostered widespread accusations of accounting irregularities, fraud and corporate governance issues that have embroiled these companies, as investors have been forced to rely on financial information supplied by Chinese firms and their auditors without the level of scrutiny given to U.S.-based firms.
Further exacerbating the situation, this combination of factors has fueled a series of short sellers to publish disparaging reports poking holes and questioning financial reports supplied by Chinese companies and often characterizing the financial statements as fraudulent. As an example, New Oriental Education, a Chinese education company that once had a $3.5 billion market capitalization and a stock price of as high as $30 a share, gained media coverage following a report by a short seller accusing the company of fraudulent financial reporting which resulted in the stock price falling below $10 a share ($18 at the date of this writing). In other more severe cases, companies have filed for bankruptcy protection or been delisted from stock exchanges altogether.
In an effort to combat short sellers, a group of more than 60 Chinese executives, investors and entrepreneurs signed a letter in September 2012 accusing short sellers of targeting legitimate companies with either no problems or minimal problems and manipulating information to write reports that “boldly tell lies.” The offensive is being led by Kai-Fu Lee, a former Google employee, who stated that short sellers have made it more difficult for Chinese companies to go public in the U.S. while acknowledging that initially short sellers did a good job of identifying fraud. Lee specifically criticized a report issued by a short seller on Qihoo 360 Technology, an operator of Internet services and seller of third-party anti-virus software, which has lost significant market value since the report was issued.
Despite criticism of short sellers, there has been proof of actual wrongdoing in several cases and the SEC has increasingly taken action over the past few years, including filing multiple complaints against Chinese companies alleging fraudulent financial reporting and other similar charges. For example, in September 2012, the SEC charged China Sky One Medical with falsifying earnings and alleged that Sky One Medical (which makes Chinese medicine and was once listed on the NASDAQ) reported about $19.8 million worth of phony export sales between 2007 and 2008.
Also, in April 2012, the SEC brought a complaint alleging that the chairman of SinoTech Energy Ltd. had misappropriated more than $40 million from the company and misled investors about the value of the company's assets during its initial public offering.
Alternative and Likely Outcomes: Will Diplomacy Rein Supreme?
There have been over 100 auditor resignations and multiple delistings of Chinese companies – both voluntary and involuntary – over the past few years related to financial reporting, corporate governance and transparency. In response, there has been an effort by China to attract companies back to exchanges in Shanghai or Hong Kong through initiatives like those at the China Development Bank (CDB), which has made a $1 billion capital pledge aimed at helping Chinese companies leave U.S. exchanges.
In addition to the CDB, interest from private equity firms across the globe has increased as they continue to look for valuable buying opportunities. The combined efforts of private equity firms and CDB funds have taken a number of companies private in the past two years. Most notably, in August 2012, Focus Media Holdings was subject to a going private bid by its chairman and a group of private equity firms led by the Carlyle Group for $3.7 billion. The deal terms have yet to be finalized. Moreover, China TransInfo Technology and Harbin Pacific Electric, which both gained access to U.S. exchanges through reverse mergers, are involved in going private transactions.
Overall, nearly 400 Chinese companies still remain listed on U.S. exchanges today, leaving billions of dollars at stake and continuing opportunities for clashes of international interests as China aims to protect its sovereignty and the U.S. aims to impose its reporting standards on Chinese companies which are publicly traded on U.S. exchanges. In October 2012, the two countries signaled a diplomatic resolution to the issue with an agreement that allowed the PCAOB to have observational visits in China (although only one such visit has been authorized to date). The agreement, however, does not allow for full access for U.S. regulators to examine the audits of Chinese companies listed on U.S. exchanges.
Despite the progress and the message to the world that the two countries are working to resolve the dispute, the core issues still remain. Without full access to audit files and work papers, Chinese companies listed on U.S. exchanges will not be in complete compliance with PCAOB and SEC requirements. The PCAOB has imposed a deadline of the end of 2012 to force the two sides to make a decision about how to proceed.
Will the CSRC grant U.S. regulators access or will the SEC be forced to engage in massive delistings if the two parties cannot diplomatically resolve the issue? Will the deadline simply be delayed, only pushing the issue further into the future? The core issue, transcending borders and sovereignty, is the need for safe, reliable and trustworthy financial information to ensure investor protection, and without which financial markets cannot function.
James S. Feltman is a senior managing director and national co-leader of Mesirow Financial Consulting’s Litigation, Investigative and Intelligence Services. He has over 30 years of experience advising clients on regulatory and auditing matters. Hannah Zeffiro is a vice president and a member of Mesirow Financial Consulting’s Litigation, Investigative and Intelligence Services team.