THE TIGER STOPS ROARING: What is Happening with Chinese Public Companies?
One of the bright spots on the public company scene in recent years has been the rise of Chinese companies going public in the U.S. The sheer size of the ever-growing Chinese domestic market was certain to present an almost endless supply of companies with millions of dollars of predictable revenue and profit. It seemed too good to be true and by mid- to late-2010, it started to become clear that in some, but by no means the majority of, cases, it was too good to be true. Something was wrong with the financial information being provided by some of these tiger enterprises.
Fueled by whistleblowers, notorious on-line talking heads and periodic regulatory audits of companies and accounting firms, around June 2010, the SEC and PCAOB started sending out informal inquiry letters to accounting firms, asking for voluntary cooperation with a fact-finding process about their practices involving Chinese public company clients. These “Dear Accountant” letters were the first clear indication that a significant regulatory review of Chinese companies was underway, largely focused on the integrity of financial reporting.
By the fall of 2010, the SEC began to formally investigate certain Chinese companies and some PCAOB-registered accounting firms. By the end of last year and continuing to the present, bans on taking on new Chinese clients have been put in place for some accounting firms. A steady stream of accountants and clients out the door began at other accounting firms. Non-reliance letters were issued by certain accounting firms to their clients. Independent directors of some Chinese companies stepped down; some even signed consent orders with the SEC. Other Chinese companies delisted from U.S. stock exchanges. And other companies threatened to fight back.
FINRA began looking at the role of investment banking firms in the going public and capital raising process and how they were conducting due diligence. A chill in the equity markets descended on Chinese companies long before the debt crisis exploded in Europe and the U.S., as investors began to question the integrity of the financial information they were receiving and, to a lesser degree, the entire process of a Chinese company’s going public and raising capital. As early as the beginning of this year, predictions of how long it would take for the Chinese public company market to recover ranged from six months to a number of years.
What went wrong? As with all things Chinese, the answer is varied, nuanced and complex.
One problem is a clash of cultures and varying expectations that come from those cultural differences. Chinese companies are often run by one or more family members. They have paramount authority and all other employees show great deference to the head of the company. This deference may be further magnified if there are age differences between employees and their boss because of the great respect older people are accorded in China. Even questioning a position taken by the company chairman could be interpreted as a challenge and that is socially unacceptable in China. However, this inhibition by employees who, let us say, are part of the company’s in-house finance department, could thwart the proper functioning of internal controls, and disclosure controls and procedures, which are cornerstones of modern securities laws and the regulations of the SEC and stock exchanges.
A related issue is that this unwillingness to act in any manner that may be interpreted as an unacceptable challenge to authority may extend to the consultants that are common in Chinese public companies. Because of language barriers that may exist in the form of the employees of a Chinese company not speaking English, as well as broad unfamiliarity in China with the technical requirements of U.S. public company reporting, including Regulation S-X (the SEC accounting rules for public companies), it is common for Chinese public companies to hire consultants – usually bilingual, younger China-based accountants who often come out of large global accounting firms – to interface with management and prepare the financial package that goes to the auditors for review or audit. The problem is that because these consultants are paid by the company, they see themselves (not incorrectly) as reporting and accountable to management. And the same deference that is shown by the Chinese employees of a company to its chairman often extends to Chinese consultants, who may also be reluctant to raise sensitive issues or question a position taken by management. Additionally, some of these consultants just aren’t that good at what they do, inhibitions or not.
Enter the auditor. In a post-Sarbanes Oxley world, the PCAOB-registered auditor has become the final line of defense. No longer advisors to management, the auditor is hired by and reports to the Audit Committee (or the Board of Directors as a whole if the company is not required to have and does not have an Audit Committee), brings an independent perspective to the company’s financial reporting before signing off on the financial statements, and reveals problems with internal controls (even for smaller reporting companies, which are not subject to auditor attestation of internal controls).
The SEC and PCAOB have been greatly concerned of late whether accounting firms have been fully following generally accepted auditing standards (GAAS) for their Chinese public company clients, given the geographic distances, language barriers, reliance on consultants and different levels of cooperation that have been discussed above. It is important to note that the vast majority of accounting errors are not the product of any deception by company management, but sometimes U.S. accounting principles are just not being employed or applied consistently in the preparation of financial statements. If the auditor does not follow GAAS strictly, as appropriate for the situation and risk, the last line of defense can be breached.
In the budget-conscious world of Chinese companies, an audit firm may quote a price for their services (almost always a flat fee) which, as a practical matter, requires them to limit the number of times and days they spend in China for field work, relying on their own outsourced China-based bilingual Chinese consultants (not the same group as the company’s consultants). If these boots on the ground are not, in regulatory parlance, being properly “supervised” and fully “engaged” in the process – or just not that good - errors may occur in their work that just flow through to the final, filed version of the financial statements. The sheer number of regulatory actions and non-reliance letters (that is, an auditor notifying a company that its financial statements can no longer be relied upon) indicates that the regulators are not off the mark with their concerns that something is seriously wrong with financial reporting by a number of Chinese public companies. The problem is systemic even though it is not universal.
The marketplace is reacting in a number of ways. Generally speaking, Chinese stock prices have been hammered, significantly under-performing the market as a whole. Some accounting firms are radically changing their policies and procedures; others are leaving the China market, voluntarily or otherwise. Some investment banking firms are now requiring an additional level of forensic accounting interposed between the company consultants and the auditor, at least when there is a public offering involved. Some directors of Chinese public companies are realizing the benefit of the Audit Committee charter and are hiring their own professionals to monitor the situation and any remediation that may be required on a case-by-case basis. In other companies, management understands that the Western adage “you get what you pay for” requires them to adjust their budgets in choosing consultants and auditors.
This phenomenon has a long way to go and there will continue to be a major shake-out as there is no sign that regulatory investigations will end any time soon. Dishonest companies will be revealed and they will fade away. Professionals who are not adhering to the rigorous standards of their professions will likewise peel off. Investors will be wary for some period of time. But the marketplace is both forgiving and has a short memory. Those Chinese companies with wise management, who assure their employees and consultants that fully following regulatory compliance when they access the U.S. public markets is expected and encouraged, and hire only those professionals who adhere to the same standards, will continue to find a welcoming environment among investors and regulators and help restore confidence to Chinese public companies as a whole. Long-term, the prospect for renewed access to the U.S. public markets for Chinese companies as a whole is bullish.
Lance Jon Kimmel is the founding and managing partner of SEC Law Firm, which represents growth companies around the globe and the regulated professionals who serve them. Mr. Kimmel’s practice focuses on public and private securities offerings, SEC reporting, corporate governance, mergers and acquisitions, representation of companies before the SEC and stock exchanges, and SRO compliance for investment bankers and other service providers. He handles capital raising at every level, from seed capital to initial public offerings, from reverse mergers to PIPEs, from equity credit lines to bank credit facilities. Mr. Kimmel is actively involved in alternative public offering strategies, including reverse mergers for domestic and Chinese companies in the United States, and working with private and public companies going public or dual listing internationally on the AIM in the U.K., the TSX in Canada and the Frankfurt Stock Exchange. Lance can be contacted on +1 310 557 3059 or by email at firstname.lastname@example.org