What do a water treatment company, a financial software provider and an advertising agency have in common?In the case of Rino International, Longtop Financial Technologies and China MediaExpress Holdings, the U.S. Securities and Exchange Commission (SEC) has now put them on a growing list of Chinese firms that have had the trading of their shares suspended on New York's bourses.
In a letter to Capitol Hill officials dated April 27, Mary Schapiro, the SEC's chairperson, wrote that the U.S. regulators have "moved aggressively" since late last year to launch a number of investigations, revoking the U.S. securities registrations of eight China-based companies. Schapiro also noted that over five weeks between March and April this year, 24 China-based firms notified the SEC about a mix of accounting problems and auditor resignations.
As the SEC's recent suspensions and auditor revocations have cast a pall on Chinese equities, they also call into question the bigger challenges involving the quality of financial disclosures of China-based and other emerging market firms listed on global exchanges, and the ability of regulators to protect investors. As experts note, clamping down on companies that don't uphold regulations is good — but creating an environment to diminish the need for such investigations is just as good, if not better. To that end, Schapiro was quoted at a June 21 conference in Washington, D.C., that the SEC has a "menu of ideas,” which it will unveil very soon to address the issue.
Shell Games?
A few weeks earlier, the commission had issued a statement warning investors about companies listed on U.S. exchanges via a little-known process called a reverse takeover (RTO). Through this transaction, companies — both domestic and foreign — can access U.S. capital markets by merging with a U.S.-listed "shell" company. The process gives the new private owners operating and management control of the combined company, not to mention a way to gain access to capital more quickly and with fewer advisory, accounting and legal costs than a straightforward initial public offering (IPO). And for the growing number of China-based firms that find RTOs attractive, “a U.S. listing also brings reputational gains … and in some cases, helps to finance overseas expansion,” notes Xi Chao, a law professor at Chinese University of Hong Kong.
According to the Public Company Accounting Oversight Board (PCAOB), the audit profession's overseer in the U.S., Chinese companies entered into 159 of 603 of the RTOs completed between January 1, 2007, and March 31, 2010, with U.S. companies making up most of the rest. At the end of the first quarter of last year, the 159 Chinese firms had a combined market capitalization of US$12.8 billion, less than half the US$27.2 billion market capitalization of the 56 Chinese companies that completed U.S. IPOs over the period covered by the PCAOB report.
The problem isn't their relatively small size, however. In a speech earlier this year, SEC commissioner Luis Aguilar noted, “While the vast majority of these Chinese companies [that transact RTOs] may be legitimate businesses, a growing number of them are proving to have significant accounting deficiencies or [are] vessels of outright fraud.”
And that is what concerns the SEC. A report in June saysthe SEC has suspended eight RTOs involving Chinese firms, including Rino (because of missing and potentially inaccurate information in its public filings involving allegations of financial fraud) and China Changjiang Mining & New Energy Company (for, among other things, failing to have an independent external auditor sign off on its most recent financial statements). A new SEC task force is now investigating fraud in overseas companies with U.S. listings, especially those that arrived via RTOs.
Casting the net wider, the PCAOB has stepped up efforts to monitor the U.S. auditors of these firms. One company it singled out earlier this year was Chisholm, Bierwolf, Nilson & Morrill, a small accounting firm whose registration has been revoked and which had its two principals barred from practicing permanently. The reason for the sanctions, according to the PCAOB: "The U.S. firm used inexperienced Chinese-speaking assistants to conduct audit work of companies with operations in China without adequately supervising them."
'China Is Hot'
It's a remarkably different reception than Chinese RTOs and IPOs have been accustomed to. “This is a fairly new phenomenon, partly because China is hot, and everyone wants to invest in Chinese companies,” says Anna Han, a law professor specializing in China trade and investment at University of Santa Clara in California.
As investor interest in emerging market stocks increases, the U.S.-listed Chinese firms in the headlines draw attention to an Achilles heel of global capital markets — the financial reporting coming out of many of these firms isn't up to snuff, something that can't be mended overnight and can't be left solely to auditors to address. “The level of accounting disclosure and general transparency isn’t there,” says Christian T. Lundblad, finance professor at University of North Carolina’s Kenan-Flagler Business School. “This is a very pervasive problem across all emerging economies.”
Adding to the complexity is the fact that U.S. auditors — including Deloitte, KPMG, PricewaterhouseCoopers and Ernst & Young, collectively known as the Big Four — are barred by many countries from practicing within their jurisdictions. So to carry out the audits of non-U.S. firms, they must use a network of affiliated foreign firms — of often variable quality. “This is not a new issue, but the rise of globalization has exacerbated it,” says Joseph W. St. Denis, director of the PCAOB’s office of research and analysis. “If you look at even the big [accounting] firms globally, they are networks of firms. The affiliate of a Big Four firm in France may have the same name, but it’s technically a different firm.”
Since the arrival of the Sarbanes-Oxley Act in 2002, the PCAOB is required to undertake annual inspections of accounting firms that audit more than 100 SEC-registered companies a year, triennial inspections of firms that audit 100 or fewer firms a year. According to PCAOB rules, if a U.S. auditor signs off on the financial reports of a foreign-based company, it has to perform most of the audit itself and oversee the work of local affiliates.
While in-country PCAOB inspections are acceptable for most countries in Latin America, Asia, the Middle East and Africa, they have not gone over well in other parts of the world. The European Union, for example, objected to Sarbanes-Oxley rules that prevented the PCAOB from sharing its findings with local regulators. But since the passage of the Dodd-Frank Act now permits such information sharing, various EU members, such as the U.K., are striking agreements with the PCAOB for in-country audits.
China is among the countries that are digging in their heels. "Recent concerns in the U.S. regarding the reliability of financial statements and valuations of certain Chinese IPOs only heighten the urgency of resolving the current barriers to inspections in China and the importance of the PCAOB’s mission,” James R. Doty, chairman of the PCAOB, said in a statement in June.
Standard Practice
While the PCAOB and the China Securities Regulatory Commission are working to — in Doty's words — “accelerate efforts” for a bilateral agreement, many investors continue to grapple with the inconsistent quality of audited financial disclosures of U.S.-listed foreign companies. There's "no question" that the Big Four want "to maintain a uniform level of quality worldwide,” says Joseph Carcello, a University of Tennessee accounting professor and member of the PCAOB’s Standing Advisory Group, which advises it on the development of auditing and related professional practice standards. “They want the Deloitte signature to mean the same anywhere in world as it does in the U.S.," he says. "But the reality is [that] auditing practices do vary around the globe, even though ostensibly the same standards are being followed. It’s a challenge for regulators and major accounting firms, and a cautionary tale for investors.”
He notes that the big accounting firms can ban affiliates from their network if the quality of their work is deemed inadequate. Yet there are other factors at play. “The firms are also in the business of making money,” he says. “If you have an affiliate in China and the quality of work isn’t as good as in the U.S., [the firm will] often think, 'We can improve on that [instead of kick them out of our network], because this is a market we have to be in if China is growing 8% to 10% a year.'”
As more companies seek access to capital markets, customers and suppliers worldwide, accounting firms have to globalize just as much, if not more. Steve Levey, CEO of GHP Horwath, a mid-tier U.S. auditor, requires that its 400 affiliates world-wide agree to integrate its own staff when auditing non-U.S. clients. To help with integration in China, 12 of GHP Horwath's 120 employees at its U.S.headquarters are Mandarin speakers and travel to Chinese client sites regularly. “We’re involved in the audit plan, staffing and review of the work [in China], and we have people at every layer on our team embedded in everything we do,” says Levey. “We don’t have a Chinese firm do the work and then stamp it.”
Yet, because China is just getting to grips with international accounting and reporting standards, “there’s a cloud hanging over all Chinese listings right now,” says Pieter Bottelier, adjunct professor of China studies at Johns Hopkins School of Advanced International Studies in Washington, D.C. “This whole standards setting we take for granted, and self-policing professional bodies are still very new in China.”
And beyond a collective change of mind set, “you need to do a lot of training [to get] experienced auditors," adds Wharton finance professorFranklin Allen. "And that just takes time."
The Long and Short of It
China's firms — not just those 156 RTOs — are learning the hard way about why that's the case. In many respects, the disclosure shortcomings of China's U.S.-listed firms have been a boon for investors who bet against a stock by selling borrowed shares so that they can repurchase them at a lower price. In recent months, Muddy Waters Research, Citron Research and a handful of other "short-sellers" have been publishing contentious reports and blogs that single out the China firms they say are overvalued, or even downright fraudulent. It's one reason why the Halter USX China Index, composed of Chinese-based companies trading on U.S. exchanges with at least US$50 million market capitalization each, fell 16% from April 1 to June 20 this year.
For a layperson, it's hard to know who is in the right, and who is just out to make some money. Short-seller Andrew Left, who publishes Citron Research, says he sent private investigators last year to sniff out the assets of China Biotics, a Shanghai-based, Nasdaq-listed probiotics firm, which reported revenue of US$81.4 million in fiscal 2010. Left says his investigators were able to locate only a handful of the stores listed on China Biotics's web site. As for the other addresses the company provided, “they weren’t stores, just empty parking lots,” he says. However, another U.S. stock analyst, Jason Nevader, has since said the company corrected the addresses for many of the stores that Left’s investigators could not find.
On June 15, Nasdaq halted trading in China Biotics due to concerns over its accounting. The company, which listed in the U.S. in 2008 via an RTO, had notified Nasdaq that it would not file its fiscal 2011 financial reports with the SEC until it resolves issues raised by its external auditor, BDO. The company's share price closed at US$3.46 on June 15, down from a high of US$19.21 in March 2010.
Whatever the outcome of the various investigations under way with U.S. regulators, where do China's U.S.-listed firms go from here? “The normal way to solve auditing problems is that international investors demand a huge premium to hold [questionable securities],” says Lundblad of the University of North Carolina. “When emerging market countries realize it’s harder for them to access global capital and that’s slowing down their economic development, that’s the push it takes for them to buy into the global system.”
In the meantime, says Wharton’s Allen: “It’s caveat emptor for investors.”
