There are two recent papers on reverse mergers that may be of interest to my readers.
The first, by Jordan Seigel of Harvard and Yanbo Wang of Boston University, is the most thorough analysis of reverse mergers I have come across. They find there were 444 reverse mergers of Chinese companies into U.S. shells between 1996 and September of 2012. While companies in other countries have done reverse mergers with U.S. companies, only Canada (with 405 in the same per-iod) comes close to China.
Seigel and Wang posit that there are two reasons why a Chinese company might do a reverse merger with a U.S. company. First, it would be to access the sup-erior corporate law of the U.S. That is nuts. While Zhu Rongji chose to list some of the largest SOEs in the U.S. in order to use U.S. corporate governance pract-ices to help reform the companies, I would wager that not a single private bus-inessman in China would incorporate in the U.S. to give his shareholders greater protection. The second reason they advance is that companies do this to commit fraud. That might be possible in some cases, but I don’t think the majority of reverse mergers set out on a plan to commit fraud.
The Hong Kong Institute of CPAs (HKICPAs) has finally gotten around to pun-ishing Ernst & Young and its former senior partner Anthony Wu for a serious independence violation. The disciplinary process was finally concluded nearly 20 years after the violations took place. Anthony Wu was a high profile CPA in Hong Kong and HKICPAs was obviously reluctant to pursue the case.
The case against Wu was a slam dunk. He signed checks for an EY audit client. His defense was laughable – he only did it when other signatories were unavail-able and had approved the payments. He also served as an advisor to the com-pany, and was involved in loans to the company. Wu’s only credible defense was that, by taking 20 years to prosecute him, his defense was undermined. But he and EY had been told to preserve documents and had not done so.
EY was found guilty of not supervising Wu. EY’s management committee had been informed of what Wu was doing and did not stop him. Neither did the audit partner, Catherine Yen, who was found guilty of violating independence rules as well for signing despite Wu’s activities impairing EY’s independence.
Drew Bernstein, Co-managing partner of Marcum Bernstein & Pinchuk LLP has written a response to my recent post about NQ Mobile’s auditor change. I have a great deal of respect for Drew. As I said in my post I think he is among the best of the non-Big Four firms working the Chinese market. He might actually be better than many of the Big Four audit teams working on U.S. listed clients. But the Big Four brand is expected by many market participants, and this will always prove a challenge for specialty firms like Drew’s. Nonetheless, MarcumBP was probably the best alternative for NQ Mobile in this situation.
I would like to thank Paul for his regular stream of sharp, well-informed observ-ations about auditing Chinese companies listed overseas, as well the positive comments about my firm, MarcumBP, in this piece. At the same time, I would like to clarify some issues that might cause confusion for the casual reader of this commentary.
As Paul knows firsthand, auditing U.S.-listed Chinese companies is a complex business. To be effective, an auditor must have in-depth knowledge of China’s business practices and regulatory framework, and be highly trained in ever evol-ving SEC accounting rules. While China has grown into an economic superpower, its legal and business information practices are still that of a developing country. An American auditor without experience in China might have great dif-ficulty adequately testing the financial statements. High-level expertise in U.S. GAAP and SEC accounting issues are still in short supply in China.
NQ Mobile (NYSE:NQ) fired auditor PwC Zhong Tian and replaced them with Marcum Bernstein Pinchuk LLP (MBP). MBP is a joint venture between 14th ranked U.S. CPA firm Marcum and unranked Bernstein Pinchuk. The joint venture audits 18 SEC registrants, ranking it 4th by number of SEC registered clients in China (but much smaller if ranked by revenue). I have considered MBP to be among the best of the small firms working the China market. Unlike some of their peers they understand China and actually do audits. The 2013 PCOAB inspection of MBP found no deficiencies in their audit work.
NQ Mobile was the subject of a report by Muddy Waters last October alleging widespread fraud. Some of Muddy Waters allegations were easily dispelled. A special investigation by Deloitte and Shearman & Sterling failed to uncover evidence of fraud, but did report missing data.
The company missed the deadline (April 30) for producing its annual report on Form 20F apparently because PwC would not sign the required audit report. The company announced that its audit committee chairman had resigned (ostensibly for personal reasons). The stock was badly beaten up.
Bloomberg today reported that the Alibaba offering is sailing through regulatory review at the SEC. That is not surprising, since it appears Alibaba assembled an army of advisors to make that happen.
Senator Robert Casey of Pennsylvania wrote to SEC Chairwoman Mary Jo White to ask her to focus on the VIE structure and the risks it poses for American investors. Casey asked the SEC to give him an analysis of how the SEC reviews VIEs. I hope he releases that analysis.
I think the SEC is doing its job with respect to VIEs. The quality of disclosures has improved significantly over the past few years. Investors who read those disclosures are informed, and they obviously think that the risks are worth taking.
The Big Four accounting firms in Hong Kong took out an ad in Hong Kong newspapers opposing the democracy initiatives currently underway. This FT article has a translation of the ad and an analysis.
Twitter erupted with criticism of the firms:
Am I naive or is this outrageous meddling? Big four accounting firms warn Hong Kong over democracy push. http://t.co/DucKB7N1pa
6/28/14, 10:10 PM
When @FT asked big four’s global headquarters for comment, "it emerged they had only learned of the advertisement through press reports."
6/28/14, 5:45 AM
"@SimonCYWong: Big Four audit firms sell out #HongKong: "It’s an act of cowardice" http://t.co/dwcGTimuWK " #spineless Big 4?
6/28/14, 12:08 AM
It is assumed by many that the firms were pressured by their clients (the largest of which are Chinese state-owned enterprises) to place this ad. Certainly there are few instances in the past where the firms have spoken out in one voice for social reforms.
The arrogance of the firms is stunning. Did they really think their voice would alter the debate? Do they really think people respect their opinions that much? Did they not see that all they were doing is setting themselves up for ridicule while diminishing their brand worldwide?
The U.S.-China Economic and Security Review Commission has issued a staff report titled: The Risks of China’s Internet Companies on U.S. Stock Exchanges. The commission advises Congress on matters related to economic issues in China.
The report focuses mostly on the variable interest entity structure and heavily cites this blog. There is nothing new in the report that has not been covered here, but it is a good summary of the issues.
It is noteworthy that the Commission took up the issue. While VIEs are risky to investors, there is unlikely any serious risk to the U.S. economy from VIE problems. The report does point out the $18 billion lost by investors in Chinese reverse mergers. The market cap exposed to VIE risks is considerably higher. Certainly, having such a high level body raise this issue will increase investor anxiety ahead of the Alibaba offering.
The proposal by the Ministry of Finance to reform regulation of auditors of overseas listed companies created a firestorm in Hong Kong. Meetings with mainland regulators and interested parties took place in Hong Kong this week. A senior partner of one of the second-tier firms told an academic conference on Tuesday that if the proposal went into effect he would have to fire half of his staff.
The proposal to bring the audits of overseas listed Chinese companies under MOF regulation is an excellent one, and long overdue. This has been a regula-tory hole – ignored by Chinese regulators who blocked foreign regulators from filling the gap.
The proposal, however, threatens the livelihood of many Hong Kong CPAs. One of the provisions requires overseas firms, including Hong Kong firms, to use a Chinese affiliate selected from the top 100 Chinese firms to do the audit work on the mainland. That is the rule that concerns Hong Kong CPAs.
The Hong Kong Stock Exchange long ago gave a franchise to Hong Kong CPAs by requiring their signature on any listing in Hong Kong. That franchise eroded a little over the years, first as some of the big Hongs like Jardines and Swire left Hong Kong before handover and their audits moved to London. Then China forced open the market to audit H-Shares and now Chinese firms, mostly Big Four affiliates, audit some of the H-Shares. But exchange rules require that all Red Chips and private Chinese companies use a Hong Kong auditor.
Hong Kong accountants are up in arms over a proposal (English translation) by the Ministry of Finance to more closely regulate the auditing of overseas listed Chinese companies. Mainland regulators told Hong Kong officials that they do not intend to close off the mainland to Hong Kong accountants, although the proposed rules may well lead to that. But that is not the most important part of this story.
The MOF is bringing audits of overseas Chinese companies under Chinese regulation.
That is a good thing. Chinese regulators previously washed their hands of U.S. listed Chinese companies. I am unaware of any executive or auditor of an alleged fraud involving a U.S. listed company ever facing justice in China, yet China also blocked U.S. regulators from doing anything. Chinese accounting firms have been unfairly maligned by shoddy work done by fly-by-night reverse merger auditors from former U.S. penny stock havens like Salt Lake City and Denver. China is cracking down on those firms, and establishing regulatory control over the auditing of overseas listed Chinese companies. Some Hong Kong accountants may be unexpectedly caught in the process.
I wrote last December about a discussion going on in Hong Kong about whether to toughen audit regulation to bring Hong Kong in line with global practices. Hong Kong had suffered the insult of losing regulatory equivalency with the EU in accountancy because of its weak regulatory regime. The Hong Kong Institute of CPAs (HKICPAs) led the debate, and based on comments most members seemed aghast at the concept of tough audit regulation. The HKICPAs concluded its consultation with members on January 17, 2014 and the debate went silent.
I hope the issue gets revived. Hong Kong practices self-regulation in account-ancy. That means the accounting firms regulate themselves. After Enron, the rest of the world pretty much concluded self-regulation does not work. It is not working in Hong Kong.
I offer as evidence the case of former EY senior partner Anthony Wu. Wu was found to have violated auditor independence rules because he was a member of the client’s executive committee, authorized signer on 13 client bank accounts, had significant personal dealings with client subsidiaries, loaned the client money, and had EY collect a retainer for his services as a financial advisor. The client, New China Hong Kong Group collapsed in 1999, spawning a series of claims. Eventually complaints were filed with the HKICPAs about Wu, another EY partner and EY itself. Auditor independence is fundamental to the accounting profession, so the allegations were serious.
The CICPA has issued their annual rankings of Chinese CPA firms for 2013. It is bad news for the Big Four. BDO’s Chinese affiliate Lixin jumped over both KPMG and EY to kick EY out of the Big Four in China. RSM and Crowe Horwath’s shared affiliate Ruihua pushed KPMG out when it passed both EY and KPMG last year. PwC continues to be the largest CPA firm in China, extending its lead over Deloitte. PwC’s growth was a modest 4%, while Deloitte actually shrunk by 5%.
Here are the top ten CPA firms in China in 2013:
In most parts of the world the top accounting firms release information on their performance. Although they are private companies, they are public interest entities and the public deserves to look in their drawers just as they look into everyone else's. In China and Hong Kong, however, the Big Four are intensely secretive about their operations. The CICPA data is the only look inside. I believe that the data are generally reliable. It is used by the CICPA to set dues, so cheating upward would be expensive, and cheating downward could risk their right to practice. The revenue includes only audit fees. The Big Four operate their consulting practices in WFOEs and local firms report consulting revenues separately.
Reports are that Hong Kong officials are headed to Beijing to lobby against proposed rules that would require auditors of overseas listed Chinese companies to use mainland affiliates. The mainland proposal appears to be related to fears that Hong Kong accountants could disclose state secrets to foreign regulators. A Hong Kong judge last week ordered EY Hong Kong to turn over working papers related to Standard Water to the Securities and Futures Commission (SFC). EY had refused to turn over the working papers because it had outsourced the audit to its mainland affiliate. The mainland affiliate refused to turn over the papers citing China’s rules. EY’s case was significantly undermined when it was dis-covered at trial that EY actually had the working papers on a hard drive located in Hong Kong.
The mainland proposal would require auditors of all overseas listed Chinese companies to follow EY’s example and outsource the audit work to their main-land affiliate. The mainland offices already audit many, if not most, overseas listed Chinese companies. Over the past decade, the mainland offices of the Big Four have grown to be considerably larger than the office in Hong Kong. Lan-guage barriers and the high cost of sending staff from Hong Kong forced that change long before Chinese regulators thought about requiring it. The proposed rules will not change the way audits are conducted for most overseas listed Chinese companies.
It is unsurprising that the HKICPAs will be opposed. The proposal, if it goes into effect, will decimate the profession in Hong Kong. The proposal will also put U.S. based CPA firms that audit many small U.S. listed companies out of the business.
The proposal probably has little overall effect on the Big Four. The Big Four will simply shift their work to the mainland, where the mainland member firm has the expertise and the required U.S. and Chinese licenses to do the work. The Big Four offices in Hong Kong will likely shrink considerably in size.
The Hong Kong Stock Exchange will need to change the rules and allow the Big Four mainland affiliates to sign off on Red Chips and P-Chips, just as they now allow these firms to sign H-Shares.
There is a fatal flaw in the Chinese proposal. It requires that the overseas firm delegate all of the audit work to its mainland member firm yet retain full responsibility for the audit. The HKICPAs points out that would violate the auditing standards under HKSA 600. It would also violate the principal auditor rules of PCAOB auditing standards. The auditor who does the work needs to take responsibility for it and sign the opinion.
In a carbon copy of the SEC’s case against the Big Four, a Hong Kong High Court judge has ruled that EY cannot withhold working papers on Standard Water, a mainland company that pursued a listing in Hong Kong. The ruling is a major blow to the accounting profession in Hong Kong.
The Securities and Futures Commission (SFC) brought the case against EY. While EY Hong Kong was the accountant of record, they apparently outsourced the audit to EY Hua Ming, EY’s mainland affiliate. When SFC asked to see the working papers, EY Hong Kong demurred, saying they did not have them and that EY Hua Ming had refused to provide them because Chinese laws prohibited doing so.
I am surprised that SFC was not able to work out a compromise with Chinese regulators along the lines of the PCAOB agreement. The PCAOB deal, which allows for a rigorous redaction process, might have been unacceptable to the SFC. Chinese regulators might have been reluctant to give up any turf for fear that the precedent would work against them with the SEC.
The SEC has released some procedural filings related to the Big Four’s appeal of the administrative trial judge decision that banned the Big Four from SEC work for six months. Briefs will not be completed until September, making it near certain that the decision on the appeal will not come within the seven months that SEC guidelines suggest. If the firms lose the appeal, which I expect they will, the decision could happen at the worst possible time – near the end of the calendar year. That would be right at the beginning of audit season for calendar year companies. Unless the Big Four are successful at getting a Circuit Court of Appeals judge to stay the decision, U.S. listed companies on a calendar year will all miss their required annual filings in April 2015.
The best outcome at this point is a negotiated diplomatic solution. The most likely time for such an agreement is the annual Strategic and Economic Dialogue between the U.S. and China that will be led on the U.S. side by Jack Lew and John Kerry. That meeting is expected to be in July in Beijing, but details have not been released.
The South China Morning Post (SCMP) has two articles today that say that Chinese regulators are cracking down on Hong Kong firms coming into China to do audits. According to the SCMP, the proposal will require firms to use their mainland affiliates to staff engagements.
Prior to this proposal, it was possible for an overseas firm to obtain a temporary audit practice certificate to come to the mainland to audit a specific company. The process was cumbersome and often ignored.
Now the mainland affiliate will have to supply the staff for the audit. I believe that was already the case in most Big Four audits. But the rule, if implemented, will highlight the principal auditor issue that I raised on Alibaba last week. Based on Alibaba’s risk disclosures, it appears that the PwC was using mainland staff for a significant part of the audit. This proposed rule will simply make sure they do that, and will likely mean that PwC Zhong Tian instead of PwC Hong Kong signs the audit report.
As the SCMP articles explain, the practice of Hong Kong firms signing mainland audit reports is institutionalized in Hong Kong, and the loss of this franchise will hurt the Hong Kong profession. I observe that all large SOE audits are signed by the Hong Kong member firm of the Big Four, even though I believe that all of them are actually audited by mainland staff.
Alibaba is audited by the Hong Kong member firm of PwC, or at least that is what the audit opinion says. I am a bit skeptical about that claim. While there may be a Hong Kong partner assigned to the account, I will bet dollars to donuts that a large portion of the hours on the audit were done by mainland staff. This raises the question of whether the audit should have been signed by PwC’s mainland member firm instead of the Hong Kong member firm.
Who signs the audit report matters to investors. I have read bloggers who are arguing that investors should trust the Alibaba accounts because the Hong Kong member firm of PwC and not the mainland member firm audited them. The mainland firm is currently appealing a judge’s order to suspend them from practice before the SEC – a ban that does not apply to Hong Kong. I have previously written about the practice of signing China reports in Hong Kong and said it is the same consumer fraud as a Chinese shirt maker sewing ‘Made in Italy’ labels on shirts made in Wenzhou.
Alibaba filed its long awaited Form F-1 to begin the formal march to its U.S. IPO. Alibaba is too big to qualify as an emerging growth company under the Jobs Act, so it was not allowed to do a confidential filing. Most Chinese IPOs file under the Jobs Act, meaning we see only the penultimate filing right before the IPO takes place. This filing is likely to go through several rounds of SEC review and I would speculate that the IPO is not likely to happen until early autumn. Significantly, the document presently includes audited financial statements for 3/31/13 and I expect it will need to be updated with the 3/31/14 accounts before it goes final.
There is a lot to absorb in this filing, so I focused on the headline news about Alibaba’s use of the variable interest entity. As expected, Alibaba has a lot of VIEs since much of its business is in restricted sectors. There is an interesting discussion of how Alipay was extracted from Alibaba in 2011 included in Footnote 4. Alipay is not in the deal, although 49.9% of its income is included through the deal to settle the VIE dispute and Alibaba will get at least $2 billion up to $6 billion if Alipay does an IPO. But it might be worth much more than that.
I was very fortunate to have KPMG consulting partner David Frey talk to my MBA class on Multinationals in China last week about the rapidly changing landscape for MNCs. He has some great insights. One of his predictions is that China will make the Yuan freely convertible sooner than people think. I hope he is right; currency restrictions are increasingly causing problems for U.S. listed Chinese companies.
Chukong Holdings Limited filed on last Friday with the SEC for a U.S. IPO. Chukong is an online game company so it uses the variable interest entity (VIE) structure despite a specific MIIT prohibition against using VIEs for game companies. The company also faces a lawsuit alleging they ripped off their game Fishing Joy from an arcade game, report that they have not been paying required employee benefits, never bothered to register their stock option plan, and have an auditor facing suspension by the SEC, but based on past history investors ignore such matters.
Chukong is unprofitable. Its losses have increased over the past three years from 30 million RMB to 91 million RMB. It has burned 84 million RMB of cash in operations over the past three years. It stockpiled that cash by selling preferred stock in its Cayman Island parent company to Sequoia and other investors.
Cheetah Mobile Inc. (Cheetah) has filed for an IPO with the SEC, joining what is shaping up to be a long line of U.S. IPOs this year. Its main product is Clean Master, the number 6 application worldwide on Google Play. The company previously listed on the Hong Kong exchange as Kingsoft and they now seem to be listing a holding company further down the chain. Fredrik Oqvist has tweeted that Cheetah may be the best name for a Chinese company since FU listed on the NYSE.
By my calculations, Cheetah’s earnings for 2013 would have been 36% higher if it had selected a different accounting firm. That is because Cheetah uses Ernst & Young (EY), which appears to be taking the position that deferred taxes are required on the undistributed earnings of variable interest entities (VIE). In 2013, Cheetah booked RMB 34 million of deferred tax expense related to “outside basis difference” which I believe relates to the undistributed earnings of the VIE.
This is the third EY client where I have seen this accounting treatment (the others are Autohome and Soufun). I have not seen this treatment on any other U.S. listed Chinese company.