The iChinaStock 30 Index fell 33% in September as concerns over regulatory problems spooked investors. Much of this regulatory concern is over the fate of the VIE structure used by many U.S. listed Chinese companies. Many investors have concluded that the VIE structure is a house of cards waiting for a regulator or the VIE shareholder to collapse.
While most of the discussion has been on the role of Chinese regulators in this process, this post will focus on U.S. regulators. I believe Chinese regulators are going to take a slow and deliberate approach to cleaning up this sector. I am not so sure that will be the case with the two most important U.S. regulators - the SEC and the PCAOB.
Several recent developments give me concern that U.S. regulators might move first. The SEC has been moving very aggressively lately. First, there was the subpoena against Deloitte for the production of working papers. Then, Robert Kuzami, director of enforcement at the SEC, reported that the U.S. Justice Department is probing certain Chinese firms. SEC comment letters seeking more information on VIEs have been issued on Shanda Interactive Entertainment, Ltd, Fushi Copperweld Inc, and Sino Assurance Inc.
The PCAOB discussed VIEs in its recent Staff Audit Practice Report on emerging markets audits. Auditors were told to consider whether the use of VIE arrangements increases fraud risk, or might result in omitted, incomplete or inaccurate disclosures. The PCAOB has also been frustrated with its inability to negotiate access to China to inspect accounting firms. James Doty, Chairman of the PCAOB recent said that they "cannot sit back and wait indefinitely". If the Chinese do not agree to joint inspections, "we will have to consider using the tools we have at our disposal, and which Congress gave us for this purpose, to protect investors." The tool that he has is the PCAOB registration that allows auditors to audit public companies and allows the public companies to remain listed.
Bill Bishop at DigiCha had an interesting post a couple of days ago about the risk that U.S. accountants might end up being the party poopers. He cites Peter Schloss, former CFO of Tom Online, who had posted this comment on China Law Blog:
One thing I have not seen you or any of your commentators discussing with regard to VIEs is the accounting issue that investors face, which is equally important as the legal issue. As you know, the VIE structure is not only a mechanism by which foreign ownership restrictions are avoided, but also a mechanism which has allowed entities that are not subsidiaries under PRC law (and US, Cayman and BVI Law for that matter) to be consolidated under US GAAP for income statement purposes pursuant to Fin. 46. Accordingly, there are really two issues at hand here: (1) the legality of the VIE structure under PRC law and whether the lack of a “clean” PRC legal opinion will impede VIEs from being listed on foreign stock exchanges, and (2) whether the SEC will continue to allow consolidation of VIE financials under Fin. 46 if the VIE structure continues to be questioned under PRC law. Without the ability to consolidate the financial performance of the operating entity that is actually controlled by PRC citizens (because of the VIE structure) the VIE structure is meaningless.
I raised this question back in March (Are VIEs a going concern?). Auditors have been hanging their hats on legal opinions that already had huge qualifications. I expect these legal opinions are going to get a lot weaker in the next round. When will the level of uncertainty rise to the level where there is "substantial doubt" as to the ability of the company to continue as a going concern? I am certain that the SEC and the PCAOB are going to be holding the accountants feet to the fire on this issue. Given the current temperament of the SEC and the PCAOB related to China, this is not going to be a pleasant experience for the accountants.
NASDAQ CEO Robert Greifeld says there are 30+ Chinese companies currently in the pipeline to list. What will these developments mean for them? I expect it is going to be a tough process. The SEC is likely to be merciless with its probes to make certain the company has complied with all Chinese regulatory requirements - MOFCOM Circular No. 10, SAFE registrations, etc., that lawyers have often blown off by saying that the VIE arrangements made them unnecessary. I guess there is always the alternative of complying with all the Chinese rules, if that is even possible.