Here is a guest post from Pauline Law, a third year law student at Penn. She analyzes going concern issues and NYSE and Nasdaq listing standards. I am not expecting to see a rash of going concern opinions on Chinese companies but this will be useful information as the standards for going concern opinions are further developed and applied in the Chinese environment. It also provides an interesting analysis of the delisting process at U.S. exchanges.
As regular readers of the China Accounting Blog know Paul has regularly discussed the issue of whether or not VIEs were a going concern. More recently, the PCAOB started examining whether auditing standards with respect to going concern issues should be enhanced. In light of the recent attention paid to VIEs by regulators and the investing community alike, auditors may well begin to issue qualified going concern opinions based on the uncertainties inherent to the VIE structure.
In the event of the issuance of a qualified going concern opinion to a Chinese company using the VIE structure, what would happen to the company’s ability to list in the United States? This post attempts to answer this question by examining how NYSE and Nasdaq have approached companies announcing going concern opinions in the context of the exchanges’ rules.
Rules and Regulations
Listed companies in the United States operate under a two-part regulatory scheme. First, the United States government makes laws relating to the sales of securities, and the Securities & Exchange Commission (SEC), a government agency, promulgates implementing regulations. Second, within the framework of the rules and regulations issued by the government, the stock exchanges issue their own rules relating to the eligibility of a company or a security to be listed on the exchanges, subject to final review and approval by the SEC. These rules do not replace the US government’s rules and regulations, but rather enhance them. In other words, the US government and SEC shape the baseline requirements for a security to be offered for any on any market, whether it is the OTC Bulletin Board, the Pink Sheets, or the NYSE, AMEX, or Nasdaq. In turn, NYSE, AMEX and Nasdaq implement their own rules, which serve as quality control measures for companies listed on these exchanges.
United States laws and regulations on public companies’ audit requirements are extensive. Section 10A of the Securities Exchange Act of 1934 imposes an annual requirement for public companies to be audited. The audit must contain “an evaluation of whether there is substantial doubt about the ability of the issuer to continue as a going concern during the ensuing fiscal year.” Other implementing regulations impose further rules on the form and content of public company reporting requirements and their dissemination to shareholders and to the investing public. As a general matter, however, U.S. laws are not concerned with the receipt of a going concern opinion per se, but companies may be subject to criminal or civil liability for failing to meet obligations under U.S. securities laws that ultimately caused that going concern opinion.
The NYSE, AMEX, and Nasdaq all have initial listing requirements related to specifically enumerated measures of a company’s performance, giving notice to companies as to the attributes that these companies must maintain in order to remain listed on the exchanges. Among other things, these requirements relate to the company’s income, assets, shareholder equity, and market value of shares. Companies that do not continually meet these quantitative standards risk being delisted from the stock markets. Additionally, the NYSE and AMEX listing rules include an explicit requirement that a listed company be a going concern or a successor to a going concern. Moreover, NYSE Listing Rule 802.01D(d) specifically invokes the issuance of a going concern opinion as a basis for delisting.
Aside from requirements specifically described by the exchanges’ listing rules, companies listed on the US stock exchanges must continually pass a “smell test” of their integrity. Rule 5101 of the Nasdaq listing rules codifies this “smell test” for Nasdaq-listed companies:
Nasdaq [. . . ] has broad discretionary authority over the initial and continued listing of securities in Nasdaq in order to [. . .] protect investors and the public interest. Nasdaq may use such discretion to [. . . ] delist particular securities based on any event [. . . ]that makes initial or continued listing of the securities on Nasdaq inadvisable or unwarranted in the opinion of Nasdaq, even though the securities meet all enumerated criteria for initial or continued listing on Nasdaq.
Similarly, Section 1003(f)(iii) of the AMEX Listing Rules permits the suspension of trading or delisting of a company if “the issuer or its management shall engage in operations which, in the opinion of the Exchange, are contrary to the public interest.” The NYSE Listed Company Manual allows for the Exchange to exercise discretion in a similar fashion.
Track Record of the Chinese VIEs
To date, no auditors have issued going concern opinions about the risks inherent to US-listed Chinese companies operating under a VIE structure. The companies delisted by NYSE and Nasdaq have been delisted on the basis of other concerns: among other reasons, many Chinese companies have become delisted because of a failure to submit timely annual or quarterly reports, to maintain a minimum bid price or market capitalization, or to comply with the exchanges’ corporate governance standards. Of the 26 companies delisted or suspended by the U.S. exchanges in 2011, only one company was delisted solely because of a reason that required the exchanges’ regulatory arms to exercise judgment: Nasdaq issued a delist letter to a company early this year because it failed to timely disclose material obligations by the company in the course of its listing application in 2010. The stock exchanges may have cited a listing rule granting the use of discretionary authority for a reason to delist the other 25 Chinese companies, but they also included other listing rules that are black and white and do not require the exercise of any independent judgment.
The regulatory arms of NYSE and Nasdaq appear to be very careful about initiating delisting proceedings. While they appear to be responsive to investor concerns about the management and corporate governance practices of listed companies, they are indeed cautious about delisting companies – despite widespread concerns about management and governance practices among Chinese US-listed companies, only one company was listed because the exchange’s regulatory body exercised its discretion, by deciding that an undisclosed obligation was “material.”
Because of the many specifically enumerated requirements for continued listing, it is much harder for companies subject to delisting proceedings to challenge these specific requirements. Each delisted Chinese company was on notice that their companies were at risk of being delisted even without the exercise of discretion by the Nasdaq or NYSE regulatory arms.
What have Nasdaq, NYSE and AMEX done in response to going concern opinions?
On its surface, the NYSE listing rule appears to take a more direct approach to delisting companies with going concern opinions. However, both exchanges take a similarly conservative approach to delisting, focusing instead on the underlying financial distress that ultimately gave rise to a company’s going concern audit opinion. Even though delisting on the basis of a going concern opinion is more than likely within the scope of Nasdaq’s Listing Rule 5101 and Section 1002 of the AMEX Listing Rules not all delisting (or warning) letters sent to troubled companies cite their auditors’ issuance of a going concern qualification.
More surprising is that NYSE does not generally appear to cite the receipt of a going concern opinion as a reason for a company’s delisting, even though this is a specifically enumerated reason for delisting. NYSE Listing Rule 802.01D(d) grants explicit grounds to delist on the basis of a going concern opinion. Nonetheless, in 2010 and 2011, NYSE did not explicitly cite the receipt of a going concern opinion as a basis for delisting any of the securities that NYSE moved to delist, even though six companies had received a going concern opinion or disclosed management’s doubt about the company’s ability to continue as a going concern due to filing bankruptcy or other reasons.
Additionally, one company’s auditors considered issuing a going concern qualification after regulators shut down its primary operating subsidiary under Rule 802.1D, which provides for NYSE’s authority to delist a company if the company’s operating assets have been substantially reduced or discontinued. In this case, NYSE did in fact cite the shut down of its primary operating subsidiary; it also touched on the company’s status as a late filer. Unlike the potential policy risk facing Chinese VIEs, however, this company’s subsidiary did in fact become discontinued; thus, NYSE’s decision to delist the company was not triggered merely on the basis of an unrealized risk.
In the end, every company listed on NYSE is on specific notice that they may be delisted if their auditors issue going concern opinion. Moreover, even though the stock exchanges’ rules grant ample discretion to delist companies on the basis of the issuance of a going concern opinion by an auditor, the continued listing requirements of the stock exchanges provide ample quantitative justifications to delist companies. A going concern opinion issued to a Chinese company that relies on the VIE structure may not necessarily trigger delisting proceedings on AMEX or Nasdaq, unless the company also becomes quantitatively disqualified from listing on the exchanges. However, considering the recent attention paid to Chinese VIEs by investors and regulators alike, the Securities and Exchange Commission may move to limit the offering of securities backed by Chinese VIEs. Investors should beware the winds of regulatory change in both China and the United States.
Pauline Law is a third year student at the University of Pennsylvania Law School with a background in economics and Chinese studies. She previously completed a summer internship in the Listing Qualifications division of Nasdaq. All research for this blog post occurred after her employment at Nasdaq. This post does not reflect the views of her former employer.