Bankers, broker-dealers should do their homework before saying ‘yes’ to Chinese companies

By Guest Contributor
August 26, 2011

By Cavas Pavri, Thomson Reuters Accelus contributing author

NEW YORK, Aug. 26 (Thomson Reuters Accelus) – The considerable negative publicity surrounding Chinese companies listed in the United States has made it increasingly difficult for investors to separate the undervalued from the fraudulent. Essential for success: Taking a close look at the firms’ auditors and corporate governance practices going forward.

In April 2011, the Securities and Exchange Commission (SEC) acknowledged that it had established a task force to address what it deemed to be abuses by Chinese companies accessing the U.S. markets through the use of reverse merger transactions. SEC Commissioner Luis Aguilar referred to the proliferation of these companies as a “disturbing trend that seems to have challenging implications for capital formation and investor protection.” In addition to the SEC, the U.S. national stock exchanges have been taking more aggressive actions against Chinese companies. In 2011, almost two dozen Chinese companies have seen trading in their securities halted or have been delisted because of accounting irregularities.

This article discusses areas that investors should focus on in performing their due diligence on investments in Chinese companies.

AUDITORS AND FINANCIAL REPORTING

The recent turmoil in the market for Chinese issuers has placed a spotlight on the “gatekeepers” generally associated with public companies. In December 2010, the Wall Street Journal reported that the SEC’s Enforcement and Corporation Finance divisions had begun a wide-scale investigation into how networks of U.S. accountants, lawyers and bankers have helped bring Chinese companies onto the U.S. stock markets.

In particular, accounting firms have come under increased scrutiny in connection with the quality and competence of their audits of Chinese companies. In July 2010, the U.S. Public Company Accounting Oversight Board (PCAOB) released a staff audit practice alert that discussed issues that the PCAOB had identified in the audits of companies with substantially all of their operations outside of the United States, with particular focus on companies located in China.

The PCAOB alert noted that the number of companies that file financial statements audited by U.S. accounting firms, while having substantially all of their operations in another country, has increased in recent years. The alert went on to note that the demand for those audit services is being met by U.S. registered public accounting firms of various sizes, including small firms. By way of example, the alert stated that in a 27-month period ending March 31, 2010, at least 40 U.S. registered public accounting firms with fewer than five partners and fewer than ten professional staff issued audit reports on financial statements filed with the SEC by companies whose operations were substantially all in the region of the People’s Republic of China (PRC).

In connection with some of these audits, the PCAOB inspection staff observed situations in which it appeared that U.S. registered public accounting firms that provided auditing services had all or most of the audit performed by another firm or by assistants engaged from outside the firm (including firms and assistants located in China) without complying with PCAOB standards applicable to using the work of another auditor and supervising assistants.

In particular, Chinese companies that have “gone public” through the completion of a reverse merger overwhelmingly tend to be audited by smaller accounting firms. Between January 1, 2007 and March 31, 2010, the PCAOB’s Office of Research and Analysis identified 159 Chinese issuers that became public through the use of a reverse merger. Of these issuers, 94 percent were audited by audit firms that were subject to PCAOB inspection triennially, as opposed to annually, which is required for audit firms that regularly provide audit reports for more than 100 issuers. Consideration should be given to avoiding issuers audited by firms that are not inspected annually by the PCAOB.

Things to consider in evaluating a prospective company’s accounting firm:

  • Does the firm have any adverse PCAOB examinations?
  • How many staff members does the firm have, compared to the number of audit clients served?
  • Is the firm licensed under the laws of China to perform audit services in China? Failure to be so licensed may inhibit or preclude the auditing firm from performing certain audit procedures, and may inhibit certain entities in China (such as banks, vendors, customers and the government) from cooperating with the audit.
  • How many staff members speak the local language?
  • Did the audit firm utilize outside parties to complete any portion of the audit process?
  • Does the firm lease employees to perform audit services?

In addition to evaluating a company’s accounting firm, the quality of a company’s chief financial officer and of the accounting staff is also critical. Not only is the CFO’s educational and professional background important, but the following questions should be asked as well:

  • Is the CFO based at the headquarters of the company? If not, what type of access does the chief financial officer have to the company’s records?
  • Does the CFO have direct access to the company’s bank accounts, or must he or she go through other officers or employees to access such information?
  • Does the CFO report to the chief financial officer, or does he or she report around the chief financial officer to the chief operating or executive officer?
  • Does the CFO regularly interact with multiple members of the accounting staff of the company, as well as with the members of the audit committee?
  • Does the CFO attend meetings of the audit committee at least quarterly?
  • Does the company employ accounting personnel (other than the CFO) who have experience with U.S. GAAP and who were previously employed by top-ten auditing firms? If so, how many, and what are their qualifications?

CORPORATE GOVERNANCE

A large number of Chinese issuers, particularly companies that have undertaken a reverse merger, have a significant number of their shares held by a few persons, typically the company founders or management. These large shareholders have the ability to control the actions taken by the company, and, often dominate the actions taken by the company’s management and board of directors. Against this backdrop, the importance of a strong independent board function cannot be overstated.

In evaluating a company’s corporate governance, special attention should be paid to the audit committee. Audit committees should be independent, active and knowledgeable, should include both English-speaking and Mandarin-speaking directors, and should include at least one financial expert.

The appointment and empowerment of a lead independent director is also an important factor in establishing strong corporate governance. The lead independent director serves as the day-to-day liaison between the company’s board of directors and management; relays any questions posed by the board of directors or any board committee to company management; and should speak both English and Mandarin, if possible.

Virtually all issuers are required to adopt a “Code of Ethics” that applies to their executive officers and certain accounting personnel and to publicly disclose such code. Unfortunately, too often these codes are adopted, but are then ignored or poorly implemented. When dealing with companies with operations located in the PRC, these codes should be in both English and Mandarin.

Considerations when evaluating a prospective company’s corporate governance:

  • Does the company comply with all corporate governance standards required of U.S. issuers?
  • How often does the board of directors meet? How often does the audit committee meet?
  • Has the board of directors or audit committee formally approved all SEC periodic reports? What procedures does the company use to obtain such approvals?
  • Does the audit committee confer with the auditors and with the chief financial officer prior to the company releasing the results?
  • Is the audit committee qualified to conduct a meaningful review of the company’s audit function?
  • Does the company have an ethics officer? Do his or her duties include education of the employees of their duties under the code of ethics?
  • Are the employees required to reaffirm the code of ethics every year?
  • Is the code of ethics in both English and Mandarin, or just in English?

CONCLUSION

While the items above are important considerations, they are by no means exhaustive. Potential investors and lenders considering an investment in China should begin with these questions, and be proactive in obtaining information about these companies and seeking the assistance of legal counsel experienced in dealing with Chinese issuers before making any investment decisions.

(Cavas Pavri is a member in the Business Law Department of Cozen O’Connor. Pavri concentrates his practice in the areas of securities offerings and compliance, mergers and acquisitions and general corporate matters.)

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus.  Compliance Complete (http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance-complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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