Regulator standoff on Chinese reverse mergers

Author: | Published: 18 Aug 2011
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

Cross-border audit negotiations between US and Chinese regulators have reached a standoff over US oversight of Chinese audits, according to a CPA licensed in both countries.

“I don’t see China as being willing to accept anything that is different than the kind of deal the US reached with some of the European regulators,” said CPA Paul Gillis, a visiting professor at Peking University in Beijing.

The US Securities and Exchange Commission (SEC) and the US Public Company Accounting Oversight Board (PCAOB) met with China Securities Regulatory Commission (CSRC) and Chinese Ministry of Finance and Commerce (MOFCOM) officials on July 11 and 12 in Beijing during the Sino-US symposium on audit oversight.

The meeting followed 24 securities fraud class-action law suits, mostly on grounds of accounting fraud, against Chinese reverse merger companies (CRMs) issued between January and June of this year.

US accounting firms subject to triennial PCAOB inspections audited most of these companies, but many of them delegated accounting oversight to firms in China.

Last year the SEC requested information from US audit firms to verify financials of foreign based companies traded on US exchanges. Over 24 PRC-based companies responded with auditor resignations, accounting problems, or both, according to SEC Chairman Mary Schapiro’s April 27 2011 letter to Congressman Patrick McHenry.

The SEC suspended trading and revoked registration of some of these CRM companies for “failing to make required periodic filings.” The agency also filed enforcement actions against US auditors.

Stephen Mahinka of Morgan Lewis & Bockius believes some of the problems arising from Chinese audits might be a case of less evolved accounting practices, rather than intentionally exaggerated income reports.

“You certainly wouldn’t be surprised if it was simply the relative lack of sophistication of their accounting practices,” Mahinka said.

“As an institutional matter, you have well developed systems in Europe, the US and Japan, but you don’t have long-working systems developed to the same degree in China because they weren’t needed for the first several decades of the regime,” he said.

In their July meeting, US and Chinese regulators expressed their intention to increase cross-border audit cooperation, but an agreement allowing the PCAOB to send investigators to Chinese accounting firms was not reached.

Osler Hoskin & Harcourt partner Kevin Cramer is not optimistic that the PCAOB will be given permission to do its US statutory duty of investigating China based auditors of US traded companies any time soon.

“While a careful reading of the August 8th [PCAOB] press release indicates incremental progress was made, it is also clear that the process going forward will be a slow one and unlikely that a bilateral agreement between US and Chinese regulators will be achieved in the near future,” he said.

Exchange action

US exchanges have also tackled the problem.

Rules to be listed on the exchanges allowed for reverse mergers to forgo stringent registration requirements. The NYSE, NYSE Amex and NASDAQ have now proposed rules making it more difficult for Chinese companies to list via a reverse merger.

The NYSE and NYSE Amex would require a reverse merger company to trade for at least a year in the US over-the-counter market, while NASDAQ would require 6 months of trading in the US over-the counter-market.

All of the exchanges would require the reverse merger company to maintain a minimum share price of $4 for an extended period and file audited financial statements and an annual report with the SEC. They would also have the ability to make stricter requirements if warranted.

“I think it will have a significant cut back [in reverse mergers] because essentially the NYSE regulation will make it more difficult for companies to use the reverse merger approach and avoid the full rigors of SEC review,” Cramer says.

According to the SEC website, Gillis is the only person who has posted a comment on NASDAQ’s proposed rule.

“We’ve had a lot of problems with some of these [CRM] companies on NASDAQ. Most of the time, it was a small accounting firm based in the US that goes to China, and that was a formula for disaster,” said Gillis.

“PCAOB found situations where an auditor couldn’t speak Chinese, so they were relying on the local accounting firms to do all the work, and that is just not acceptable,” he added

Gillis pointed to one thing that seems certain: “Today, I don’t think a big four [firm] would take on a reverse merger company outside some extraordinary levels of due diligence.”