The PCAOB has announced a deal with CSRC and MOF on enforcement cooperation. The Memorandum of Understanding is here.The deal will allow the PCAOB to get access to audit documents, including working papers from Chinese accounting firms. There are a number of detailed operational rules, including one that requires the PCAOB to describe the conduct or suspected conduct which gives rise to the request. That implies that the deal works to get access to documents for specific investigations and cannot be used for “fishing expeditions” or inspections.
PCAOB chairman James Doty told Reuters that the agreement does not replace the need for the PCAOB to inspect audit firms in China. He called the deal a “step in the right direction”. I think it may be a step the other way.
The deal applies only to the PCAOB. I expect, however, that a deal is also being finalized with the SEC. There is growing pressure for this to happen. Earlier this week the Business Roundtable, FEI and several other organizations wrote to Jack Lew asking that a deal be done. The IPO market for Chinese companies is moribund. Billions of dollars of private equity money is locked up in China and a U.S. IPO may be the only key that works to set it free. While the regulatory disputes over auditing are not the only overhang on the market, they have been significant.
I am in Washington for the meeting of the Standing Advisory Group of the PCAOB, of which I am a member. This morning PCAOB chairman James Doty reported on PCAOB activities. He said this about China:
China, in particular, has taken considerable attention. We continue to discuss our need for a protocol to inspect PCAOB-registered firms in mainland China and Hong Kong. I am mindful that we cannot wait forever. Meanwhile, though, I am optimistic that we will soon be able to announce a protocol to exchange documents and other information necessary to enforcement investigations and disciplinary proceedings.
This would be an important start that, I believe, reflects the Chinese authorities’ understanding that investors in both our countries need to have confidence that allegations of fraud will be properly investigated. It would be an acknowledgement that access to relevant documents is fundamental to effective investigations. Access to documents will also, of course, be necessary to carry out an effective inspection regime.
Overseas listed Chinese companies mostly use offshore listing vehicles to avoid Chinese restrictions on overseas listings. These offshore vehicles are typically incorporated in the Cayman Islands for its favorable tax regime and well-established corporate laws based on English law. Companies listed through reverse mergers often have U.S. corporations at the listing vehicle, which has the unfortunate side effect of bringing the Chinese company under the U.S. tax system.
Overseas listed Chinese companies typically operate in China through subsidiaries known as wholly foreign owned enterprises (WFOE). A WFOE is a corporation and is also the normative form of operation in China for multinational corporations. When a WFOE has profits that it wants to distribute to its parent company, it must pay over a dividend withholding tax of 10% of the proposed distribution before it will get permission to convert the RMB profits to foreign currency and distribute them to the offshore parent company. In the case of Cayman Island holding companies, there is no further tax in the Cayman Islands so the profits can then be distributed to public shareholders with no further tax. In the case of U.S. parent companies (as in reverse mergers or MNCs) the U.S. may take another cut, although this is so complex I will not go into it.
The SEC administrative proceedings against the Big Four and BDO in China have shown some life.
On April 30, the Administrative Trial Judge issued a ruling shooting down a request for summary judgment on a number of procedural issues. The accounting firms were mostly trying to get the case dismissed based on arguments they were not properly served.
The firms also argued that in a number of the instances in which they were charged they did not actually issue any audit reports, which under their legal theory ought to set them free. I have suspected that many of these cases related to companies that attempted to upgrade to Big Four firms when the reverse merger scandals began to appear in large numbers in 2011. Many companies that had to come to market using smaller accounting firms tried to change to a Big Four firm to distinguish themselves from other reverse merger companies. This was particularly common with former clients of Frazier Frost, which had a number of clients fail in the early running of the scandals. In a number of cases the attempt to upgrade failed when the Big Four firm could not get comfortable with their new client, and that often led to the company being delisted. The SEC probably asked for the working papers on these companies to figure out what went wrong.