Bill Bishop over at Digicha has a post up: Chinese Groupon Clone Lashou Files for US IPO. Lashou's preliminary F-1 is interesting to me because of its expanded disclosures regarding its VIE arrangements. It is preliminary and could still change, but by the time they get to this stage they are pretty much done. This was the first public filing, but there were likely several confidential filings before this. It looks like it might have been a rocky process. The company was forced to restate all of its prior financial statements due to errors that were discovered, which is embarrassing to the accountants. James Zhang, CFO, was the audit committee chairman of alleged fraud Duoyuan Printing. Ernst & Young are the auditors for Lashou.†
Many have wondered what the SEC was going to do after all the recent concerns over the VIE structure that have been raised. It is important to understand that the SEC is not responsible for approving the VIE structure. The SEC is responsible for making sure the risks of the offering are properly disclosed - not to evaluate the appropriateness of investors taking those risks. That is different than the role of Chinese regulators, who require lower levels of disclosure and tend to consider the appropriateness of the security as a prudent investment. I have been guilty of saying that U.S. listing requirements are looser than Chinese requirements. That is only true with respect to reverse mergers - otherwise they are just different. †
G+, Gerson Lehrman Group's new interactive community, is holding a teleconference on VIEs on Tuesday, November 1. They are bringing together four of the leading bloggers on VIEs
Paul Gillis†Professor, Peking University, (China Accounting Blog)
Fredrik ÷qvist†CEO, Chi-Eco Consulting, (China Finance)
Stan Abrams†Law Professor, Central University of Finance & Economics Law School, (China Hearsay)
Steve Dickinson†Partner, Harris & Moure, PLLC, (China Law Blog)
†This is a good opportunity to ask questions about where the VIE structure is headed. For more information and to register for the teleconference go to this link:
I did my first post on VIEs on March 9, 2011. While I had been aware of the structures since their inception, I focused in my doctoral thesis on how they were used to develop China’s capital markets, and this blog was a conceived of as a way to put some of my ideas out for criticism. I got plenty of that early on. Some said I was overstating the issue and that I just did not understand China. Over the past six months, however, the risks I pointed out in those early posts have all materialized. I said in that first post that I would do two more on VIEs; I have now done 19. The post explaining VIE structures is still the most popular on this site, with over 17,500 page views since it was posted. It still gets 600 visits a week. †Several months ago my former student Fredrik Oqvist started his own excellent blog to discuss VIE issues, partly because I wanted to make this more than just a VIE blog. I have not been able to stay away, because VIEs have become central to the issues that most interest me – the role of accounting and transnational regulation in the development of China. †
Reuters is out with news that that the Big Four and two other CPA firms were summoned last week to meet with CSRC and MOF officials. The topic apparently related to whether these firms had disclosed any information from their China audits to overseas regulators or their overseas offices. †
One of Reuter's sources indicated that the Chinese regulators emphasized the need to maintain the confidentiality of audit information. Firms have been told to do a self examination of whether they have disclosed any information to foreign regulators or their overseas offices. The self examination is to be done this week. †
China has recently focused on keeping state secrets. The State Council directed that Chinese companies in critical industries should consider the protection of state secrets when selecting accounting firms, suggesting that some firms are better than others at doing this (presumably those without foreign partners). Recently Deloitte was subpoenaed by the SEC for its working papers on Longtop and advised the SEC that it was unable to comply because Chinese regulators would not give it permission to do so.†
Carson Block of Muddy Waters Research has risen to fame for his skill in outing Chinese frauds, making Bloomberg’s list of the 50 most influential people in global finance.† The former Jones Day Shanghai lawyer and adjunct professor at Chicago-Kent College of Law coauthored Doing Business in China for Dummies.††He has outed some notorious frauds in China, including Rino International and Sinoforest.†He has also apparently misfired on some allegations.† Block accused Orient Paper of serious fraud, yet a blue chip independent investigation found no evidence to support his allegations.
Block appears to have now turned his attention to the Big Four.†In a recent letter to the PCAOB, Block charges the Big Four with conspiring with their clients in China to commit fraud.† Block writes:
Even the most reputable auditors in China seem to be in a race to the bottom. We believe that there are particularly egregious situations in which some Big Four partners in China offices have actually conspired with their clients to defraud investors. Further, it is a reasonable proposition that the conflict of interest inherent in the Chinese auditor’s business model also affects the quality of US company audits.
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. ††
Dune Lawrence of Bloomberg Business Week published an excellent article that broke no new ground on VIEs, yet has ignited a firestorm in the blogoshere. †Check out the China Law Blog, China Hearsay, Digicha, and the China Finance Blog. While they express different and strongly held opinions I think they are all saying the same thing. The VIE structure is unusual, risky, and in trouble. †No one expects the Chinese government to suddenly shut down Baidu and Sina over their use of VIEs yet I think all would agree that the days for these structures are numbered. The questions that remain are how quickly will new IPOs of VIE deals be shut down and how are the respective governments going to deal with existing VIEs. † On the first issue, I think that lawyers and accountants are going to face incredible pressure from many different directions that may stop new deals in their tracks. I will have a post on this later today. †
The second issue is the most important. How does China find a way for its successful entrepreunerial companies to find capital? This is a much broader issue than just VIEs. Today's Wall Street Journal reports on efforts to expand the access to credit for private companies in China. †Most of the problems we see today in the China concept stock space, from VIES, to reverse mergers, to fraud, have their roots in the failure of China to provide adequate access to capital for its entrepreunerial companies. At first the problem was ideological, as China's capital markets were initially conceived as a way to reform SOEs, not to support the capitalist roaders. By the time (2001) that Jiang Zemin welcomed entrepreuners to join with workers, farmers, cadres, and PLA officers and men to build socialism with Chinese characteristics, the trail to overseas capital markets had already been blazed.†
The PCAOB today issued† Staff Audit Practice Alert No. 8 - Audit Risks in Certain Emerging Markets.
In a broad sense the Alert points out how emerging markets differ from developed markets, and points to the need to modify audit procedures because of these differences.† That should not be surprising to anyone, but the recent frauds in China which likely motivated the report indicate that too often Western auditing practices were imported wholesale to China without modification for the differing cultural environment.†
I have been developing a hypothesis that because auditing and internal control practices were developed in the West, they are founded on the assumption that collusion between two parties is difficult. The concept of separation of duties is fundamental to the design of any internal control system. As any beginning student of sociology learns, the West has a highly individualistic culture while the East has a collectivist culture (read the famous work of Geert Hofstede on this topic). I believe that Western designed internal control systems (and audit processes intended to test these systems) have failed in China because they have not recognized how these systems are undermined in a collectivist culture. The PCAOB Alert is a good start on recognizing the issues.†
TechRice has found a list of Chinese internet companies and their sizable cash positions. Because each of these companies uses the VIE structure, these companies are at the confluence of the two big Chinese accounting stories of 2011 - auditing cash in China and variable interest entities.
3). Alibaba (HKEX: 1688), 1.5 billion
4). Tencent (HKEX: 0700), 1.25 billion