Eight years following the crash of the Chinese reverse merger boom and a slew of SEC enforcement proceedings, the SEC is once again concerned with the financial reporting by U.S. listed companies with operations based in China. In December 2018, the SEC issued a cautionary public statement from SEC Chair Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III entitled “Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally – Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China.”
Just reading the title reminded me of the boom in China-based reverse mergers around 2009-2010 followed by the trading halts or delistings of at least 50 companies in 2011 and 2012. In the summer of 2010, the SEC launched an initiative to determine whether certain companies with foreign operations—including those that were the product of reverse mergers—were accurately reporting their financial results, and to assess the quality of the audits being done by their auditors. By June 2011, the SEC was strongly warning investors of the risks posed by reverse mergers in general, and Chinese deals in particular, singling out six Chinese issuers.
Numerous SEC enforcement actions and civil lawsuits were filed claiming fraud and misrepresentations in SEC filings including financial reports. Partially as a result of the crisis, in late 2011 both the NYSE and Nasdaq amended their listing requirements to add a seasoning requirement following a reverse merger. The seasoning rules prohibit a company that has completed a reverse merger with a public shell from applying to list until the combined entity had traded in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange, for at least one year following the filing of all required information about the reverse merger transaction, including audited financial statements. In addition, the rules require that the new reverse merger company has filed all of its required reports for the one-year period, including at least one annual report.
In addition, the seasoning rule requires that the reverse merger company “maintain a closing stock price equal to the stock price requirement applicable to the initial listing standard under which the reverse merger company is qualifying to list for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to the filing of the initial listing application.” The rule includes an exception for companies that complete a firm commitment offering resulting in net proceeds of at least $40 million.
In addition to the specific additional listing requirements contained in the new rule, the Exchange may “in its discretion impose more stringent requirements than those set forth above if the Exchange believes it is warranted in the case of a particular reverse merger company based on, among other things, an inactive trading market in the reverse merger company’s securities, the existence of a low number of publicly held shares that are not subject to transfer restrictions, if the reverse merger company has not had a Securities Act registration statement or other filing subjected to a comprehensive review by the SEC, or if the reverse merger company has disclosed that it has material weaknesses in its internal controls which have been identified by management and/or the reverse merger company’s independent auditor and has not yet implemented an appropriate corrective action plan.”
Slowly since that time, Chinese companies have again started to access U.S. capital markets via both reverse mergers and direct IPO’s. However, clearly the issues and concerns raised by the SEC in 2011 have not all been resolved.
SEC Public Statement
The SEC’s recent cautionary public statement was issued jointly from SEC Chair Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III. The statement’s opening sentence sets the tone for the rest of the content, and in particular, “[A]s we are nearing the end of the fiscal year for many reporting companies, it is important to remember that complete, accurate financial statements and credible audits are things we—investors, issuers, and regulators worldwide—all care about.”
The statement continues with a recognition of the global nature of both capital markets and companies, with U.S.- and non-U.S.-based companies seeking access to the U.S. capital markets and the fundraising and liquidity they bring. The statement points out that U.S.-listed companies accounted for approximately 40% of the market capitalization of global public companies in 2017. Capital access and liquidity are made possible by the assurance that companies that list and trade on U.S. markets provide high-quality and reliable financial information and that U.S. rules, regulations, and regulatory oversight apply. When the listed company operates outside the U.S., regulators must operate in multiple jurisdictions to be able to access audit-related information and otherwise effectuate their responsibilities over any company trading in the U.S. markets.
A multinational company must comply with financial reporting obligations in many of the countries in which it operates and its auditors must be able to operate on a worldwide basis. The multi-jurisdictional aspect is sometimes challenging in that information necessary for regulatory oversight does not always flow back to the U.S. as it should. Barriers to the information flow include data protection, privacy, confidentiality, bank secrecy, state secrecy, or national security laws. The U.S. has been working with foreign jurisdictions to address these laws and barriers where a company subjects itself to U.S. regulatory oversight by listing on U.S. securities exchanges and accessing U.S. capital markets. For example, the SEC is one of over 120 signatories to the International Organization of Securities Commissions (IOSCO) Multilateral Memorandum of Understanding, which provides for enforcement consultation and cooperation, and the exchange of information. Moreover, the SEC has over 75 formal cooperative arraignments with foreign regulators, the PCAOB has conducted inspections of registered accounting firms in over 50 foreign countries, and the PCAOB has cooperative arrangements with 23 foreign regulators.
Unfortunately, China is not one of these cooperative arrangements, and the PCAOB has been facing issues being able to inspect auditing firms in China, as well as Hong Kong where the audit client has operations in mainland China. Based on reports to the PCAOB from audit firms up to March 31, 2018, there were 213 listed companies in China and 11 in Belgium for which the PCAOB and SEC have not been able to inspect audit records despite ongoing and significant efforts. From March 31 to the date of the SEC’s public statement, some of those companies changed their listing or trading status, dropping the number down to 178 companies.
The SEC is and remains the principal regulator of the world’s largest securities markets and, as such, must often deal with cross-border issues. The SEC sees its mission as administering and enforcing requirements for reliable financial reporting globally in light of the global nature of the economy and the many companies that operate worldwide. The SEC furthers this mission by communicating and cooperating with regulators in other countries and by participating in international organizations such as IOSCO (the International Organization of Securities Commissions) and The Monitoring Group, which engages in the monitoring of international accounting, auditing, and ethics standards.
The SEC also oversees the PCAOB which, in turn, is the principal U.S. regulator that oversees the audits of public companies and SEC-registered brokers and dealers. The PCAOB is required by U.S. law to conduct regular inspections of all registered public accounting firms, both domestic and foreign, that issue audit reports or that play a substantial role in their preparation. As noted above, the PCAOB has inspected audit firms in 50 different foreign countries. The PCAOB also often works in cooperation with foreign regulators and their audit inspection authorities.
However, despite the cooperative arrangements, there are legal impediments blocking the free flow of information from some countries. In particular, blocking statutes and data protection, privacy, confidentiality, bank secrecy, state secrecy, and national security laws sometimes complicate or outright restrict the sharing of information with U.S. regulators. Some of these laws prohibit foreign-domiciled companies from responding directly to SEC requests for information and documents or doing so, in whole or in part, only after protracted delays in obtaining authorization. Other laws can prevent the SEC from being able to conduct any type of examination, either on-site or by correspondence. Accordingly, securities regulators around the world seek agreements with one another for access to business books and records or auditor documentation. Likewise, some countries prohibit the PCAOB from inspecting audit firms within their borders, even if the auditor is PCAOB-registered. In that case, the PCAOB usually enters into cooperative arrangements with local regulators that allows them to jointly inspect a firm.
However, the SEC is generally not satisfied with their ability to inspect, investigate and enforce the U.S. securities laws in China. Despite the significant value of China-based companies trading in U.S. markets, Chinese law requires that the business books and records related to transactions and events occurring within China be kept and maintained there. China also restricts the auditor’s documentation of work performed in the country from being transferred out of China. Also, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers. As a result, for certain China-based companies listed on U.S. stock exchanges, the SEC and PCAOB have not had access to the books and records and audit work papers. The SEC and PCAOB are engaging in ongoing discussions with Chinese officials and regulators but have not made satisfactory progress.
The SEC believes that if a company wants to access U.S. securities markets, the SEC needs to be able to directly supervise these entities and the auditors that audit their books and records. Any audit firm that registers with the PCAOB is legally obligated to cooperate and provide documents and testimony, if requested, in connection with inspections and investigations regardless of their locations. If the SEC and/or PCAOB cannot access a company or its auditor, they will seek sanctions and other remedial measures. To help keep investors informed of these issues, the PCAOB publishes a list of companies and auditors for which they have not been able to conduct inspections or obtain sufficient information.
The SEC continues to try and negotiate with Chinese authorities to improve relations and allow the SEC and PCAOB to have timely access to information necessary to conduct investigations or inspections but has not been successful to date. Many China-based companies and companies with significant operations in China want to access U.S. securities markets, but the inability of U.S. regulators to properly access records is causing the SEC concern about the risk to investors. Even if an audit is conducted correctly and financial reports are accurate, there is a greater risk to investors if the SEC cannot do its job and inspect the records. Of course, there is also the very real risk of fraud, which could emanate from a large company (for example, Enron or WorldCom) and have a broad market impact. The SEC is considering remedial measures, which could include requiring affected companies to make additional disclosures and placing additional restrictions on new securities issuances.