U.S. stock exchanges and the China problem

Despite a lot of sabre-rattling by regulators and lawmakers, investors keep losing money from Chinese frauds and Chinese companies continue to list on U.S. stock exchanges.

Despite all the rhetoric from U.S. regulators and lawmakers, hyped-up and potentially fraudulent Chinese companies are still applying to list on US stock exchanges, continuing the chronic exploitation of U.S. investors.

The Holding Foreign Company Accountability Act (HFCA) grants the Securities and Exchange Commission the ability to delist foreign companies that fail to comply with securities laws that require companies to be audited by a firm that can be inspected by U.S. audit regulator, the Public Company Accounting Oversight Board.

According to Paul Gillis of Peking University in a recent Bloomberg podcast: “China has a very expansive definition of state secrets such that basically any transaction with a state-owned enterprise in China is considered to be a state secret … for example, my mobile phone bill is technically a state secret.” Chinese audit firms have been using variations of this excuse for years to evade inspection by the PCAOB.

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The law says:

The Commission shall– “(A) identify each covered issuer that, with respect to the preparation of the audit report on the financial statement of the covered issuer that is included in a report described in paragraph (1)(A) filed by the covered issuer, retains a registered public accounting firm that has a branch or office that– “(i) is located in a foreign jurisdiction; and “(ii) the Board is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction described in clause (i), as determined by the Board;

The SEC’s rule requires:

… the Commission to identify public companies that have retained a registered public accounting firm to issue an audit report where the firm has a branch or office that: (1) is located in a foreign jurisdiction, and (2) the Public Company Accounting Oversight Board (“PCAOB”) has determined that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction…

For 15 business days after this provisional identification, a registrant may email the SEC if it believes it has been incorrectly identified, providing evidence supporting its claim. After reviewing the information, the registrant will be notified whether the SEC will “conclusively identify” the registrant as a Commission-Identified Issuer… SEC will (potentially) impose an initial trading prohibition on a registrant as soon as practicable after.

The PCAOB recently issued Rule 6100, a guideline for how it will operate to handle audit firms it is unable to inspect. The PCAOB established this rule as a result of the HFCA, which mandated a response from the PCAOB and SEC regarding how they will evaluate the level of resistance from an audit firm and its client before moving towards delisting.  

In short, the PCAOB will tell the SEC when it is not able to inspect an audit performed by a firm that resists. The PCAOB will provide the SEC a list of the public companies audited by that firm. The SEC will review that list and send an inquiry to the companies to ask that they either verify compliance will occur or change auditors. If the company does not comply or respond to the SEC inquiry that they will change audit firms they face removal from U.S. based stock exchanges. The law went into effect December 18, 2020.

It is too soon to tell what it will take for the PCAOB to formally refer an audit firm and its clients to the SEC.

There’s nothing new about delisting companies or de-registration of audit firms. Delisting is part of the Securities Exchange Act of 1934 and successive updates. Registration/de-registration is a core activity of the PCAOB since its founding in 2002, based on the Sarbanes-Oxley law.

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However, HFCA seems duplicative of existing law and is reactive, enacted to feign focus on a chronically hot topic: Uncooperative Chinese audit firms that provide opinions for the Chinese companies listed on U.S. exchanges that have turned out to be frauds. The law has multiple blind spots companies can exploit to evade delisting, especially the Chinese companies. 

The HFCA focuses on China mainland, Hong Kong and Macau headquartered companies that use China-headquartered audit firms, including those headquartered in Hong Kong. The law is designed to address only companies with a specific business model. In fact, this business model is only a small slice of the entire pie of Chinese companies listed on U.S. stock exchanges and companies that use audit firms the PCAOB has been unable to inspect. 

Chinese companies and their auditors can exploit the loopholes in the law based on the locations of company units and location of the auditor signing the opinion versus the audit firm doing any actual audit work.

Chinese companies can manipulate what is essentially a Rubik’s cube of combinations between business locations and auditor locations. The table below lists the most common combinations of business structures and auditor location.

We reviewed data obtained from the research site Auditor Analytics. We looked at the three scenarios not typically talked about with regard to the new law, the orange, blue and grey lines on the table.

We looked only at data from 2019-2021 for Chinese-affiliated companies issuing audit opinions and found only only 54% are explicitly covered under HFCA. The law seems to overlook roughly 46% of cases, which means investors are left exposed to several other scenarios.

The second largest chunk of the pie above — China-headquartered companies with auditors based outside of China — shows most of the audit firms are located right in the United States. A much smaller number of auditors of China-headquartered companies are based elsewhere, primarily in Asian and European countries.    

We can gain additional insight by understanding the corporate structures, where companies are domiciled, and who the key executive are. The majority of Chinese companies listed on a U.S. exchange use a business structure known as a Variable Interest Entity (VIE) through a country such as the Cayman Islands.  The illustration below from the Washington Post provides an excellent illustration of a typical VIE set-up.

This structure makes it extremely difficult for the PCAOB to review the financial data of China-based companies. These companies create a straw man that blocks U.S. regulator access to actual audit workpapers with detail about China operations audited. Which firm actually signs the audit opinion? Where are the operations an auditor must review? What if the signing audit firm is in a place that won’t allow inspections?  What if the firm doing all the work produces workpapers that can’t be viewed outside of China by a supervising firm or a regulator?

Who are the main PCAOB-registered non-Chinese audit firms signing audit opinions for issuers headquartered in China? Friedman LLP, Marcum LLP and its affiliated firm Marcum, Bernstein & Pinchuk, and WithumSmith + Brown PC.   

Chinese companies may take advantage of the HFCA law’s limitations using the following loopholes.

Loophole I: China-headquartered companies with audit opinions signed by an audit firm outside China

In this scenario a Chinese-affiliated company will establish its charter in the PRC but hire an audit firm headquartered in a different country. Why is this problematic? The auditor must rely on a local Chinese firm to do the audit work. It’s nearly impossible to review and supervise the work of an audit firm in China from somewhere else. That’s why Marcum LLP is currently barred from auditing any Chinese operating companies. During the period of a surge in Chinese reverse merger frauds, the PCAOB highlighted instances of U.S. based audit firms signing opinions for China-based companies without having the ability to adequately review and supervise the work.

Why did the PCAOB drop its guard regarding this issue?  

From 2019 – 2021 Friedman LLP, Marcum LLP, and WithumSmith + Brown PC led the way in the number of audit opinions signed for China-headquartered companies. However, the majority of the opinions signed, more than 50%, were signed in New York (63.57%), California (10.8%), and Texas (9.30%). 

Loophole II: Companies headquartered outside China with audit opinions from Chinese audit firms

U.S.-listed Chinese-affiliated companies can be subsidiaries of China-based companies located in the U.S. or really anywhere in the world and still have opinions issued by audit firms based in China. From 2019-2021 “Big Four affiliated” auditors in the PRC have led the list of China-based firms that sign opinions for Chinese-affiliated companies that are not based in or operating primarily in China.

These companies may fly under PCAOB radar because not they are not headquartered in China. If the PCAOB requests an inspection of a China-based audit firm, the PCAOB may only select audits of only China-headquartered companies. If the China-based audit firms continue to resist a PCAOB inspection, some non- China-based companies’ audits will never be inspected either.

How do China-based auditors perform an audit if the company and its primary operations are based in the U.S. or somewhere else in the world? For example, BeyondSpring is a U.S. domiciled company listed on NASDAQ but the auditor of record, Ernst & Young Hua Ming LLP,  is in China. Recently, a group of U.S.- based shareholders hired a law firm to investigate if BeyondSpring engaged in securities fraud or unlawful business practices.

When trying to investigate or sue BeyondSpring, one must determine how to obtain the company’s financial records. BeyondSpring maintains a U.S. corporate address in New York and a business registration in Delaware but significant business operations and its auditor, Ernst & Young Hua Ming LLP, are in China. Examining business transactions and financial records from the U.S. is virtually impossible given the complexity of BeyondSpring’s business structure.

It’s also quite difficult for U.S. regulators or a U.S. law firm to investigate business operations and obtain records in China as well quite difficult to gain cooperation or interview executives or business partners in China unless a Chinese law firm or forensic accounting firm is providing assistance. Several BeyondSpring operations are based in China, but a few others are based in known secretive offshore financial centers such as the British Virgin Islands.

This is emblematic of another loophole PRC-based companies can exploit to circumvent the Holding Foreign Companies Accountable Act.

Loophole III: Chinese-led companies headquartered in the U.S. or outside PRC with audit opinions from non-China headquartered audit firms 

Chinese companies that place their corporate headquarters outside of China and use U.S. or non-Chinese based audit firms can also exploit a loophole in the law. The company establishes an address for their corporate headquarters in the United States or outside the PRC and hires a U.S. or non-Chinese based public accounting firm to issue an opinion.

A recent example is Forbes Global Media Holdings Inc., with the majority owner headquartered in the PRC, but actual business operations and signing audit firm, so far, in the United States.  The operating company’s executives may be headquartered in the US but its Chairman, and a significant amount of its executive and board activity may occur in China. However, the U.S. based audit firm will claim that a negligible amount of audit hours are necessary for work in China.

The U.S. based audit firm may fail to acknowledge the amount of work expended by the China-based audit affiliate, given the complexity of revising and supervising it from the U.S..

Another example is biotechnology company LianBio, which has its headquarters in China and the U.S.. As stated in their S-1 Prospectus LianBio has significant operations in both the United States and China. There are numerous descriptions of the amount of business they presently and plan to conduct in China.

The company even signed a lease for a new Shanghai corporate headquarters as stated in a recently released 8-K. However, LianBio’s business address in SEC documentation is Princeton, New Jersey and its auditor is listed as KPMG based in New York, New York. Moreover, LianBio’s auditor KPMG US suggests in its Form AP that it worked with another auditor, but does not mention its name.

At the end of their most recent 10-Q they offer this warning to potential investors:

There is no accusation of wrong doing. The PCAOB’s Form AP rules do not require the firm to name any affiliates that provide less than 5% of the engagement hours, but given the extensive descriptions of operations and activities in China it is hard to understand how so little audit work could have been performed in China.

Many of the auditors of record in this scenario are smaller firms, less well-known than their Big Four counterparts. On the surface their client companies look entirely U.S.- based. That enables the audit activities and accountability to fly under the radar of regulators and investors. However, on a practical bases most of these companies’ operations are often in China.

Another example is a company known as Bit Digital. It lists its corporate address in New York City, and even uses a Queens, NY auditor.  Actual business operations are in the PRC, even though on paper they appear to be based in the United States. 

Regulators may want to double check how Bit Digital was allowed to re-list on a U.S. exchange. That’s because originally Bit Digital was known as Golden Bull Limited and was delisted after being accused of fraudWithin 24 months of newly going public Bit Digital faced new allegations of fraud that forced its leadership to step down. Bit Digital now faces a class action lawsuit. Yet somehow is still allowed to trade on the NASDAQ.   

The only thing we can be sure of is this is not the plot of an old Leonardo DiCaprio movie about the art of being an imposter.

Closing the Loopholes

Legislation at the federal levels that attempts to solve the “China fraud” problem has been reactive rather than proactive and duplicative rather than adding something new and useful. Policymakers have given-up and all that’s left is caveat emptor, buyer beware.

Investors should look beyond the hype and potentially less than fully-audited financials to suspicious corporate governance structures and problematic management. This is a classic and time-honored approach to evaluating publicly traded companies. 

In the almost 50 years since President Nixon stepped foot in Beijing China has made great economic strides against the United States. The decision both countries face is one of confrontation or collaboration. Let’s hope the relationship improves so that cooperation, at least as far as financial disclosure and audit integrity, prevails.

© Francine McKenna, The Digging Company LLC, 2022

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