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Accounting Fraud In US-listed Chinese Companies « Back
Matt Atkins, September 2011
Page 2 of 2
But Chinese sources maintain that that the closer you get to the mainland, the less likely you are to see the type of fraud on show in the US. Where Hong Kong was once a popular location for reverse mergers, the practice is now discouraged, and has been for the past 10 years. Listing in Hong Kong requires evidence of three years of profit, and probing reviews by a listing department of the local stock exchange and independent listing committee. “Chinese companies in Hong Kong are less likely to fool investors than those in the US.

Hong Kong has the advantage of being closer to the mainland language-wise and culturally,” Charles Li, chief executive officer of Hong Kong Exchanges & Clearing Ltd. told Bloomberg. “If I were going to run a fraud, I would find the most gullible people and if the locals in my backyard know that I don’t have a business here, then I will go abroad.” Chinese managers of fraudulent companies listed in America are beyond the reach of authorities; the same cannot be said of companies listed in Shanghai.

US reaction

The Hong Kong authorities indicate that they believe many of the recent problems have been due to loose listing standards in the US, and the SEC has acknowledged problems with the way some companies have been able to list.

Many non-US companies that access the US markets through a reverse merger method rely on small US auditing firms, many of which do not have the resources to meet the auditing requirements. The problem is compounded by the fact that often these firms outsource their audit and review work to foreign accounting firms which may be no more able to comply with the required standings. In these situations, auditing firms may be unable to identify where reverse-merger companies are breaching accounting standards. Some commentators have noted that a number of Chinese companies employed the same auditors and investment banks in their reverse mergers. Whether this shows deliberate malpractice among auditors and banks, or a localisation of lax standards, remains to be seen.

The SEC issued an investor bulletin on 9 June warning investors against purchasing shares in companies that enter the US market through reverse mergers. The bulletin explained the reverse merger process, and described the potential risks of investing in such companies. “Given the potential risks, investors should be especially careful when considering investing in the stock of reverse merger companies,” said Lori J. Schock, director of the SEC’s Office of Investor Education and Advocacy. “As with any investment, investors should thoroughly research the company – including ensuring there is accurate up-to-date information – before making a decision to invest.”

The publication of the bulletin is a continuation of steps taken by the SEC since 2005 to tackle the issue of reverse mergers. The Commission has sought to regulate the practice more effectively. Among the amended securities rules adopted since 2005 are: adding a definition of a ‘shell company’; amending Rule 144 to impose a longer restriction period for resale of securities of a former shell company; and requiring shell companies to advertise their shell company status more prominently in periodic reports.

On 11 July, a joint PCAOB and SEC delegation met with representatives of China’s Ministry of Finance and the China Securities Regulatory Commission (CSRC), seeking a bilateral agreement allowing the PCAOB to inspect audit firms in China. Last month, the PCAOB rejected an application by Hong Kong-based Zhonglei CPA Co. to be become registered with the PCAOB, citing its inability to inspect the firm’s work for companies based in China. While in the near term, accounting fraud will almost certainly continue, the scale and severity of the current crisis has emphasised the need for immediate action. Accounting fraud will only be tackled with the cooperation of the Chinese authorities, and the meeting of the PCAOB and CSRC is a tentative step in aligning US and Chinese auditing requirements. “This meeting is the commencement of our accelerated efforts with the People’s Republic of China to forge a cooperative resolution to cross-border auditing oversight,” says PCAOB Chairman, James R. Doty. “I believe we share a common objective with Chinese regulators to protect investors and safeguard audit quality through our mutual cooperation.”
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