Chinese listed companies

Professor Paul Gillis, who writes the essential (and highly readable) China Accounting Blog, just came out with a bombshell of a post. Or rather, his post explains the bombshell that landed Wednesday in the form of a 112-page opinion from Cameron Eliot, Administrative Law Judge at the US Securities and Exchange Commission (SEC). Judge Eliot’s opinion prohibits the Big Four accounting firms’ China entities (i.e., Ernst & Young Hua Ming, KPMG Huazhen, Deloitte Touche Tohmatsu, and PricewaterhouseCoopers Zhong Tian) from practicing or appearing before the SEC for six months.

I highly recommend reading Gillis’ post in its entirety, but the short version is that the Big Four’s Chinese entities were found to have violated the Sarbanes-Oxley Act by refusing to turn over documents of US-listed Chinese companies under investigation for accounting fraud. Good ol’ Sarbanes-Oxley. As someone who did a judicial clerkship in Houston not long after the collapse of Enron, it’s oddly comforting to hear echoes of that scandal still reverberating.

The Big Four’s basic defense was quite succinct: Chinese law prevented them from turning over the requested documents. Judge Eliot’s response was equally succinct: then don’t represent US listed companies. In one of many tartly worded sentences, Judge Eliot observed that “to the extent Respondents [i.e., the Big Four’s Chinese entities] found themselves between a rock and a hard place, it is because they wanted to be there.” As Paul Gillis sums up: “Ultimately, the only way this gets settled is if China agrees that companies that list in the US are subject to all US securities laws.”

Judge Eliot’s decision can be appealed, and it appears it will be, but there’s no positive spin on this for the Big Four’s Chinese entities. They defied the SEC, and they got hammered. Although they are allowed to continue practicing before the SEC during the pendency of the appeal, it’s unclear how many of their clients will wait for the other shoe to drop. Would you risk your firm being delisted out of loyalty to an accounting firm that is banned from appearing before the SEC?

It’s this consequence of Judge Eliot’s decision which may have the greatest ripple effect. Once again, Paul Gillis: “Companies could switch to non-Big Four firms and avoid any consequences. There are almost 50 Chinese CPA firms registered with the PCAOB, but few, if any, have the scale and skills to audit the Big Four’s clients. I do expect that some of the second-tier firms like Grant Thornton, BDO, and Crowe Horwath/RSM are going to pick up a number of IPOs given the uncertainty surrounding the Big Four.”

The Big Four, it should be noted, have a near-monopoly on the auditing of public companies in China.

Many of our clients use either the Big Four or second-tier firms to do their accounting work in China. These clients are primarily non-Chinese companies that have WFOEs or joint ventures in China. But if their second-tier accounting firm suddenly acquires a dozen big new clients with upcoming audits or IPOs, what happens to all the regular accounting work for the old clients? The status quo cannot hold, but what will come is anyone’s guess.

As we are always saying, you can win all the cases you want against Chinese companies in United States courts, but getting them to pay is another thing. Yet the march of Chinese companies to US stock market listings may be changing that ever so slightly. For small-time Chinese firms used to doing business on their own terms, often with little regard for contracts, this can be a radical realization.

This is what makes the spectacle of publicly traded Vision China Media’s (VISN) battles in the New York courts such a great test case.

Let me explain.

VisionChina’s business is those television screens playing advertisements in just about every elevator, bus and subway in China. This is an industry that has had some amazing revelations recently. Most notably, China MediaExpress (CCME) is facing so many fraud allegations, NASDAQ has halted trading in its stock (this is a fascinating story in its own right). Meanwhile, most every reputable company working for them has walked away. Fraud in Chinese reverse-listed companies has become almost expected, but VisionChina looks a bit different. It secured its NASDAQ listing by going the traditional IPO route and it is now being accused of simply refusing to pay for an acquisition.

In 2009, VisionChina agreed to buy DMG, an industry rival with a foothold in the subway sector. DMG was particularly appealing because it had just won the contracts for the Shanghai subway systems ahead of the 2010 Expo. The deal was structured so DMG’s investors would get $100 million in cash and stock at or about when the deal closed, along with two subsequent $30 million cash installments on each of the first two anniversaries of the closing date. In “Fear The China Joint Venture And Front-Load Your China Licensing Agreements,” we talked of the importance of front-loading payments in your China deals.

The public documents on the case go into too much detail to cover here, but the gist is that VisionChina put the first $100 million payment into escrow to be released a few months after closing and a large portion of that money was released as planned, with several more million of those escrow funds released a few months later.

After that though, things started getting sticky. VisionChina turned in a couple of very bad financial quarters and then it decided it wanted to re-negotiate its DMG deal. Not surprisingly, DMG had little interest in revisiting its already done deal with VisionChina. Then in August, 2010, VisionChina’s CFO, Scott Chen, resigned and VisionChina’s founder and CEO, Li Limin, had this to say in a press release:

Mr. Chen has made significant contributions to VisionChina Media’s financial management and investor relations. Additionally, he led our successful acquisition of Digital Media Group Limited in 2009 as well as the integration of the two companies. We are saddened by Mr. Chen’s decision to resign, but respect his wish to further pursue his career in investment banking. We are grateful to Mr. Chen for his service to the Company and wish him well in his future endeavors

Not exactly the words of a CEO firing his CFO in a fit of rage.

Now let’s fast forward to December 2010. VisionChina is already late on its second installment payment to DMG and it then pre-emptively(?) sues DMG’s investors claiming fraud. The fact that a Chinese company doing business exclusively in China chose to sue in New York is a testament in itself to the new calculation for US-listed companies.

VisionChina’s complaint sets out the following:

On December 24, 2009, just over a month after the Closing Date, VisionChina received Unaudited Interim Condensed Consolidated Financial Statements for the eight months from January 1, 2009 through August 31, 2009, which had been prepared by Ernst & Young (the “E&Y Report”). The E&Y Report revealed for the first time that DMG’s total revenue for the first eight months of 2009 – the period covered by the Management Accounts – was not RMB 104.7 millions, as represented.

*  *  *  *

[DMG’s investors] must have known that they were giving VisionChina false financial information during due diligence in order to induce VisionChina to enter into the Merger Agreement.

In other words, DMG’s investors misrepresented DMG’s financials. Well, maybe.

VisionChina apparently released tens of millions of dollars from escrow on January 2, 2010, more than a week after it said it received the E&Y Report. Then five months later, VisionChina released millions more. VisionChina apparently waited more than a year after reading the E&Y Report to bring its case against the DMG investors. I know nothing more about this case than what I have read in the public documents, but in my experience companies do not usually wait so long to sue in these sorts of circumstances; there is a saying in the legal business that debts do not get better with age.

In his affidavit, VisionChina’s former CFO, Scott Chen states:

I did not think at the time [of closing that DMG’s] revenue report was particularly impressive…I was primarily concerned  with verifying DMG’s subway contracts because of the strategic nature of the acquisition and DMG’s revenue stream was not the primary reason for the acquisition.

*  *  *  *

The [Ernst and Young] SAS 100 Report did not reveal any issues with the 2009 preliminary management accounts that would have prevented the closing of the acquisition of DMG.

At no time in the period between the signing the Merger Agreement and my departure in August 2010 did I participate in any discussions concerning any alleged fraud in DMG’s unaudited financial statements, nor was I aware of any such discussions.

Remember when Mr. Chen resigned in August 2010, VisionChina’s CEO, Li Limin, said he was “saddened” to see him go.

I’m looking forward to watching this case play out for three reasons:

  1. VisionChina is a Chinese company that listed on NASDAQ by way of a standard IPO. The prevailing wisdom says a company is more likely to be on the up and up if it goes through the more rigorous process involved with this type of listing.
  2. As a U.S. listed company, VisionChina has reasons to be concerned about an adverse New York court ruling and would likely face real consequences if it chooses not to abide by any decisions by that court.
  3. Given ChinaMedia Express’s recent near total collapse, I wonder what another market player taking a major hit will do to the Chinese media sector. I should stress, however, that unlike with ChinaMedia Express, I have seen no allegations that VisionChina is not a legitimate functioning company — merely that it is reneging on its contracts.

Perhaps, most interestingly, unlike many disputes between Chinese and foreign companies, this drama is going to play out in full public view. It should be interesting and I will be watching. No doubt there will be more lessons to be learned from this case.

What do you think?