I am about to heartily recommend a book that I have not read, nor even seen.

The book is The Big Four and the Development of the Accounting Profession in China (Studies in the Development of Accounting Thought, by Paul Gillis. And despite not having read the book, I am quite certain it will make for a helpful read. I am certain of this because Paul Gillis knows as much about the big picture China accounting issues as any other English language speaker out there. Paul has written extensively and well (both on his blog and elsewhere) about the Big Four in China and about China big picture accounting issues and if his book were nothing but a compilation of previous writings (which it is not), it would still be well worth the read. Paul is to whom I refer journalists and others seeking answers to China accounting questions because he is the guy with the answers.

So if China accounting is your thing, read the book.

For a pretty comprehensive list of recommended English language books on China (with a slant towards those that are instructive for doing business in China or practicing China law) check out A New China Book List.

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.

Back in 2011, we were writing like crazy about the risks of China VIEs.  And every time we did, someone with a financial stake in one would tell us that we were being too negative.  VIE stands for variable interest entity and those are entities that are used to allow a company in China to technically be a Chinese domestic company, but de facto controlled by a foreign-owned entity or entities.  VIE structures are usually used to allow foreign companies to get involved in various sectors of China’s economy that are forbidden to foreign companies.

In our last piece on VIEs, entitled, VIEs In China. The End Of A Flawed Strategy, we vehemently set forth the proposition that they are to be avoided:

None of this is actually new. These risks have long been known. However, the clarity of the Regulations means it is now nearly impossible to claim that Chinese law on these issues is ambiguous or unclear. Where Chinese law says that ownership by foreigners is restricted or prohibited, the law means what it says.  Foreigners who invest in violation of the law are making a bet that the violation will be ignored. This is extremely unlikely in today’s China. Such bets are sucker’s bets and should be avoided at all costs.

We have been speaking out against VIEs for years and just about every time we do so, someone says that if they are illegal, why have so many large law firms, large accounting firms, and large companies gone along with them? The answer is simple. Money. Big money. Really big money. Now, some of these same law firms and accounting firms and companies are denying that anything has changed. And why is that? Again, money. Only this time they are taking positions not so much to make more money going forward, but to avoid losing through lawsuits the money they have already made.

And then we stopped.  Not because our position on VIEs had changed, but because we had said our piece (way more than once) and it was time to move on.

I am writing on VIEs today not just to say to everyone who doubted us that we told you so, but to emphasize that whatever the risks were with VIEs back in late 2011, they are even greater now.  They are even greater now because exactly what we said about China’s laws forbidding VIEs has been borne out by a recent China Supreme Court case with a very unfavorable ruling for those invested in a VIE.

The New York Times Deal Book did an article on that case today, entitled, In China Concern about a Chill in Foreign Investment, on the recent case. According to the Supreme Court, the contractual agreements between the foreign and the Chinese company “had clearly been intended to circumvent China’s restrictions on foreign investment, and amounted to ‘concealing illegal intentions with a lawful form.'”  Though some commentators in the story talk of how such deals are more “sophisticated” today, in the end, they too are “intended to circumvent China’s restrictions on foreign investment….with a lawful form.”

The article goes on to note that since 2010, “Shanghai’s arbitration board has invalidated two variable interest entities that had been used by foreign companies to control onshore businesses. In one case involving an online game company, the panel applied China’s contract law to reach the same conclusion as the supreme court in the Chinachem case — saying that the variable-interest entities were ‘concealing illegal intentions with a lawful form.'”  It then quotes Paul Gillis (who truly knows whereof he speaks when it comes to VIEs) to the effect that “China is attacking these VIE structures and the other ways that people have used legal form to get around the substance of what Chinese law says you can’t do.’

We were not surprised.  Were you?

No fewer than three people have sent me an article, entitled, “The Simplicity of Chinese Accounting Scandals.”  All three people raved about the article, one going so far as to use the term “revelatory” in describing it.  Wrong, wrong, wrong.  There is absolutely nothing revelatory about it and that is the heart of the problem.

The article consists mostly of a list of four methods commonly used by Chinese companies to perpetrate a fraud on their investors.  Paul Gillis, who knows China accounting better than just about anyone, is the progenitor (I’ve been waiting years to use/mis-use that word) of the list.  And it is a good list in that all of the methods are fairly common.

But here is the problem.  These sort of accounting cheats are not by any means peculiar to China.  They are cheats that have been employed again and again all around the world.  Yes, Virginia, even in the United States.  There is nothing new here because when it comes to fraud, there is rarely anything new under the sun.  I doubt there is an auditor with even two months of experience at any big accounting firm who has not already been trained to look out for every single one of them.  These methods are not even interesting because they are so routine.


No, the big deal here is not so much the methods of cheating, but the need to always be vigilant for cheating.  In other words, the big deal here is the need for anyone who is buying a Chinese company (or any company for that matter) to look at every number/every line item with a very healthy skeptism.  We talked about this in our post last year, entitled, Buying A Chinese Company? Why China Deals DON’T Get Done.

Yes, Chinese company fraud is no doubt far more common than in the United States and, in many instances, more blatent and bolder.  But in the end, thorough due diligence is necessary everywhere and it works most of the time.  Most of the frauds I have seen (and I have seen far too many) could easily have been spotted had the victim merely done the basics to try to uncover them.  We have ended many of our posts on topics like this by saying “trust yet verify.”  When it comes to investing in China, one word suffices:  verify.

What do you think?

GLG Research is going to be moderating what I am certain will be a fascinating discussion tomorrow on China VIEs and the SEC’s pending investigation into New Oriental Education (EDU). The event is entitled, VIEs – SEC Investigation into New Oriental Education and it will be taking place live on the net and by teleconference on July 25 at 2:00 PM EDT.

The two speakers at this event will be China Law Blog’s own Steve Dickinson and Paul Gillis, Professor of Practice at Guanghua School of Management at Peking University.  The webcast/teleconference is expected to focus on the following:

  • The structure and legality of VIEs
  • The enforceability of New Oriental Education’s (EDU) VIE contracts under Chinese law
  • The Significance of the SEC’s investigation into EDU and its impact on other US-listed VIE companies.

For more information on this event, go here.  If you miss it live, there will be an audio replay within around 24 hours and there will also be a transcript available for purchase.

For those of you who really want to prepare for this event beforehand, I recommend you read the following China Law Blog posts:

And the following China Hearsay posts:

And the following China Accounting posts:

And the following China Finance posts:

If you read all of the above, you will probably know more about VIEs than anyone else alive. If you are going to read just one post, make it “Explaining VIE structures.” Oh, and just to give you more to read, I also recommend you read the Silicon Hutong post, “VIEs, The Long Resolution.” In that post, David Wolf talks of how the Chinese government likes to “boil its frogs slowly, not all at once,” and he then talks of how VIEs are on the wrong side of where China wants to be going.

For the seventh straight year, Danwei has come out with its Model Workers List of best China blogs in various categories. Yes, China Law Blog is on the list, but honestly, we are running this link-over because the list is so thoughtful, so informative, and so thorough.  Danwei’s blog list is considered by many (me included) to be the definitive list of best China blogs.

Danwei breaks the blogs out into various categories, the most relevant to our readers being “Business and Law,” which consists of the following (my comments are in italics):

  • Buy Buy China. A website about Chinese consumers, the retail industry and branding.”  I am embarrassed to admit this is the first I have seen of this blog, but it is very good and it fills an important niche. 
  • China Accounting Blog. Paul Gillis’ blog provides detailed insight and accessible commentary on topical accounting issues in China. This is an especially useful resource for following the Big Four corruption scandal.” This blog is on our blogroll (which we take very seriously) for good reason. Gillis knows more than anyone out there writing on China accounting, particularly as that relates to China’s publicly traded companies and VIEs.  
  • “China Car Times. Developments in the car industry, new models and news, and reporting on Chinese auto shows.” I’ve been a big fan of this blog for a long time; the only reason it isn’t on our blogroll is because it is so industry-specific.  But if you are doing anything relating to cars in China, it’s a must-read.
  • China Economic Review. News, reportage and commentary.” Not a blog, but definitely the best English language China business magazine on the planet.
  • China Hearsay. Commentary on Chinese legal affairs and business by Beijing-based lawyer Stan Abrams.”  It’s an excellent blog and it’s been on our blogroll since our inception — for good reason.
  • China Law Blog. Practical commentary on Chinese law and its application to business. Includes lots of no-nonsense advice for small companies and information about general issues of interest to anyone doing business in China.”  What can I say beyond the fact that I really like the description we get.
  • Chinese Law Prof Blog. Analysis and articles on Chinese legal issues by law professor Donald C. Clarke. The true dean of China law blogging and an absolutely first rate (and often highly topical) blog.  It too has been on our blogroll since our inception and that too has been no accident.  
  • Jerome Cohen’s blog. Blog of the venerable Professor Cohen.”  Calling Professor Cohen venerable is an understatement. He is truly the dean of China lawyers.  His blog makes for a great read, mostly on deep-think legal and political issues.
  • Jing Daily. Interviews, articles and news about luxury products, marketing and business in China.” Along with Maosuit (see below), the place to go regarding China’s luxury market.
  • LawAndBorder. Visa and the law for foreigners living in China and emigrating Chinese.” These are the guys to whom my firm refers China visa matters. ‘Nuff said.
  • Maosuit. Fashion and couture from an expat seasoned in the industry. Includes plenty of photos and some commentary on the latest Beijing fashion shows and private screenings. Along with Jing Daily (see above), the place to go regarding China’s luxury market.
  • Silicon Hutong. Business, PR, Internet and technology from China media and tech industry veteran David Wolf. See also Wolf’s Twitter feed.” I have been a huge fan of Wolf for years.  He just gets it when it comes to China business, particularly media and internet.
  • Stylites A tastefully minimal blog documenting street fashion and the fashion industry in Beijing and beyond. I’m hardly qualified even to comment.

Anyway, if you are looking for some more good China reads, I urge you to check out the ones above that appeal to you and I also strongly suggest you go to Danwei’s full post to check out the list of other great China blogs.

What do you think?

On November 4, CLB’s own Steve Dickinson participated in an Internet discussion regarding Variable Interest Entities (VIEs) in China. The discussion was entitled, “Foreign Ownership in China: Still VIEable?” and the other participants were China Hearsay’s Stan Abrams (an attorney), China Accounting Blog’s Paul Gillis (an accountant), and China Finance Blog’s Fredrik Öqvist (a financial analyst).  A full transcript of the proceedings can be found here. If you have any interest in VIEs or investing in the companies that have VIEs, I strongly urge you to read the transcript. I also urge you to check out this post on VIEs, which has a long list of good readings on VIEs.

What I found most interesting about the discussion is that everyone seemed to agree that Chinese courts will not enforce the contracts on which VIE structures are based. In light of this, what exactly do U.S. listed companies with VIE structures really have in China?

For the last couple of years, there has been massive discussion regarding Variable Interest Entities (VIEs) in China. We at China Law Blog have taken a strong stand on them and our position has always been that we will not do them because we do do not think they hold up to legal scrutiny. Or to put it another way, our law firm is too small to withstand the onslaught of malpractice litigation we forsee when these VIEs start to unravel.

Under a VIE structure, a Chinese Internet provider is effectively owned by a foreign entity through a complex set of contractual arrangements, rather than through ownership of stock.  The control by the foreign entity is so total and complete that the arrangement is considered the equivalent of ownership under U.S. accounting rules. However, by there being no actual foreign ownership of stock, these VIE structures have managed to operate in China, evading the clear rules restricting foreign ownership.

Our concern has always been that the Chinese side in these deals will be able to jettison the foreign company because the foreign company will not be well positioned to fight back because its connection with China is not legal. We are hearing that none of the Big Four accounting firms will have anything more to do with VIE deals so it appears that our stand on this issue has now become the new reality.

Others do not see things the same as us and think that we are being too cautious and that VIEs are too important to China and so will always be protected.

This Tuesday, November 1, there is going to be a web discussion/debate/cage fight involving some very outspoken people on VIE structures. The event is going to consist of CLB’s own Steve Dickinson (an attorney), China Hearsay’s Stan Abrams (an attorney), China Accounting Blog’s Paul Gillis (an accountant), and China Finance Blog’s Fredrik Öqvist (a financial analyst).

There will also be a VIE-related Q&A through the G+ site during the course of the week. Anyone with an interest in VIEs should tune in. Go here to find out more. The main event will take place this Tuesday, November 1, from 10 am until 11 am EST.

For background on VIEs, I suggest you read the following China Law Blog posts:

And the following China Hearsay posts:

And the following China Accounting posts:

And the following China Finance posts:

If you read all of the above, you will probably know more about VIEs than anyone else alive. If you are going to read just one post, make it “Explaining VIE structures.” Oh, and just to give you more to read, I also recommend you read the Silicon Hutong post, “VIEs, The Long Resolution.” In that post, David Wolf talks of how the Chinese government likes to “boil its frogs slowly, not all at once,” and he then talks of how VIEs are on the wrong side of where China wants to be going. I could not agree more. I do not see VIEs disappearing overnight; instead, I see foreign companies involved with VIEs suffering a very long and very gradual squeeze out.

What do you think?

Chinese Law Professor has an excellent post, entitled, “Who Owns The Chinese Internet,” seeking to answer that very question. The post is in reference to this article [in Chinese] by Jing Linbo and Wang Xuefeng from the Chinese Academy of Social Sciences, asserting “(a) that foreigners (“foreign capital”) in the article’s terminology) have come to control the Chinese Internet, and (b) that this is a bad thing.”

Chinese Law Professor analyses whether or not foreigners do control China’s Internet and he concludes they do not. In fact, he persuasively argues that many of the Variable Interest Entities (VIEs) to which the Linbo/Xuefeng article cites, are actually controlled by Chinese, not foreigners:

  • Take Baidu (the Cayman Islands company listed on the NYSE), for example. 52% of the voting power is owned by Robin Li, either directly or through a BVI company he owns and controls. Another 16% is owned by his wife. Except for a Scottish partnership that holds 2.49%, the rest of the voting power appears to be widely held. In other words, foreign capital is helping out Robin Li, but exercises no control. Robin Li, to the best of my knowledge a patriotic citizen of China, controls the offshore company and the money.
  • Sina.com presents a third model. The president and CEO, Charles Chao, is of PRC origin. (I don’t know if he is still a citizen.) He appears to be the largest single shareholder, controlling over 8.66% of voting rights. Only one other shareholder holds more than 5% of the voting rights. In other words, the shareholding is largely dispersed and there is no controlling shareholder. Since Jing and Wang admit in their 2009 article that Sina.com has no controlling shareholder, how then can they claim at the same time (as they do) that the company is “controlled by international capital”? They state that ownership of more than 50% of the shares constitutes absolute control, but this means that some unified will – a single person or a unified group – has to control all those shares. In grammatical terms, the subject of the verb “to own” has to be an entity capable of thinking and expressing a will. “International capital” is not a person with a unified will. The authors appear to believe that in a 10,000,000-share company, if 5,000,001 foreigners each own one share, that is “foreign control” just as much as if one foreigner holds 5,000,001 shares. It is not. One can always identify a group of random and unconnected shareholders in any company whose holdings add up to more than 50%; that does that mean that they control the company. When a company has no controlling shareholder, who does control it? The answer is: management. And in the case of Sina.com, management appears to be predominantly in the hands of Chinese nationals.
  • Dangdang presents another model of control. In this case, the Chinese entrepreneurs – Li Guoqing and Peggy Yu – don’t have absolute, majority control. They do, however, control more than 45% of the company’s voting power and occupy the top management and board positions. This doesn’t look very much like control by foreign capital.

To which I say so what? To me the big question is not who owns China’s Internet? I know the answer to that and if you define it by who actually controls the content or who actually has final say over the overwhelming bulk of Internet companies, it is the Chinese. I mean, come on. Chinese law effectively precludes foreign involvement and though there are foreign companies involved in China’s Internet through VIEs and other patchwork solutions, those companies are always going to be at least somewhat beholden to their Chinese “partners.”

The better question is who is perceived in China, by Chinese, to “own” China’s Internet? 

if the perception in China becomes that foreigners control China’s Internet, that perception will lead to repercussions for those entities that are perceived to be foreign and perceived to control China’s Internet. Or as the China Accounting Blog put it in its post, “Communist Party School on VIEs:

We have already seen regulatory challenges to VIEs, leading to Yahoo losing its interest in Alipay, and alleged theft of a VIE.  Now we can add political risk.  I think it is time to again ask the question whether VIEs are a going concern.  I started this series suggesting that the VIE could be compared to the fable of the Emperor’s new suit – not really doing what people are told they do.   My recommendations to clean up this sector remain valid.

The China Real Time Report blog of the Wall Street Journal has picked up this story. There is also a good analysis of it at China Finance Blog.   An interesting read on the legal theories at play here was posted by Professor Clarke at the Chinese Law Prof Blog.  I like his conclusion:  “I think we all agree that these structures are OK until they are not OK.”  Are we there yet?

China Finance blog is more blunt. In its post, “China IT Just Got Even Riskier,’ it starts out noting that the Linbo/Xuefeng article has deemed China’s Internet to already be controlled by foreigners and that this does not bode well:

The piece doesn’t just brand the obviously foreign companies as being controlled by foreign capital, but includes almost every Chinese internet company in this group. As such the risk of increased scrutiny of VIE structures (explained at lengths in the article), and any dealings between foreign and domestic players in the sensitive IT market has gone up significantly.

China Finance Blog then goes on to note that no matter how accurate the article is or is not regarding foreign control of China’s Internet, the “bigger picture” is what is going to matter:

Although I think the report misses the mark on some issues, the details are unlikely to matter too much, the bigger picture will sell it.

One of my disagreements with the article lies for instance in that the Alipay case to some extent demonstrates the power that VIE structures can give the Chinese government over the IT-companies, rather than highlight the dangers of foreign investment.

That this issue is being discussed in this detail, at this level, at this point in time, should give everyone reason to take this quite seriously, indeed.

The last time I wrote on VIEs, Paul Gillis of the China Accounting Blog left the following comment:

What about all the lawyers who have given clean opinions to the use of these structures for the past decade?

What about all those lawyers? Don’t cry for them. Any lawyer worth his or her salt that was involved in a VIE structure wrote a lengthy CYA letter making crystal clear that VIEs were risky, that the whole purpose of VIEs is to usurp/circumvent Chinese law, that Chinese law is itself risky, and that nobody really knows what will happen to VIEs or for how long they will be allowed to exist.

China Hearsay spoke to this as well, in its post, “Gray Areas in China Law: A Vote For Legal Realism:

I think what this comes down to is that Dan Harris and I are looking at this [VIE structures] as practitioners. If a client wants to do a deal in a restricted area by setting up a structure that has never been shut down by the government in 25 years, I still can’t tell that client that this is a “gray area.” I just can’t do it as a lawyer, for basic liability reasons.

What I can say is that it is technically illegal, and then explain the history of enforcement (or lack thereof). If the client then wants to proceed, then (in some cases), I will stay on board and help facilitate the transaction (in some cases, I will beg off).

I think I might add something along the following lines: VIES. They were risky yesterday and they are even riskier today. They are okay right now and will be okay until they are deemed not okay. I have no idea when or if that will ever happen, nor does anyone else, but hey, you are big boys and it’s your money, so you make the call.

What do you think?

I was on a panel of speakers yesterday at the Offshore Investment Conference 2011. We panelists were to give a statement enunciating “the one key point” from the talks we had given earlier in the day. Yongjun Peter Ni, who heads Zhong Lun’s tax practice, said something about how foreign companies need to abide by China’s tax laws because China is now very serious about enforcing them. My first thought when he said that was “absolutely” and my second thought was that this is becoming true of all the laws that apply to foreign companies.

In the last few years, corporate taxes in China have assumed pretty much the same level of significance for Western companies as in their home countries. China’s increased emphasis on maintaining transfer pricing controls is a salient example of this.

Which brings me to the China Accounting and the China Finance blogs. Both of these are relatively new blogs dealing with China accounting/finance issues and both are well worth reading.

China Accounting Blog is written by Paul Gillis, an Assistant Professor of accounting at Peking University’s Guanghua School of Management. Gillis joined academia in 2007, after an almost thirty year career at PricewaterhouseCoopers. China Finance is by Fredrik Oqvist, one of Mr. Gillis’s former students. Both have been providing in-depth coverage on Chinese Variable Interest Entities (VIEs) and reverse mergers.

Accounting and finance are rising to prominence in China and if you want to keep up, you should be reading China Accounting and the China Finance.

What do you think?