Restoring confidence: Strengthening the regulatory system for PRC firms listing overseas

The diagram below describes the process of listing overseas. Overseas companies are usually shell companies. The planned company is a shell company usually established in the British Virgin Islands or the Cayman Islands, where the local political, economical and tradable environment is stable and many conveniences and preferential taxes are implemented. The investors normally refer to private investors including some investment banks or private equity funds, etc. The choice of a Hong Kong company as an intermediary entity is common due to the close relationship between Mainland China and Hong Kong and due to preferential tax policies. Between 1999 and 2010, more than 91 Chinese domestic entities landed on American stock exchanges using the VIE structure. In 2010 alone, there were 38 domestic entities listed through the VIE structure on foreign bourses, including 34 on US stock exchanges and four on the Hong Kong Stock Exchange. The VIE structure has become a trend for Chinese entities listing abroad.

From the diagrams it has been noted that during the process of an overseas listing, the substantially operating entity retains onshore status, while the overseas listing company is just a shell company, which results in great potential legal risks. On August 8 2006, six PRC regulatory agencies, including the Ministry of Commerce (Mofcom), the China Securities Regulatory Commission (the CSRC) and other four administrative authorities jointly promulgated the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors (关于外国投资者并购境内企业的规定) (M&A Rules), a new regulation with respect to the mergers and acquisitions of domestic enterprises by foreign investors that became effective on September 8 2006. This was revised by Mofcom on June 22 2009. Subject to the M&A Rules, a domestic entity engaging in an overseas listing by equity merger shall require approval from Mofcom and the CSRC. However, until recently, the Chinese government had turned a blind eye to the VIE structure. In addition, towards the VIE structure, significant uncertainties exist because the overseas shell company is capable of controlling the domestic company simply by way of signing a series of contractual agreements. In the recent Zhifubao case from March 31 this year, a debatable issue arose that astonished overseas investors. Ma Yun of Alibaba.com unilaterally terminated its VIE contracts with Zhifubao, which directly ended up giving the actual controlling power of Zhifubao to foreign shareholders, Soft Bank Corpation and Yahoo! Inc. The termination of the VIE contracts led directly to the listed company become a complete shell company and this highlighted the VIE listing structure as being unstable and uncertain.

As of August 25 2011, Mofcom issued the Provisions for the Implementation of the System for Security Review of Acquisition of Domestic Enterprises by Foreign Investors (实施外国投资者并购境内企业安全审查制度的规定) (Security Review Rules). Although this action is regarded by most specialists and experts as a Chinese governmental response to the VIE structure after the Zhifubao case and the VIE is now listed in the review scope, the regulatory range of the security review is limited to those industries or companies that may affect state security. Most companies intending to list overseas do not reach this threshold of requiring a security review, therefore the application of the Security Review Rules is unclear. However, these new rules reflect the current attitude of the Chinese government towards VIE structures to some degree.

The CSRC had no jurisdiction over offshore listing companies, and it is difficult for the SEC to make on-site investigations. Mary Schapiro said those questionable PRC companies used the remoteness between their operating location and the listing location to successfully conduct fraud transactions and escape from penalties. A related regulatory system needs to be built up to revive and improve the credit access and reputation of Chinese companies.

The listing rule differences between the US and the PRC are an important reason why some Chinese companies choose an overseas listing. The US adopts a registration system, while the PRC adopts an approval system in queue. The registration system obligates a company to submit its materials in a complete and accurate manner to the security administrative agency for registration subject to relevant laws. The security administrative agency then conducts a formal examination over the veracity, accuracy, completeness and timeliness of the application materials subject to the principle of information disclosure, and the value of the company stock is left to be judged by the market.

Therefore, the short registration time and low thresholds are obvious attractions to listing on US stock exchanges. It normally takes six months to a year to realise a listing in the US. In comparison, China has implemented the approval system. The approval system obligates a company to disclose its true information and be in compliance with the requirements of Chinese laws and regulations, and to follow necessary conditions required by the CSRC. The securities regulator is entitled to deny the application for a stock issuance by a company under the circumstance of non-compliance with the CSRC's requirements. The CSRC conducts not only a formal examination, but also substantial extra examinations such as reviewing the management structure of a legal person, the character of business, capital elements, development prospects, quality of senior management, competiveness of a company, etc. A company is usually required to experience a complicated procedure, a stringent examination and a high threshold when listing in China. This process often sees a company spending three or more years attempting to list. Some companies urgently desire to be listed for financing purposes and approach the process without adequately preparing or providing the requisite information to listing authorities. This leads to all sorts of problems later on. Some intermediary organs will help certain companies to list by performing fraudulent actions (eg. creating false reports) to deceive listing authorities. Therefore, the creation of a related regulatory system is imminent.

The said two regulatory systems have respective advantages and disadvantages and mutually complement each other. For the purpose of strengthening the build-up of a regulatory system, some regulations adopted by the Chinese approval system may be taken as reference.

Training system prior to an overseas listing

In current practice, most Chinese companies with an overseas listing are private enterprises controlled by one or several actual controllers. The actual controller knows little or nothing about the overseas listing information – from the law, accounting, oversight of overseas listing, etc. In contrast, Chinese companies will most likely choose a listing location in developed countries or areas where the capital markets are mature, there is a developed regulatory system and the requirement of the actual controller is higher. This significant loophole puts forward potential risks in an overseas listing.

The CSRC implemented the Measures for the Administration of Initial Public Offerings of Shares and the Listing Thereof (IPO Measures) (首次公开发行股票并上市管理办法) and the Measures for the Administration of the Sponsorship of the Offering and Listing of Securities ( Sponsorship Measures) (证券发行上市保荐业务管理办法) in May 2006 and December 2008 respectively. Pursuant to the provisions of the above regulations, the sponsoring institution is obligated to, prior to an initial public offering (IPO) of stock and listing, carefully check and train the Chinese company on the spirit of due diligence and credit. The sponsoring institution is obligated to train the directors, supervisors, senior management, shareholders with not less than 5% of equity interests and the actual controller (or the legal representative). The training content includes, but without limitation, the grasping of relevant laws and regulations, understanding the rights and obligations in respect of information disclosure and promise fulfillment, and establishing the awareness of credit, self-discipline and compliance with law. After the completion of training, the local branch of the CSRC will review the results of the training.

To better gear this training, a competent governmental authority (for example, the SEC) should stipulate regulations governing the training system for senior management in a domestic entity. This will help rectify the thought direction of senior management objectively, to clarify that a listing is for the long-term development of the company asides from financing; that it will help to establish a scientific company management structure, to improve internal accounting controls, and to enrol the company in international competition and set it on an international path. To make this training system more practical, the liability of a related administrative authority, the obligations of training the institutions, the content of training and methods of examination should be very detailed. Moreover, the examination result should be publicised, and an additional training section may be involved in the prospectus.

Regulating the accounting system

In the scandals of certain US-listed Chinese companies, most of these were found to have different tax payment records and financial data recorded at the State Administration of Commerce and Industry (SAIC) and its local branches from those submitted to the SEC. Due to different accounting principles onshore and offshore, some minor differences are permitted. However, large contradictions always lead to doubts. In practice, some companies use 'creative' methods to pay very little or no taxes at all, so by some strange phenomenon, it appear that some companies are actually earning large volumes of profits while their accounting books show a different story, one of financial loss or limited revenue. Some companies actually prepare several different accounting books: one for themselves, another for the competent tax administrative agency, another for the local counterpart branch of the SAIC and yet another one for auditors, which causes different institutions to have different accounting books for the same company within the same period. For the purpose of an overseas listing, some companies will select the most favourable of the above accounting books or will create a new accounting book. These dodgy practices demonstrate that an improvement of an internal accounting supervision system is urgent.

Other than the aforementioned training tailored to senior management, an investment into an internal accounting system and human resources should be strengthened to improve supervision and create publicly transparent accounting information. A company should employ staff who have already completed US GAAP and internal management training, and should also employ large accounting firms to provide consulting services in respect of internal controls. The company shall establish a stable and high-level financial team to strengthen the confidence of investors for its financial reports. After an adjustment and improvement of financial management, the company can engage an accounting firm recognised by the Publicly Company Accounting Oversight Board (PCAOB) as an auditor. In addition, senior management should communicate often with the Chief Financial Officer (CFO) and avoid situations where there is a frequent change of CFOs.

Improving the corporate management structure

At the moment, a number of domestic substantial entities of Chinese companies listed in the US consist of domestic private companies that are controlled by a family. At the early stages of private enterprises, these companies were usually controlled by a family – which allowed for a cohesive power to develop quickly that was bound by blood relationships. This is one historic reason that explains the highly centralized management structure many of these PRC companies have. The actual controller is the founder who is entitled to limitless authoritative power in a company. Other senior management must obey the actual controller, and sometimes the board of directors or supervisors wield no influence either. A scientific or logical decision-making system and democratic management system can be absent from some of these PRC entities, and important policies are entirely determined by the actual controller himself or themselves. These random and unsystematic controls bring about the potential risks. The special situation of the actual controller makes the relevant management rules difficult to put into practice.

To possibly remedy this, the current corporate management structure should further strengthen and empower the board of directors, and improve the quality of directors and the ratio of independent directors. The directors should be familiar with the corporate business and be responsible for challenging the authority of the actual controller. Independent directors should carefully monitor from the sidelines and ensure that corporate actions are conducted in the best interests of shareholders. To carry this out, it is material to engage independent directors that have mastered corporate industry, capital markets, accounting principles, security laws, information disclosure, sale and other aspects. Additionally, the ratio of independent directors in the board of directors needs to be increased.

The above corporate management structure shall not only be built up in the overseas listing company, but also in the domestic substantial entity because almost every significant decision is made and carried out by the domestic entities. Therefore, for foreign investors and foreign security censorship institutions, they should pay more attention to the corporate management structure of the domestic entity. It is recommended that the information, with respect to the corporate management structure of the domestic substantial entity, shall be disclosed in the prospectus. It is a dynamic challenge to build up an efficient, scientific, and democratic corporate management structure that is accepted by the companies, and that is also recognised and protected by China and the US.

Information disclosure system

Information disclosure is highly emphasised in listing matters everywhere. Since a listed company is a public one and many investors purchase stocks outstanding, the public investors have the right to timely and thorough knowledge about all a company's information in respect of business management and other aspects. The company has the obligation to publicise and disclose the related information accurately, completely and in a timely manner. The crux of the current problem is that the listed company is a shell company abroad, while almost all of its assets and the senior managements of the operating entity are inside China. Guaranteeing the quality of information disclosure is a very material issue.

Shanxi Puda Coal Group Co. (Puda Coal Group) is a Chinese domestic entity that conducts explorations of coal resources, and produces, processes and transports coal and production-of-coal chemical products. In 2005, Puda Coal Inc.( Puda Coal), a shell company for Puda Coal Group, successfully landed on the Over the Counter Bulletin Board (OTCBB) in the US. After combining Puda Coal's accounting sheets under the US' GAAP, it was no longer regarded as a shell company but a public company controlling Puda Coal Group. As of September 22 2009, Puda Coal transferred to the bourse NYSE Amex Equities (Amex), raising almost US$30 million in capital. In July and December 2010, Puda Coal Group and Citic Trust entered into agreements, joining a trust plan. As of April 8 2011, Alfred Little (a prominent blog on investment in China) featured an article doubting that Puda Coal had become a shell company in 2009 and that it did not disclose the affiliated transactions to American investors. Affected by this article, the share price of Puda Coal plunged and as of April 11 2011, the NYSE had to delist the stock temporarily. Bernstein Liebhard Law Firm and the Audit Committee of Puda Coal each announced they would make investigations respectively. According to the records of the competent branch of the SAIC, as of September 3 2009, the equity interest of Puda Coal Group incurred a great change and Puda Coal Group registered with the competent branch of the SAIC pursuant to Chinese laws. However, this substantial change was not disclosed in the filings as of November 13 2009 to the SEC. This change was not disclosed to foreign investors until April 8 2011. It is hard to believe that Puda Coal made another two financing transactions after the change of equity. The total financing sum amounted to US$116 million.

In the Puda Coal case, besides the company itself, each intermediary organ should be held accountable for their respective obligations. Learning from Puda Coal's example, financial consultants or investment banks should select qualified and credible domestic companies to back for an overseas listing and carefully conduct an oversight of the actions of those companies. The accounting company as auditors should disclose the internal change of relevant financial information of the domestic entity. The law firm should conduct thorough due diligence and provide other requisite legal services. Therefore, related provisions governing the actions performed by each of the intermediary organs shall be included in the establishment of a regulatory system. These provisions shall, without limitation, identify and clarify respective scopes of duty, content, terms, liabilities and other aspects of each intermediary organ responsible for an overseas listing.

Shared oversight

Recently China and the US have begun to strengthen bilateral cooperation and communications in respect of overseeing companies that list in either jurisdiction's capital markets.

In May 2011, in the third-round strategic economic dialogue between the PRC and the US, the Chinese delegation led by Wang Qishan, Vice Prime Minister of the State Council of the PRC, and the US Department of Treasury, the SEC, and the Public Company Accounting Oversight Board (PCAOB) had discussions. The issues relating to joint oversight is included in a dialogue communiqué between the PRC and the US, and the two countries agreed to speed up regulatory cooperation. The two countries welcomed the continuation of bilateral talks, were working hard to reach the agreement of multinational supervision, and they agreed to accelerate the process together.

The project concerning the cross-border oversight discussed by and among the PRC Ministry of Finance, US Department of Treasury, the CSRC, the SEC will be achieved in the near term. The direct appeal from the US is that the US and the PRC shall establish a work mechanism, including information exchange concerning oversight of accounting firms providing audit services to the Chinese companies, and that the two countries can jointly perform spot checks. China would be entitled to the same right in the territory of US. Currently, the scope of investigation and the penalties administered to auditors by the Ministry of Finance and the CSRC remains internal. When China has a mature international capital markets board, the above administrative authorities are likely to go to the US and conduct similar investigations

Towards the legality of overseas listing structures, especially the VIE structure, it is recommended that the Chinese government should maintain restrict limitations upon the industries related to the national economy and livelihood, strategic development and safety. This would safeguard these industries from being controlled by foreign investors by means of the VIE structure for the sake of national security. Then, the authorities should loosen the ties binding the Permitted and Encouraged industries. In addition, the government should amend some regulations, such as: 1. adding an independent director to the board of directors in a WOFE; 2. stipulating in the articles of association that without the prior written consent of an independent director, VIE contracts cannot be revised or terminated; and 3.VIE contracts shall be recorded with the competent AIC for the convenience of review by the public and supervised by the competent AIC.

Final thoughts

A wise solution to the current credit crisis of Chinese companies is to improve the building of a regulatory system in a timely matter, including, but without limitation, training and examining senior management, improving financial matters and the corporate management structure, strengthening the effect of intermediary organs with respect to information disclosure, and enlarging and deepening cross-border oversight. It will be the combination of internal efforts and external support, and the cooperation between onshore and offshore that will propel Chinese companies from their current dilemma of a credit and credibility crisis.

Wang He, DeHeng Law Offices, Beijing