Regulating U.S.-listed Chinese companies

The second issue relates to related party transactions. No details were disclosed by Alibaba as to which related party transactions might be under investigation. Related party transactions have been at the root of many problems with U.S.-listed Chinese companies, as a number of Chinese executives have looted U.S.-listed companies by stripping out assets or burdening them with debt without disclosure to investors. There is no indication that Alibaba has been involved in these types of activities, and it is unclear what the SEC might be looking for.

The third relates to Alibaba's reporting of operating data from Single's Day. Single's Day, a sales extravaganza that occurs every November 11, is China's biggest online commerce day of the year. Alibaba and other e-commerce companies have reported some mind-boggling numbers for Single's Day. The figures filed are not direct sales of Alibaba, since the group does not actually sell products but rather earns commissions and service income for allowing merchants to sell through its platform. Instead, Alibaba reports gross merchandise value (GMV), which represents the total value of transactions processed through its platform. Other e-commerce businesses also report GMV, and a short seller recently attacked Alibaba's competitor JD.com, arguing that the GMV reported by the latter is a meaningless metric. GMV is what is known as a non-GAAP measure, which means that there are no accounting standards for how the value is measured, and that the figures are not audited by external auditors. The lack of rules means companies define GMV differently. A major concern with Chinese companies that report GMV is that the numbers may be inflated by merchants reporting fake sales in a process known as “brushing”. The SEC has announced a major initiative focused on non-GAAP reporting, and Alibaba appears to have become one of the first companies to fall on its radar. Alibaba is unlikely to face serious problems for its non-GAAP reporting, unless the SEC is able to establish that it knowingly reported false numbers. And about the only way the SEC could do that is through a whistleblower.

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Whistleblowers

A whistleblower program was established by the SEC in 2011 to reward those who provide information that allows the SEC to prosecute violations of securities laws. Through 2015, the SEC has paid $54 million to 22 whistleblowers.

There were 43 whistleblower claims filed from China in 2015. The SEC does not disclose whether any rewards were paid with respect to claims from China. While many whistleblower claims relate to false disclosures or market manipulation, others are concerned with the Foreign Corrupt Practices Act (FCPA). Since the SEC has been quite active with respect to bribery by multinational companies in China, a number of these claims from the PRC may be FCPA-related. Since rewards are only paid after the SEC collects a fine, whistleblowers share the frustration of the SEC in pursuing cases against U.S.-listed Chinese companies.

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Enforcement challenges

The SEC has a tortured history with U.S.-listed Chinese companies. Widespread fraud—much of it by companies that came to market using the loosely-regulated reverse merger method—led the SEC to form the Cross-Border Working Group in 2010. The Working Group has enabled the SEC to file fraud cases against more than 120 foreign issuers or executives, and at least another 25 non-fraud cases involving more than 40 other defendants and respondents, most of whom were auditors and other gatekeepers, and deregister the securities of more than 145 firms.

Most of the companies that were deregistered had “gone dark,” meaning they stopped filing reports with the SEC and communicating with shareholders. Many of these were tiny companies that came to market through reverse mergers and failed to obtain listings on major exchanges. Other than revoking registrations, the SEC has not been very successful at prosecuting securities fraud against U.S.-listed Chinese companies. As long as the executives stay in China, they are beyond the reach of U.S. laws. In cases were the SEC has successfully brought enforcement actions, the actors have been American citizens or have been present in the U.S.

The largest SEC case related to China was against the Chinese member firms of the Big Four accounting firms and second tier firm BDO. The auditors had refused to provide access to their working papers related to U.S.-listed Chinese companies, despite a requirement in the Sarbanes-Oxley Act that they do so. The firms argued that PRC laws forbid them from sharing their work with foreign regulators. The SEC won a judgment against the firms banning them from the U.S. market for six months. On appeal, the case was settled with the firms paying a fine and the Chinese government agreeing to a process to produce the redacted working papers.

The SEC faces significant challenges investigating and prosecuting securities law violations by U.S.-listed Chinese companies. While both China and the U.S. are signatories to the International Organization of Securities Commissions' Multilateral Memorandum of Understanding, the SEC has often found it difficult to obtain information necessary for enforcement, to the detriment of investors.

The SEC has tried to use diplomacy to obtain better cooperation from Chinese regulators. The SEC and the China Securities Regulatory Commission (CSRC) have instituted regular staff-to-staff conference calls to facilitate cross-border enforcement cooperation and other information sharing arrangements. Chinese regulators appear to be limited in their ability to cooperate to the full extent due to concerns of national sovereignty and state secrets.

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Regulating auditors

Auditors play a critical role in ensuring that investors have reliable information upon which to make investment decisions. All U.S.-listed companies are required to file annual reports with the SEC that include financial statements audited by a registered accounting firm. The regulation of auditors was assigned by the U.S. Congress to the Public Company Accounting Oversight Board (PCAOB) by the Sarbanes-Oxley Act.

The PCAOB is charged with three primary responsibilities: 1) It sets the standards for auditing U.S.-listed companies; 2) It inspects all auditors that register to audit U.S.-listed companies; and 3) It investigates and disciplines those that fail to comply with the standards.

Since its inception, the PCAOB has been unable to meet its responsibilities with respect to U.S.-listed Chinese companies.

Under Sarbanes-Oxley, the PCAOB is to inspect Chinese accounting firms every three years. When the PCAOB attempted to come to China to inspect the 50 or so accounting firms that had registered with the PCAOB, they were blocked by PRC regulators who argued that the inspections violated Chinese sovereignty.

Negotiations between the PCAOB and the PRC Ministry of Finance and CSRC have continued for more than a decade with little progress.

In 2013, the PCAOB and Chinese regulators reached an agreement on enforcement cooperation, but failed to finalize one on inspection access. And without inspections, the enforcement agreement is of little benefit.

The U.S. and China have an annual Strategic and Economic Dialogue (S&ED). The U.S. team is led by the Treasury Secretary and the Secretary of State. In 2011, the PCAOB began to participate in the S&ED in an effort to find a way to better cooperate with Chinese regulators. While this effort likely led to the enforcement cooperation agreement, it has failed to reach agreement on inspections.

The most recent S&ED was held in early June in Beijing. No agreement on inspections was announced; rather a joint commitment to continue to work on the issue was made:

“Both sides express appreciation for the mutual efforts and extensive work undertaken since last year's S&ED to advance cross-border cooperation on the oversight of the audits of public companies. Building on the results of last year's S&ED, both sides are to endeavor to begin inspections in the near future and are to continue to explore effective ways of long-term cooperation in this area in order to protect investors and promote public trust in each country's capital markets.”

Efforts during the past year to reach agreement on inspections failed. The reason is believed to be Chinese insistence that certain sensitive domestic companies are not to be inspected, including state-owned enterprises and internet businesses. Such a restriction is unacceptable to the PCAOB.

There seems scant opportunity for the PCAOB and Chinese regulators to bridge their differences. The PCAOB may be forced to bring action against the Chinese audit firms it cannot inspect (which include the Chinese member firms of the Big Four). The outcome of any disciplinary action could include a deregistration of Chinese audit firms that the PCAOB is unable to inspect. Such an action would mean that most U.S.-listed Chinese companies cannot be audited by a registered firm, which would lead to the delisting of these companies from the U.S. capital markets.

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Privatization and relisting

Widespread fraud with U.S.-listed Chinese companies has scared many investors from the market, and a number of stock prices have dropped below the IPO valuations. At the same time, Chinese equity markets have soared and, even after a major correction, they still value companies significantly higher than those in U.S. markets. That has led to 47 U.S.-listed Chinese companies announcing plans to delist from the U.S. since 2015. As of June 22, 2016, there are 91 Chinese companies listed on NASDAQ, and 49 on the NYSE.

The plan for most of these firms is to buy back shares from U.S. investors at depressed prices, delist from U.S. exchanges, and then relist on China's stock exchanges, often using the same reverse merger technique they initially used to list in the U.S. At first China encouraged this process, even having the state-owned China Development Bank fund many of the going-private transactions. Perhaps Chinese regulators saw the privatization and relisting process as a means to resolve conflicts with the U.S. over regulating the companies. Once relisted in China, the companies could see valuations that were multiples of those in the U.S. Recently, PRC regulators have become concerned that these transactions might be creating a bubble that can burst and hurt Chinese investors, and have indicated they will clamp down on reverse merger transactions.

There has been much criticism that the SEC has failed to protect U.S. investors in these take-privates, but most of it is misplaced. The SEC's responsibility is to ensure certain investors have adequate information to evaluate going-private offers. Most U.S.-listed Chinese companies are incorporated in the Cayman Islands, which offers scant protection to minority shareholders in privatization transactions, and the SEC is not empowered to override Cayman Islands law.

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The future

It appears the market may solve the regulatory problem for the SEC. Chinese companies now seem to prefer Chinese equity markets to the U.S., and the trend of delisting from the US and relisting in China is likely to continue. Chinese equity markets are also opening up to foreign investors, but the question will be whether the regulators are up to the task of protecting shareholders.

Paul Gillis, Professor
Guanghua School of Management, Peking University, Beijing

Alibaba Group Holding Limited, the largest Chinese e-commerce company, listed on the New York Stock Exchange (NYSE) in 2014, marking the largest initial public offering (IPO) in history. The company chose to list in New York instead of Hong Kong or Shanghai in part due to more flexible U.S. listing requirements and, by doing so, became subject to regulation by the Securities and Exchange Commission (SEC).

Alibaba recently disclosed that it is the subject of a probe by the SEC into its accounting practices. While Alibaba has indicated it is cooperating with the investigation, many U.S.-listed Chinese companies have not been as willing. There have been more than 100 cases of alleged fraud at U.S.-listed PRC firms, and investors have lost billions. The SEC has been largely ineffective at enforcing U.S. securities laws against these Chinese businesses.

A statement made by Alibaba CEO Jack Ma with respect to the SEC investigation raised eyebrows: “Alibaba's business model does not have any references in the U.S., so it's not just a matter of one or two days for the U.S. to understand Alibaba's business model.” Alibaba's annual report filed with the SEC is 298 pages long, and Ma's suggestion that it is not adequate for U.S. investors to understand the business has been negatively received.

The SEC's investigation of Alibaba is focused on three areas. The first is whether Alibaba should be consolidating its logistics arm, Cainiao, in its books. This is a highly technical accounting question. Alibaba has responded by significantly increasing disclosures related to Cainiao, which may or may not satisfy the SEC. This may ultimately come down to the SEC questioning the judgment of Alibaba and its auditors, but it is unlikely to create significant problems for the company.