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A new understanding in transnational audit regulation: exploring the state of relations between U.S. regulators and China.

Between January 1, 2007, and March 31, 2010, U.S. capital market participants invested large sums into small Chinese companies through a process known as a "reverse merger." According to a PCAOB research report on this topic, a reverse merger is--

Broadly used to describe any acquisition of a private operating company by a public shell company that typically results in the owners and management of the private operating company having actual or effective voting and operating control of the combined company. Through a reverse merger transaction, although the public shell company is the surviving entity, the private operating company's shareholders control the surviving entity or hold shares that are publicly traded. In a reverse merger transaction, the entity whose equity interests are acquired (the legal acquired) is the acquirer for accounting purposes. Through such a transaction, the private company, in effect, becomes a SEC reporting company with registered securities without filing a registration statement under the Securities Act of 1933 or the Exchange Act of 1934. ("Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 1, 2010," PCAOB Research Note 2011-PI, Mar. 14, 2011)

By September 2012, however, 79% (126 of 159) of these companies either had delisted from U.S. stock exchanges or had "gone dark," meaning that they no longer filed current reports with the SEC (PCAOB Research Note 2011-PI). Numerous lawsuits have been brought in U.S. courts by shareholders who feared the worst and attempted to recover lost funds.

As a result of these investor losses, sorely needed capital for similar small enterprises in China has virtually disappeared over the past several years--not only from U.S. investors, but also from worldwide sources (Paul Gillis, "Remarks at the China Best Ideas Conference," China Accounting Blog, Oct. 14, 2013). Some experts on the Chinese markets have noted that these small Chinese firms were in over their heads in trying to comply with the U.S. regulatory system (Gillis October 2013), whereas some investors (short-sellers, such as Muddy Waters and Citron) alleged financial improprieties and fraud (Floyd Norris, "The Audacity of Chinese Frauds," New York Times, May 26, 2011).

The attention generated by these and previous investor losses and accounting scandals in China (e.g., Longtop Financial Technologies Ltd., China Biotics, SinoForrest, China Intelligent Lighting & Electronics, China Integrated, China New Century Media, China MediaExpress, ShendaTech) has caused the SEC and the PCAOB to focus on these problems. The regulators have attributed reverse merger losses to a lack of transparency, an absence of due diligence, and a lack of rigor in the normal registration process, as well as a lack of regulatory oversight in the Chinese market, due to the PCAOB's inability to perform inspections--the United States and China have not been able to reach an agreement for PCAOB inspections of China-based auditors on Chinese soil.

International Regulatory Oversight

Complicating any agreements between the countries are Chinese laws prohibiting the removal of documents and information (including audit work papers), an aversion to losing national sovereignty, and an apprehension of divulging state secrets. (Many of the larger entities going public through normal registration statements are state-owned enterprises.) Such laws, which include copied documents in their scope, make off-site auditor inspections via document review impossible. The penalties for violations of Chinese secrecy laws are substantial, including long-term imprisonment.

China's negotiating position has long been that its regulatory oversight should be acceptable to U.S. regulators and should substitute for independent inspections. According to Gillis in a GAA Accounting article (Teresa Lee, "Border Control: Hong Kong Caught in the Middle of the U.S./ China Auditor Tug of War," Oct. 28, 2011)--

   The CSRC's [China Securities Regulatory
   Commission's] current proposition--that
   the PCAOB should rely on the Chinese
   regulator's work--has significant flaws
   because the CSRC is unable to fulfill the
   PCAOB role regarding Chinese and
   Hong Kong firms. ... The regulatory
   power of the CSRC extends only to
   auditing firms that also possess securities
   licenses. But none of the Chinese registrants
   with the PCAOB has such a license
   and is therefore not subject to CSRC
   inspections. CSRC inspections also
   do not apply to overseas-fisted Chinese

Furthermore, the article states the following:

   Hong Kong auditing firms, meanwhile,
   are subject to regulation by the HKICPA
   [Hong Kong Institute of Certified Public
   Accountants] through its practice review
   programme and disciplinary proceedings.
   The Financial Reporting Council
   initiates investigations into auditors of
   fisted companies on the basis of complaints
   but does not discipline or prosecute.
   Another shortcoming, Gillis says,
   is that most Chinese examiners are
   unlikely to be familiar enough with
   PCAOB rules or U.S. accounting standards
   to inspect the audits of U.S.-listed

PCAOB Rule 5113 appears to grant the PCAOB (upon its own motion or the recommendation of the director of enforcement and investigation) the power "in appropriate circumstances, [to] rely upon the investigation or a sanction, if any, of a foreign registered public accounting firm by a non-U.S. authority." The exact meaning of the phrase "in appropriate circumstances" is not discussed or clarified. It is unclear whether this power can be granted to all inspections of a non-U.S. regulator, because the power appears to be written in singular terms (i.e., "the investigation" or "a sanction"). Taken to its logical conclusion, Rule 5113 could be an abdication of the PCAOB's mission. If this happened on a wider scale, there would be a need for alternative oversight of the regulator by the PCAOB--but isn't that the SEC's role with respect to the PCAOB?

The PCAOB's website provides the following guidance about its non-U.S. regulatory oversight:

Under the Act [Sarbanes-Oxley Act of 2002 (SOX)] and the Board's rules, non-U.S. registered firms are subject to PCAOB inspections in the same manner as U.S. firms. This often raises special considerations. The Board began talking about these issues with its non-U.S. counterparts not long after its establishment, and adopted a cooperative framework that allows the PCAOB to rely, to a degree deemed appropriate by the Board, on inspection or enforcement work performed by a home-country regulator. Reliance by the Board is based on a sliding scale--the more independent and rigorous a home-country system of oversight, the more the Board may rely upon it. By developing cooperative arrangements with its counterparts, the PCAOB endeavors to minimize administrative burdens and potential legal or other conflicts that non-U.S. registered firms may face. ( default.aspx)

Some of the cooperative arrangements between the PCAOB and regulators that it has reached agreement with indicate a shared arrangement at best. Many of these countries have regulatory oversight models that are similar to that of the PCAOB, but in no jurisdiction does the PCAOB rely entirely on a non-U.S. regulator. Total delegation of its duties would likely be an abdication of the PCAOB's responsibilities. At minimum, there would be a need to oversee the foreign regulator in order to ensure that the PCAOB remained true to its mission of furthering the public interest and its vision of improving audit quality.

Even if the two countries reach an agreement for joint inspections, the issue of administering punishment for wayward firms likely represents another point of significant disagreement. According to Gillis, China would likely insist that it alone administer any punishment of noncompliant Chinese auditors ("Auditing Wars: Traditional Accounting Regulation in China," Forensic Asia, Jan. 15, 2013). Many experts believe that the PCAOB could not function if the only threat available to it were the deregistration of noncompliant Chinese auditors. Effectively, the PCAOB would create a two-tiered system of administering punishment for poor audit behavior--one for firms with normal sanctions embodied in their rules and another for Chinese firms.

The most promising development in negotiations between the countries came in August 2012, when Chinese regulators agreed to allow PCAOB inspectors to observe the quality control portion of the Chinese inspection of Ernst & Young in China; however, the PCAOB was not allowed to inspect any audit working papers. PCAOB officials indicated that the observations served as a trust-building exercise and did not meet the requirements of an inspection.

SEC Enforcement Proceedings against Auditors

Frustrated over mounting investor losses, the SEC brought enforcement actions against the Big Four (Deloitte Touche Tohmatsu CPA Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen, PricewaterhouseCoopers Zhong Tian CPAs, Ltd) and BDO (BDO China Dahua CPA Co. Ltd) affiliates in China on December 3, 2012, for violation of SOX and "the Securities & Exchange Act by failing to provide the Commission with copies of audit working papers" (Terence Healy, John Tan, and Jennifer Achilles, "SEC Not Backing Down in Fight against Chinese Auditors," Corporate Counsel, Feb. 6, 2013).

The auditing firms argued that complying with the SEC subpoena would permit Chinese regulators to "dissolve the firm entirely and seek prison sentences, up to life ... for partners and employees who participate in the violation" of the very broadly interpreted Chinese State Secrets and Archives Law (Healy, Tan, and Achilles 2013). This law also places limitations on overseas regulators inspecting Chinese companies, requiring approval from the Chinese government (Healy, Tan, and Achilles 2013). As stated above, this is an issue of sovereignty: only the Chinese government may sanction and discipline Chinese accountants.

By drawing this line in the sand and bringing an enforcement action, the SEC forced the hands of the Big Four affiliate firms and the Chinese government to yield to the investigation of the cases. These firms find themselves having to choose between a potential long-term prison sentence in China for violations of Chinese secrecy laws and civil violations in the United States for violations of SOX and PCAOB regulations.

The SEC order instituting the proceedings indicates that the SEC has been trying to obtain audit documentation for several months as part of an investigation of wrongdoing by nine China-based companies whose securities are publicly traded in the United States. The auditing firms have refused compliance with U.S. law, fearing the repercussions in China and potential criminal penalties. According to Robert Khuzami, then-director of the SEC's Division of Enforcement--

Only with access to work papers of foreign public accounting firms can the SEC test the quality of the underlying audits and protect investors from the dangers of accounting fraud. ... Firms that conduct audits knowing they cannot comply with laws requiring access to these work papers face serious sanctions. ("SEC Charges China Affiliates of Big Four Accounting Firms with Violating U.S. Securities Laws in Refusing to Produce Documents," SEC press release 2012-249, Dec. 3, 2012)

The SEC cited in its press release that the initiative and strategy taken is part of the work of its Cross-Border Working Group, which has already deregistered the securities of 50 companies and filed more than 40 fraud cases involving foreign issuers and their executives. The SEC cited actions against Deloitte Touche Tohmatsu for failing to produce documents and working papers for one China-based client, Long-Top Financial Technologies Ltd. According to Kara Brockmeyer, cohead of the working group--

U.S. investors should be able to rely on the quality of audited financial statements. ... Our Working Group's actions demonstrate how the SEC is proactively identifying emerging risks to protect U.S. investors from accounting fraud. (SEC press release 2012-249)

Typically, such an SEC enforcement action case must be settled within 300 days of the date of service; however, the administrative law judge (ALJ) requested a 100day extension until early 2014. All parties appeared to be hoping that a breakthrough with Chinese regulators would allow an exchange of the paperwork requested in the subpoena that is the subject of the enforcement action and possibly a dismissal of the enforcement action.

On January 22, 2014, ALJ Cameron Eliot administered what appeared to be a harsh finding against the Chinese affiliates of the Big Four by suspending them from practicing before the SEC for a period of six months and only censuring the former BDO affiliate known as Dahua. The Chinese affiliates of the Big Four have appealed the decision to the full SEC, the rules of which allow up to seven months for a decision, not including extensions. If the SEC upholds the ALJ decision, the Big Four affiliates may appeal the decision to the Federal Circuit Court of Appeals, requesting a stay to prevent the suspension until the case is adjudicated. No matter the outcome of this process, the problem will likely be replicated the next time the SEC subpoenas records from a firm under Chinese authority. In the author's opinion, it is more likely that this decision will accelerate a political solution, forcing both parties back to the negotiating table.

Although the regulators remain firm in wanting to resolve the open cases, they do not appear to be inflexible, hoping for a resolution to the impasse. Chinese regulators have recently shown signs of compromising with U.S. authorities; the CSRC reached a written "understanding" with the PCAOB in May 2013 and, more recently, made a verbal promise in July 2013 to U.S. Treasury Secretary Jack Lew to assist on a few cases that are still pending (Sarah N. Lynch and Anna Yukhananov, "Treasury Secretary Says China to Hand Audit Work to SEC," Reuters, Jul. 11, 2013, article/2013/07/12/us-chinaaccounting-idUSBRE96902Q20130712).

If these cases go well, it will make future cooperation between foreign governments and U.S. regulators more likely. On October 14, 2013, PCAOB Chairman James R. Doty indicated to a Hong Kong news source that he was hopeful that negotiations for access to inspections of Hong Kong accounting firms, including those auditing Chinese enterprises, would be fruitful (Gillis September 2013).

Striking an Understanding

On May 24, 2013, 144 days after the self-imposed deadline of December 31, 2012 (three years after its initial deadline of December 31, 2009), the PCAOB and the Chinese government reached an enforcement understanding. The PCAOB announced that it entered into a memorandum of understanding (MOU) that "establishes a cooperative framework" with the CSRC and the Chinese Ministry of Finance (CMOF) for the "production and exchange of audit documentation ... in furtherance of investigative duties"; according to Doty, this "is an important step toward cross-border enforcement cooperation that is necessary to protect the interests of investors in U.S. capital markets" ("PCAOB Enters into Enforcement Cooperation Agreement with Chinese Regulators, May 24, 2013, http://pcaobus .org/News/Releases/Pages/05202013_ ChinaMOU.aspx). The sidebar, A Look into the Memorandum of Understanding between China and the PCAOB, delves into several of the MOU's important items.

Such a cooperative agreement had been sought between the parties since the inspection process began in 2005; however, the agreement does not allow the PCAOB to inspect the 47 Chinese audit firms registered with it. In addition, the SEC (which handles administrative matters and sanctions registrants that violate its rules) and the U.S. Department of Justice (which brings criminal actions against registrants when criminal statutes are broken) are conspicuously absent as parties to the understanding. Although agreements have been in negotiation for some time and there is an air of hopeful optimism, no definitive agreements have been struck. If successful, the MOU and subsequent agreements or understandings might eventually be credited not only with saving the PCAOB registrations of Chinese auditing firms, but also with preventing the potential delisting of U.S. companies with operations in China for their failure to be audited by properly registered and inspected firms.

U.S.-listed companies are required to undergo an annual audit that follows GAAS established and maintained by the PCAOB. All auditing firms are subject to periodic PCAOB inspections to ensure that the audits performed are following the rules of evidence embodied in GAAS and that the quality controls deployed by the auditing firm are sufficient enough to ensure a proper level of audit quality. Occasionally, PCAOB inspectors discover departures from GAAP applied by management and signed off on by the auditor. In such cases, PCAOB inspectors provide the SEC with this data in order to ensure that SEC issuers restate their financial statements as needed. Although the current agreement is one of enforcement, the inspection issue is being negotiated. PCAOB officials have indicated that they believe they are close to a deal.

If the deregistration of China-based auditing firms did occur due to a lack of proper inspection, there may also be substantial unintended consequences for U.S.-based companies with substantial operations in China. Because many of the audits of U.S.-based multinationals utilize Chinese auditors to complete a substantial portion of their work on the audits and because these deregistered auditing firms will not be able to play a "substantial role" (as defined by the PCAOB) in the preparation or furnishing of an audit report, the audit might not be able to be completed without sending U.S. auditors to China and complying with Chinese laws and regulations (Gillis January 2013). In either case, the reports of the U.S.-based multinationals dependent upon China-based auditors for a significant portion of the audit of their Chinese operations will likely not be completed on a timely basis, if at all. This could lead to a suspension of trading and possible delisting.

The stumbling block, prior to the MOU or similar agreements that might emerge, was that such disclosure of audit workpapers and other registrant documents would be in violation of Chinese law, potentially subjecting auditors to long-term incarceration. (Eight years to life is not uncommon.) China's official position is that a foreign regulator, enforcing foreign laws on Chinese soil, against Chinese companies, violates China's national sovereignty (Gillis January 2013). The position of the Chinese government regarding the secrecy laws was succinctly stated by PCAOB board member Lewis H. Ferguson as follows:

This concern has deep historical roots, specifically relating to the humiliations that China suffered at the hands of Western powers in the nineteenth and early twentieth centuries. The second concern ... has been a concern expressed that inspection of audit work papers, particularly work papers from the audits of state-owned enterprises, could lead to disclosures of state secrets ("Investor Protection through Audit Oversight," speech at California State University's 11th Annual SEC Financial Reporting Conference, Sept. 21, 2012).

China and the European Union (EU) have previously addressed this situation with an agreement that recognizes "the equivalence of the audit oversight systems in 10 third countries [i.e., any country other than those belonging to the EU (first) or member states (second)]. ... The third countries and EU member states can now mutually rely on each other's inspections of audits" (Gillis January 2013).

Therefore, the MOU can be considered a truce in the transnational audit regulation conflict that has transpired between China and the United States over the past several years. The urgency was brought to a head by the PCAOB deadline, as well as a rash of Chinese companies gaining access to the U.S. capital markets by virtue of a reverse merger and then delisting or going dark, leaving many investors with massive losses. Although these reverse mergers have been small, they have wreaked havoc on the Chinese financial markets; in addition, they bred mistrust and questioned the credibility of Chinese firms from the perspective of U.S. investors. A brief review of reverse mergers will allow CPAs to better understand the scope and magnitude of the problem.

Chinese Reverse Mergers

In a definition that differs slightly from that in PCAOB Research Note 2011-PI, the SEC explained reverse mergers as follows:

In a reverse merger transaction, an existing public "shell company," which is a public reporting company with few or no operations, acquires a private operating company--usually one that is seeking access to funding in the U.S. capital markets. Typically, the shareholders of the private operating company exchange their shares for a large majority of the shares of the public company. Although the public shell company survives the merger, the private operating company's shareholders gain a controlling interest in the voting power and outstanding shares of stock of the public shell company. Also typically, the private operating company's management takes over the board of directors and management of the public shell company. The assets and business operations of the post-merger surviving public company are primarily, if not solely, those of the former private operating company ("Investor Bulletin: Reverse Mergers," investor/alerts/reversemergers.pdf).

Several Chinese reverse merger (CRM) deals from 2001 to 2012 are identified in the Exhibit, as taken from an unpublished paper that identified DealFlow Media as the source of the CRM information (Mary L.P. Chai, Virginia M.C. Lau, and Kitty F. Xie, "The End Justifies the Means? Signaling the Effect of How and Where to List," Seventh Asia Pacific Interdisciplinary Research in Accounting Conference, July 2013, http://www .apira2013 .org/proceedings/pdfs/K227.pdf). It shows a significant increase in activity for 2004 to 2006 and a huge spike from 2007 to 2010, with a slight pullback in 2009 (the U.S. stock market hit a five-year low in March 2009).

The potential abuses of CRMs were outlined in Ferguson's speech at California State University's 11th Annual SEC Financial Reporting Conference:

   To date, 67 of these China-based issuers
   have had their auditor resign, and 126
   issuers have either been delisted from
   U.S. securities exchanges or gone dark.
   ... Billions of dollars of market capitalization
   of such companies have been lost
   in U.S. securities markets and it is fair
   to say that all of these smaller China-based
   companies listed on U.S. securities
   exchanges have suffered serious
   losses of both market value and investor
   confidence as a result of the problems
   of other companies.

According to PCAOB Research Note 2011-PI, there were 159 CRMs with U.S.-listed public shells during a 39-month period ("Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 1, 2010"). Using Ferguson's numbers, a staggering 79.25% of these CRMs studied by the PCAOB are no longer traded, and the auditors of 42.14% resigned. This rate of failure, assuming that all CRMs delisting or going dark are not a result of change in the business (e.g., going private, switching exchanges), is striking. This data set requires further in-depth analyses to better understand the dynamics of what occurred and to provide good recommendations to regulators.

New SEC regulations for reverse mergers. The SEC took action on November 9, 2011, prohibiting a reverse merger company from applying for listing on NASDAQ, the New York Stock Exchange (NYSE), or the NYSE AMX for a period of one year. The one-year delay has been called a "seasoning period," during which a company can fist on an over-the-counter exchange, such as OTC Bulletin Board or another regulated U.S. or foreign exchange. In addition, the SEC mandated that a company have all of its filings up-to-date and timely, as well as achieve a certain minimum share price for 30 of 60 days of trading before the listing application and the exchanges' decision to list ("SEC Approves New Rules to Toughen Listing Standards for Reverse Merger Companies," SEC Release 2011-235, Nov. 9, 2011). This was done because several reverse merger companies failed to file the required reports almost immediately; however, a significant number of these failing CRM firms complied with the requirements for some time and would not have been curtailed by the one-year seasoning period.

In the authors' opinion, it is possible that this action will allow the SEC to catch the truly bad apples, but it could lose other entities that might be sawier about complying with the rules in the short term. The legitimate companies in this group will likely bear the extra costs of switching exchanges. The SEC's actions bring it in line with the rules of other exchanges, including the Hong Kong Stock Exchange.

According to the PCAOB report, as of March 31, 2010, U.S. registered accounting firms audited 74% (116 registrants) of CRM companies, whereas 24% (38 registrants) were audited by Chinese registered accounting firms. Small (triennially inspected, with fewer than 100 registrants) accounting firms audited 94% (147 companies) of CRM companies as of March 31, 2010. Canadian registered accounting firms audited three registrants, and two registrants no longer file financial statements with the SEC.

Based upon its inspections, the PCAOB is concerned that some U.S. registered accounting firms might be conducting audits outside the United States that do not conform to Staff Practice Alert 6, "Auditor Considerations Regarding Using the Work of Auditors and Engaging Assistants from Outside the Firm." The PCAOB commented on this in the report:

   In some situations it appeared that U.S.
   firms provided audit services by having
   most or all of the audit performed by
   another firm or by assistants engaged
   from outside the firm without complying
   with PCAOB standards applicable

   to using the work and reports of another
   auditor or supervising assistants. ...

   ... The Board's inspection staff has identified
   indications that U.S. firms are not
   properly applying AU sec. 543 in the
   audits of companies with substantially all
   of their operations in another country. For
   example, in one instance described in the
   Alert, a U.S. registered accounting firm
   retained an accounting firm in the China
   Region, and the audit procedures performed
   by the other firm constituted substantially
   all [emphasis added] of the
   audit procedures on the issuer's financial
   statements. The U.S. firm's personnel
   did not travel to the China region during
   the audit, and substantially all of the
   audit documentation was maintained by
   the firm in the China region. As noted
   in the Alert, AU sec. 543 does not contemplate
   an auditor taking responsibility
   for the work of another auditor that has
   audited an issuer's financial statements
   substantially in their entirety.

   The Board's inspection staff has also
   observed situations in which U.S. registered
   firms have engaged assistants from
   outside the firm for audit work on companies
   with substantially all of their
   operations in another country. In one
   example described in the Alert, in order
   to perform audit procedures for an issuer
   operating in the China region, a U.S. firm
   engaged a consulting firm whose personnel
   could speak and read the language
   of the area in which the issuer's operations
   were located. The Board's inspection
   staff concluded that the U.S. registered
   Ann's involvement in the audit work
   performed by the consultants was insufficient
   for the firm to assert that the audit
   provided a reasonable basis for the firm's
   opinion [emphasis added] on the financial
   statements, (pp. 7-8)

Future inspections by the PCAOB of any foreign operations will likely review documentation regarding the use of other auditors and ensure that the requirements set forth in the practice alert are being followed.

Foreign Control of Chinese Companies: Variable Interest Entities

The abusive use of special purpose entities (SPE) like those exhibited by Enron CFO Andy Fastow has led to increased scrutiny of these vehicles. The fear of SPEs and China's restrictions on direct foreign investment have led to the use of variable interest entities (VIE) in reverse mergers:

A Chinese VIE is a company that is owned by Chinese individuals, but is controlled through a series of contracts by a publicly listed company. Because Chinese laws prohibit foreign investment in restricted sectors, the VIE contracts arguably avoid the restrictions on foreign investment because there is no actual foreign ownership. Investors would have been wise to stop right there--no actual ownership means what it says. Because the contracts assign most of the benefits of ownership to the public company, the VIE accounting rules allow the company to be consolidated in the financial statements. VIEs are widely used; half of U.S. listed Chinese companies use the structure, as do many multinational corporations.

Control through contract is usually inferior to control through ownership, and many investors in Chinese VIEs have painfully learned this lesson. Over the past few years, several VIE arrangements have cost investors clearly (Paul Gillis, "Accounting Matters: The Three Terrors of Investors in Chinese Stocks," Forensic Asia, Jul. 25, 2013).

Gillis goes on to cite the Alipay case at Alibaba, where Yahoo and other investors quickly realized that doing business in China has its risks, and that the VIE is the vehicle used to exercise control over that business. Other cases cited (China Minsheng Bank and ChinaChem, as well as two cases related to online gaming) illustrate that China might use substance-over-form arguments or mles to counter VIEs used by non-nationals to circumvent Chinese law.

This author agrees with Gillis's claim that the VIE structure is unsustainable, not only in China, but also in other countries that rely on a similar model; however, until more investors lose money, the likelihood of this practice ending anytime soon is unlikely. It is likely that the wholly owned subsidiary structure will experience a rebirth in China, but certain restricted industries will not be funded unless they are opened. The two-classes-of-stock solution is a viable alternative, with foreigners unable to vote but able to become legally recognized owners. Regardless of the method, changes to Chinese corporate law are needed.

A Call to Action

Although it appears that written understandings and verbal agreements represent a good first step in the process of restoring trust and confidence in China's small-capital markets, it is imperative that both sides follow up with actions that back their words. Further agreements are critical to this success, once trust is established in the dealings between regulators in both countries. Too often, China said what the United States wanted to hear, but then failed to follow through. Now is the time to protect U.S. investors and to fund the small and medium-sized enterprises in China that depend upon foreign capital, due to restrictive rules on public investment in China. The VIE structure cannot be relied upon because it can be voided at the will of the Chinese enterprise. A change in Chinese law is needed, and better investment vehicles must be established.

Moreover, the PCAOB and the SEC must remain vigilant by ensuring that auditors follow GAAS as a minimum standard and strive to ensure that all audits are of high quality. Recent SEC actions [e.g., SEC v. Patrizio & Zhao (http://] seem to indicate that the SEC is ready to take the steps necessary to stop poor quality audits. Finally, investors must realize that SEC issuers that use reverse mergers and VIEs represent a significant risks; thus, investors must exercise heightened due diligence.


Mutual Assistance and Exchange of Information

The MOU recognizes the importance and desirability of providing mutual assistance and information exchange on a timely basis in order to enforce and secure compliance with laws, rules, and regulations. Denials are permitted for exceptional items, such as violations of domestic law, requests not made in accordance with the MOU, the public or national interest, or if the request is not sufficient or specific enough.

Scope of Assistance

Under the MOU, assistance includes documents to identify all audit, review, or other professional services; audit work papers and other documents held by the firm that relate directly to the work subject to regulatory oversight; and documents regarding the firm's quality control system. The scope will not be denied if the action is not a violation in the respondent's jurisdiction and does not cover items that are not entitled to protection under the laws and regulations of the respondent.

Requests for Assistance

Requests must be made in writing; specify the information requested; and describe the suspected conduct prompting the request, the purpose for which the information is requested, the link between the law or regulation and the request, the party expected to possess the information, and the time period for the response.

Permissible Uses of Information

Nonpublic information and nonpublic documents may be used solely for the purposes set forth in the request (ensuring compliance with laws and regulations), conducting administrative enforcement proceedings, and conducting an investigation that can lead to sanctions. Any use beyond this must be approved by the other party, and the supplier of the information must be kept informed of the progress and results achieved.


Each request must be kept confidential and nonpublic. In the event of a legally enforceable demand, the party supplying the information must be notified in advance, but must first exert all avenues for exemption or privilege.

Exceptions to Confidentiality

Before sanctioning an auditor, the other party must be notified in advance. The information received under the MOU is subject to the confidentiality provisions of section 105(b)(5)(B) of the Sarbanes-Oxley Act of 2002, which states that the items are "confidential and privileged as an evidentiary matter (and shall not be subject to civil discovery or other legal process) in any proceeding in any Federal or Slate court or administrative agency, and shall be exempt from disclosure, in the hands of an agency or establishment of the Federal Government, under the Freedom of Information Act," with the exception of the possible distribution to the SEC, the U.S. attorneys general, or any of the states' attorneys general. Transfers to other authorities may be requested upon notification stating the reasons for transfer.


The agreement may be terminated with 30 days' notice, but all pending items must still be delivered.

Steven A. Solieri, PhD, CPA, CMA, CIA, CISA, CITP, CFF, CRISC, is an assistant professor at Queens College, CUNY, Flushing, N. Y. He is also a member of Solieri & Solieri CPAs PLLC, New Hyde Park, N.Y.

Chinese Reverse Mergers (CRM)

2001    2
2002    2
2003    9
2004   28
2005   32
2006   34
2007   70
2008   66
2009   45
2010   81
2011   41
2012    8

Source: Dealflow Media, as cited in Mary L.P. Chai, Virginia M.C.
Lau, and Kitty F. Xie, "The End Justifies the Means? Signaling the
Effect for How and Where to List," Seventh Asia Pacific
Interdisciplinary Research in Accounting Conference, July 2013,

Note: Table made from bar graph.
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Title Annotation:Accounting & Auditing: auditing
Author:Solieri, Steven A.
Publication:The CPA Journal
Geographic Code:9CHIN
Date:Apr 1, 2014
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