In the past few years, a reverse merger has been a popular way for China-based companies to access U.S. capital markets. Since the end of 2010, a number of companies that have engaged in such mergers were accused of committing accounting fraud, resulting in a suspension in trading or even delisting. They have also been under investigation by U.S. authorities for violating securities laws or found themselves targeted by class action lawsuits represented by U.S. plaintiffs' lawyers. Most of these besieged companies were found to be lacking robust corporate governance and internal controls. The purpose of this article is to introduce our experience in conducting internal investigations as an effective response to head off claims of improper conduct. The author will outline several commonly-seen irregularities revealed during the course of these investigations, highlighting the need of U.S.-listed Chinese companies to enhance their compliance mechanisms.

I. Audit Committee Initiating Internal Investigations

When a company is facing U.S. government inquiries, or brought into class action lawsuits, or if such a possibility is looming ahead, the company should investigate as soon as practical to determine whether the claims and allegations are true. Launching an internal investigation demonstrates to the outside world that the company is managing the crisis in a responsible and proactive way. If the outcome of a properly conducted investigation is positive, it affords the company the best evidence to convince regulators to suspend inquiries, and seek relisting.

Internal investigations are initiated typically as a result of the following events:

  1. Short-selling investment research firms usually look for and identify discrepancies between the company's U.S. disclosure and its corporate annual filings maintained at Chinese Administration of Industry and Commence (AIC), and then issue research reports based on these findings, accusing the company of fraudulent accounting practices;
  2. The company's external auditor has suspicion of accounting fraud during its annual auditing, but cannot obtain satisfactory explanations by the company, or is even obstructed from continuing audit work. The auditor resigns, resulting in delayed submission of the company's audited quarterly or annual filings, in turn triggering a halt in trading or delisting;
  3. The company's business competitors or disgruntled employees make anonymous complaints to the Securities Enforcement Commission (SEC) and the stock exchange where the company's shares are bought and sold;
  4. Occasionally, the SEC may initiate investigations without first being tipped off.For instance, in July of 2012, SEC started its probe into New Oriental Education's VIE structure, and the day after the SEC's announcement of its investigation, U.S.-based short-selling firm Muddy Water issued its research report questioning New Oriental Education's accounting practices.

Most U.S.-listed Chinese companies are accused of fictitious revenue records, fabricating cash balance and account receivables, undisclosed related party transactions, and unlawful lending and borrowing practices.

For listed companies, an internal investigation is normally launched by an audit committee created by the board of directors. The audit committee first hires a U.S. law firm to lead the investigation. Because the majority of the investigation work is expected to be carried out in China, the U.S. law firm would engage a Chinese law firm, and typically, a reputable international accounting firm's China-based affiliate. Because members of the audit committee are mostly comprised of independent directors, and due to the high level of professional ethics expected for legal counsels' accountants, final findings made by them have a high likelihood of being accepted by U.S. authorities. Their findings become the factual foundation to convince the government to drop charges.

A successful internal investigation is critical for a troubled company to maintain its listing status. To minimize negative impacts brought about by the internal investigation, the audit committee should first formulate a well thought-out plan.The goal is to carry out a thorough probe while at the same time avoiding intrusive obstruction over the company's daily business operations. The remainder of this article will briefly discuss an internal investigation's general procedure, and some tips.

II. Walking Through the Internal Investigations Process

  1. Initiating Internal Investigations

After forming an investigation team comprising an army of counsels and accountants, the first task is identifying issues. They are chiefly based on the allegations and suspicions raised by the short-selling firms, government authorities, public media, or former auditors.With these issues in mind, the investigation team formulates a road map.

The whole process typically takes four months or even more to conclude. Since the stock exchange staff members would not suspend their delisting proceedings simply because of the company's initiation of an internal probe, the investigation team must prioritize its work and focus on the most serious allegations, such as the veracity of the company's trading records and balance sheet. It is well advised to aim at delivering an interim report within the first two months of the internal investigation, with an attempt to produce preliminary yet substantiated findings on those most damaging accusations. If the investigation team can successfully demonstrate that it has been working diligently and vigorously, but still could not unearth any serious accounting fraud, the stock exchange staff members may be persuaded to suspend their delisting proceedings awaiting the team's final report.

The investigation road map should also take into account the pace of the SEC inquiries.If the SEC has issued subpoenas ordering the company to deliver commercial and accounting records for its review, the internal investigation team is in a better position than the company's management to collect documentation required for submission.

  1. Document Review

The first step of any internal investigation is to collect the company's documents including electronic files saved on computers used by executives and key employees, including the president, general manager, finance director, production manager, sales manager, and administrative director, etc. Electronic document retrieval is generally performed by the accountants as they possess the electronic discovery software to accomplish this job. If one of the key issues to be investigated is related to verification of sales records, the accountants will also retrieve data from computers used by employees from the sales and finance departments. The degree of cooperation demonstrated by the company reflects whether the company is trying to cover up any evidence of accounting fraud.

The amount of data collected from dozens of computer hard drives is quite significant, typically amounting to several million copies of electronic files and e-mails. Junior members of the investigation team would spend a week or so performing preliminary document review, with the aim of eliminating irrelevant files. Documents potentially relevant to the issues are tagged and categorized into different "issue folders". The contents of key documents are also summarized. Even after the initial screening, the number of files left would still be in the range of 10,000. If the company under investigation is a production enterprise, most of the documents collected would be related to raw material purchase, product manufacturing and sales records. It is the accountants' job to pull out the company's physical books and records, and make verification against the original sales and revenue data saved on the computers.

While the accountants are retrieving and screening electronic files, the lawyers' job is to request and review corporate files such as contracts and transactional documentation. It is very unlikely that the company could hand over all the requested document in one batch, we recommend using excel forms to track which documents have been provided, and which are still outstanding. This also makes it easier to add new document requests to the list as the investigation reveals more sub-issues to be followed up.

  1. Interviews with Employees and Third Parties

At the same time the document reviewing process is underway, the investigation team should conduct a first round of interviews with the company's senior executives.It is not recommended to directly delve into the issues. The purpose is rather to understand the corporate structure, management hierarchy, manufacturing process, transaction patterns, sources of financing, so that the investigation team can understand the documents they are reviewing.

Following the completion of document review and the first round of employee interviews, the investigation enters its key stage – external interviews with the company's financiers, guarantors, related parties, suppliers and customers. Taking manufacturing companies as an example, the focal point of US short-sellers' accusations is on the company's sales revenue disclosures. To verify the veracity of sales transaction records, the investigation team must conduct interviews with the company's customers, asking questions about the previous transactions. Aside from interviewing these customer companies' supply managers, the accountants should also conduct sampling by reviewing selected accounting records kept by the customers, as a way to confirm whether they match with the records obtained from the company. Pertinent records normally include transportation vouchers, inventory entries, invoices, payment receipts, etc.

During this process, the investigation team should try to avoid causing too much disruption to the company's business relations with its customers and bankers. If the questions asked are considered improper or even offensive, it would not only impede the effectiveness of the investigation process, it may also end up jeopardizing the company's source of revenues. Some U.S. attorneys are skeptical about the independence of external interviews arranged by the company's management.In our experience, however, appearing at a third party's business premises without prior announcement actually increases the chance of obtaining either valueless or untruthful information. The interviewees are not mentally prepared to answer intrusive questions about their business and accounting practices. As many domestic companies more or less have accounting irregularities, when encountered with unscheduled meetings, some interviewees' first defensive mechanism is to hide or even to lie about the business transactions between them and the company. This causes serious issues on the accuracy of the information obtained.

Having the company's management arrange third party interviews does not mean the investigation team will accept the arrangement made without any reservation. During the document review stage, we have collected the company's key customers' business addresses.Sometimes, it is advisable to hire a professional investigator to verify these addresses. The investigation team should not take information received from the company at face value. As we have learned from past experience, some Chinese companies do create fictitious customers and their legal addresses as a way to defraud external auditors. That said, not every discrepancy between the customers' real operating address and its AIC-recorded addresses mean it is a fraud.It is not uncommon for some Chinese companies to have their actual business operation premises located at a different place than their registered legal addresses, in order to receive local government incentives from places where they register their legal addresses. Sometimes a company also finds it difficult to move its original registered legal address because the local authorities want to retain its tax contribution. As a result, many Chinese companies have to separate their actual business addresses from their registered addresses.

  1. Verifying Sales Records

Not all apparent discrepancies can be easily explained by the investigation team. In one case, one of a company's top-five customers suddenly stopped buying products at the beginning of 2011. Because the timing was quite close to the FY10 annual audit, the former external auditor decided to conduct a thorough review of that customer ("Customer A"). Unfortunately, because most of the previous transactions were concluded by telephone or fax, and the company's responsible sales person had left, no one at the company knew much about Customer A. When the former external auditor visited Customer A's business address recorded on the company's transaction documents, it turned out that it was not a business address, and phone calls made to Customer A's regular contact person always went unanswered. The company could not provide a satisfactory explanation, and eventually the external auditor resigned.

Following the former auditor's resignation, the company's audit committee swiftly engaged our firm and initiated an internal investigation.During our external interview with one of the company's other customers situated in Southern China ("Customer B"), we realized that the missing contact person of Customer A was actually Customer B's employee. That employee purchased products from the company under the cover of Customer A, and then re-sold the same products to his employer Customer B and cut decent profits in between. When Customer B realized it had been defrauded by its own employee, that person resigned and closed down Customer A's business. Unfortunately, Customer B did not communicate its findings to the company. We pulled the sales records between Customer A and Customer B, and it turned out that they match the sales records between the company and Customer A.

Based on our experience, very few companies dare fabricate their sales figures. It is more likely they exaggerated the company's growth potential and business model, or concealed misconduct falling in so-called "grey areas", for example, mischaracterizing trading customers as production customers, or failing to disclose indirectly-controlled related parties. A large portion of such non-disclosure was not done purposely but rather due to ignorance of rules imposed on U.S. listed companies.

  1. Concluding Investigation

After concluding external interviews, the investigation team will conduct a final round of internal interviews with the company's management personnel, major shareholders, and financial advisors who assisted the company in the listing. They will be questioned on the issues and problems identified during document review and external interviews, and given a chance to provide explanations and clarifications. The whole process normally takes one or two weeks. After wrapping up these interviews, the investigation team will prepare a final investigation report and submit it to the audit committee.

In our experience, many Chinese companies accused of committing accounting fraud did not fabricate sales revenues or profit margins. However, almost all of them are not in strict compliance with legal and accounting rules, such as setting up off-the-book accounts, using the same underlying transaction or project to obtain multiple bank loans, evading of China's foreign exchange control regime, and borrowing from "shadow banks".

III. Comments

  1. Enhance Internal Control, Foster Corporate Governance

We have noticed that many investment banks and financial advisors that helped a company gain listing in the U.S. have failed to build a strong internal control and compliance infrastructure for the company.Many China-based companies' executives know very little about rules and regulations that need to be strictly followed.Although they hire U.S.-trained Chinese financial advisors as CFOs, many of the CFOs reside in the U.S. for most of the year, and mainly focus on raising capital in the U.S. securities market.As a result, they have to rely on second-hand information passed from the company's sometimes less competent and trustworthy local accounting managers.

  1. Crisis Management

When a company becomes a short-sellers' target or is under investigation by U.S. regulators, the company must stand firm against these short-selling institutions, make timely announcements rebuking unfounded accusations, and if necessary, file defamation lawsuits against slanderers. When Evergrande Real Estate was hit by short-sellers in June 2012, its crisis management is an excellent example of how a company should react when faced with adversity. At that time, U.S. short-selling firm Citron made serious accusations that Evergrande committed accounting fraud and had already been insolvent.Evergrande swiftly made public statement rebuking Citron's allegations, followed by a more detailed and thorough clarification the next day. Within the next few days, Evergrande also garnered support from Citibank, Deutsche Bank, Bank of America Merrill Lynch, JP Morgan Chase, Credit Suisse, UBS, Macquarie Securities and DBS Bank.They unanimously gave Evergrande shares a "buy" or even higher rating. Evergrande's shares then rebounded.

Even if a company is gaining positive references in the media, an internal investigation is still very necessary in order to provide to the outside world substantiated evidence that the company is clean. The company's full cooperation is the key. In many internal investigations we have conducted, we find that Chinese companies are still lagging behind their Western peers in terms of transparency. For example, in one case, we obtained incomplete records showing that the company maintained an off-the-book account. When we questioned the responsible accounting manager, his admission of wrongdoing was initially limited to the records we had found, and he denied there have been any other transactions relating to that account.However, we later discovered the full extent of the records through electronic discovery process. Although most of the income and expenses relating to the account are legitimate, the stock exchange where the company's shares were traded eventually refused to allow the company to resume trading, and based its decision mainly on the company's intentional withholding of information from the internal investigation team.

IV. Conclusion

The crisis that hit so many US-listed Chinese companies in 2011 may be gone, but the compliance risks remain.New Oriental Education became the latest victim of U.S. short-sellers in July 2012.After the SEC announced it commenced investigations into the company's variable interest entity structure, it had been named in seven class action lawsuits in less than two months.Strengthening internal controls is the best way to root out improper conduct that will attract short-sellers' attacks, and when the company becomes a target of U.S. regulatory inquiries or plaintiff's law firms, a properly conducted internal investigation coupled with a successful public relations campaign is the best proactive approach to bring the company out of the legal morass.