Comply at Your Own Risk: Reconciling the Tension Between Western Due Diligence Practices and Chinese State Secrets Law

• Publication year: 2017
• Author: By Raymond Tran*

Comply at Your Own Risk: Reconciling the Tension between Western Due Diligence Practices and Chinese State Secrets Law

By Raymond Tran*

INTRODUCTION

????? (Ten-thousand different matters, the first step is difficult).¹

Since China's market opened in 1978, its maturing companies sought to be listed in U.S. markets to access potentially billions in U.S. capital.² However, to access such capital, Chinese companies and their accounting firms face the quandary of conflicting laws. Complying with U.S. regulatory requirements and satisfying investor expectations for transparency risks violating China's vague State Secret Law. Resolving this conundrum requires the United States and China to overcome their differences in business practice, corporate governance, and accounting regulations. Recognizing this issue, the U.S. Securities Exchange Commission (SEC) and China Securities Regulatory Commission (CSRC) attempted to cooperate by signing a Memorandum of Understanding; but rather than facilitating cooperation, this memorialized the problem. The SEC insisted on cross-border oversight to facilitate inspection, and the CSRC refused to allow cross-border oversight or inspections to protect China's sovereign interests.³ China cannot ignore this problem; even if Chinese companies redirect efforts to other markets, without the solution discussed in this article, similar problems will surface.⁴

Given the failure of prior attempts for joint solutions, China needs to take an approach that aligns with international precedent. China should create the regulatory body discussed in this article that would allow requests from foreign regulators, and enable an approach that addresses U.S. investors' needs to rely on the quality of audits,⁵ Chinese concerns about state sovereignty,⁶ and bi-national desires for clearer procedures.⁷

This article advocates for creating this body with a few caveats. First, the article addresses state secret claims⁸ raised as a result of materials sought for the purpose of due diligence audits, not materials pre-classified by Chinese authorities as state secrets.⁹Second, this article acknowledges the current heightened U.S. listing requirements for Chinese reverse merger companies,¹⁰ even though reverse mergers are an acceptable means to finance a company and go public.¹¹ Finally, this article does not undertake the task of capturing and fixing all "ten-thousand different matters;" instead it argues for China to design a regulatory body on its own soil tasked to resolve the gap in compliance.

Part I summarizes the factors and circumstances that arose when complying with one nation's laws created a dilemma in complying with another nation's laws. Chinese corporate governance and reverse mergers are briefly discussed before the key occurrences which revealed this gap in the law are summarized. Part II discusses the historical issues that need to be addressed to resolve this stalemate, beginning with a discussion on the United States zealously wielding sections of the Sarbanes-Oxley Act to compel compliance, and continuing with an analysis of how China's corporate governance regime is not yet caught up with global standards, as well as a discussion of the interplay of vague statutes and a complex bureaucracy within that regime. Part III is devoted to discussing the proposed solution and analyzing how it resolves the issues presented. It discusses the regulatory body's application in resolving the tension and providing proactive mechanisms for cooperation, and then compares the body to Japan's precedent to illustrate its effectiveness.

I. REGULATORS AND FIRMS: LOST IN TRANSLATION AND FACING SUSPENSION

????, ????? (Three feet of ice does not form over one cold day).¹²

The underlying differences in Chinese and U.S. corporate governance regimes, combined with the influx of Chinese reverse mergers, has revealed the incongruence of Chinese State Secret Law and U.S. regulations. This section discusses the bigger picture of the Chinese corporate governance regime, the phenomenon of Chinese reverse mergers and the occurrences that revealed this gap in the law.

A. Distinguishing Chinese Corporate Governance

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Chinese companies face the dual challenge of raising capital while being restricted from accessing private forms of equity and competing against public companies that can access funds from public investors.¹³ Public listing on the U.S. exchange grants access to capital-rich American public investors and also signals to other potential investors that the Chinese company is capable of meeting the higher U.S. governance standards.¹⁴

Whereas most corporate governance regimes are driven to put assets into private control, the Chinese corporate governance regime is driven by a desire to allow the state to retain control over the listed assets while providing a private alternative.¹⁵ Although China looks to transform its current State-Owned Enterprise framework by converting it into shareholding companies and selling shares to private investors, it still lacks an internal governance regime with adequate fiduciary obligations and oversight structures.¹⁶ Externally, China also lacks governance rules to resolve and enforce budget constraints, accounting standards, financial disclosure requirements, imperfect information, hostile takeovers, and bankruptcy proceedings.¹⁷

B. The Insurgence of Chinese Companies Entering the U.S. Market Without Oversight

The traditional route of going public is an expensive process, and some private companies try to get listed without the traditional public disclosure procedures by acquiring a public company and reorganizing its capital—a process called a reverse merger.¹⁸ The herculean procedures to underwrite a traditional Initial Public Offering (IPO) make the reverse merger particularly attractive: the company legitimately sidesteps the due diligence required of a traditional IPO, accesses capital that it might not afford otherwise, and may also increase its "intangible value" from listing in "a more credible Exchange while crystallising [sic] the raising of capital."¹⁹ When reverse mergers show signs of suspicious behavior, counterparties to the transaction or the SEC request audits to conduct due diligence and verify compliance with standards and regulations.²⁰

A Chinese reverse merger refers specifically to Chinese companies acquiring a publicly traded U.S. shell company with listed stock and projecting optimistic growth to float new issues of stock to enter the American market without public oversight.²¹ Nearly 150 Chinese companies entered the U.S. capital market through Chinese reverse mergers between 2007 and 2010.²² This spike of Chinese reverse-merger activity raised the SEC's suspicions and resulted in the SEC requesting audit work papers prepared by firms based in China for review.²³

C. To Violate SEC Compliance or Chinese State Secret Law?

While these 150 Chinese reverse-merger companies and their accounting firms were in difficult positions, responses from the SEC and CSRC escalated the tension. Compliance with Public Company Accounting Oversight Board (PCAOB) standards would risk violating Chinese State Secret Law.²⁴ By 2010, 130 Chinese global audit firms "encountered questions about their accounting or disclosure," revealing "problems brought to light by auditors who resigned, regulators who suspended or delisted the companies from U.S. trading, or short-sellers and other investors who did their own research into the companies."²⁵

In response, the SEC and CSRC signed a Memorandum of Understanding that provided a vague framework, and ultimately did not cover the transfer of audit work papers, leaving a procedural gap and undefined expectations for cooperation.²⁶ The Memorandum of Understanding did not create any binding obligations; instead, it memorialized the discrepancies between U.S. regulators who sought cross-border or joint inspections, and Chinese regulators who would not allow either to occur.²⁷ The tension increased when the CSRC did not respond to the SEC's twenty-one requests and over thirty communications for cooperation in 2009.²⁸When private auditing firms in China further refused to cooperate with the SEC's requests, the SEC filed lawsuits and administrative proceedings in U.S. courts against each of the Big Four's Chinese affiliates.²⁹

In response to these lawsuits from the SEC, the Big Four's Chinese affiliates claimed that turning over those documents risked violating Chinese State Secret Law requiring Chinese accounting firms to get prior approval from Chinese authorities before they could disclose audit work papers.³⁰ The Big Four's Chinese affiliates also claimed that these audit work papers contained unpublicized and potentially sensitive information that could implicate China's national interests and sovereign authority to determine whether such information can be shared with a foreign regulator.³¹ These SEC administrative proceedings resulted in the SEC unsheathing Section 106(e) and 102(e) of the Sarbanes-Oxley Act to suspend the Big Four accounting firms' Chinese affiliates from practicing for six months, pressuring Chinese firms to submit to U.S. regulations over Chinese laws.³²

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II. THE DISCORDANCE BETWEEN U.S. PRACTICES AND CHINESE SYSTEMS

The incongruence between Chinese State Secret Law and U.S. regulations, whereby compliance with U.S. regulations may result in violating Chinese laws, resulted in Congress increasing the SEC's capacity to obtain foreign audit work papers to pressure foreign companies and their firms into compliance.³³ This section discusses the United States' recent actions issuing and enforcing provisions of the Sarbanes-Oxley Act against Chinese companies. It then analyzes the structural rift between Chinese and U.S. corporate governance regimes, and the internal confusion resulting from combining vague Chinese State Secret Law with complex Chinese bureaucracy.³⁴

A. Cornering China with Sections 106(e) and 102(e) of the...