U.S. regulators, in a move to sanction auditors for blocking investigations at China-based companies, have set a course that jeopardizes the listing of more than 100 stocks from the world’s most populous nation.
In a Dec. 3 enforcement action against the China-based affiliates of the Big Four accounting firms, the U.S. Securities and Exchange Commission escalated a three-year impasse between the two nations over whether auditors can share work documents with regulators investigating possible accounting fraud at companies selling securities in the U.S.
“Chinese companies that are listed on U.S. exchanges are being held captive in a sovereignty dispute,” Jim Feltman, senior managing director at Mesirow Financial Consulting in New York. “This is a step in the process to deregister companies that can’t comply with U.S. audit rules. They’ll have to leave the U.S. marketplace if their auditors cannot or will not be responsive to the SEC.”
Of about 400 Chinese companies that trade in the U.S., at least 115 have been audited by the domestic subsidiaries of the Big Four accounting firms, according to data on stocks with market values of at least $5 million compiled by Bloomberg. More than half are audited by units of Deloitte, Ernst & Young, KPMG or PricewaterhouseCoopers.
The auditors say Chinese law prevents them from complying with the SEC’s demands, hindering U.S. efforts to probe allegations of fraud that have wiped 61 percent from a gauge of Chinese and Hong Kong stocks traded in North America since January 2011. Failure to reach an agreement on cross-border access to records may prompt U.S. regulators to seek to deregister the firms, said Paul Gillis, professor at Peking University’s Guanghua School of Management.
“I don’t think there’s a resolution in sight,” Gillis, also an adviser to the Public Company Accounting Oversight Board, said from Beijing. “China is hypersensitive to the idea of foreigners operating within its borders and enforcing foreign law. The next step is likely to be the PCAOB trying to deregister accounting firms it can’t inspect. It’s eventually all leading to the de-listing of Chinese firms in the U.S.”
The SEC, PCAOB, China’s Ministry of Finance and the China Securities Regulatory Commission have been unable to resolve differences over the inspection of audit documents. Chinese law bans the removal offshore of audit papers, while foreign regulators aren’t allowed to work inside the country’s borders.
PCAOB Chairman James Doty said talks and negotiations with the Chinese government are proceeding.
“I continue to believe the Chinese regulatory authorities have every reason to resolve these issues of transparency and access to audit work papers,” Doty said in a statement. “There is no question that we are nearing a crossroads, a decision point.”
Auditors who don’t comply with SEC demands face temporary or permanent deregistration in the U.S., according to the rule under which the proceedings are being brought. China-based auditors signed off on 26 percent of the 159 so-called reverse mergers by Chinese companies in the U.S. between Jan. 1, 2007, and March 31, 2010, Lewis Ferguson, a PCAOB board member, said at an SEC conference in September.
“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,” SEC Enforcement Director Robert Khuzami said in a statement. “Firms that conduct audits knowing they cannot comply with laws requiring access to these work papers face serious sanctions.”
The CSRC didn’t immediately respond to requests for comment. Questions faxed to the Ministry of Finance were not immediately answered.
The SEC has deregistered the securities of almost 50 companies and filed fraud cases against more than 40 issuers and executives as part of its investigation into the non-U.S. based firms. Many of them entered U.S. capital markets through reverse mergers, in which a closely held firm buys a shell company already public on an exchange, allowing them to list shares without the scrutiny of a public offering.
Joseph Christinat, a spokesman for Nasdaq OMX, and NYSE spokesman Rich Adamonis, declined to comment.
A gauge of Chinese and Hong Kong stocks listed in North America has tumbled since its January 2011 peak after short sellers said companies including Sino-Forest Corp. were manipulating their financial information, embezzling money and lying about factories and customers.
Five companies targeted by short-seller Carson Block in 2010 and 2011 lost almost $5 billion in market value through June 2011, according to data compiled by Bloomberg. In addition to Sino-Forest, Block’s Muddy Waters LLC also shorted China MediaExpress Holdings Inc., which was delisted in the U.S., and Rino International Corp. which trades for 2 cents a share over the counter.
“The SEC is unfortunately two years too late,” Kevin Barnes, an equity analyst at Kerrisdale Capital Management LLC in New York, said by telephone. “They are finally filing enforcement action for events that relate to the 2010 fiscal year or earlier,” he said.
Earlier this year, the agency announced a separate enforcement action against the Shanghai-based Deloitte affiliate after seeking to enforce a subpoena in federal court. This week’s action brings to a head the question of whether the SEC is sufficiently armed to protect U.S. investment dollars in China, according to William McGovern, the Asia partner at law firm Kobre & Kim LLP.
“Simply swinging the hammer of enforcement, while effective at garnering headlines, will likely not be enough to achieve the SEC’s goal,” McGovern, a former SEC enforcement attorney, said. “As capital flows from the U.S. to China at an increasing rate the pressure will grow on the SEC to find a way to forge compromise. The path to compromise may mean that the SEC has to recognize China’s sovereign interest in protecting certain industries or companies.”
Ernst & Young LLP will pay $117 million to settle claims in a Canadian class-action suit that Sino-Forest and some of its directors and officers, auditors and underwriters misled investors about business and accounting at the now insolvent Chinese timber trader, Siskinds LLP and Koskie Minsky LLP, the law firms behind the action, said in a Dec. 3 statement.
“Ernst & Young Hua Ming supports close working relationships between regulators to enable them to cooperate and share information with one another,” Will White, director of global and EMEIA media relations for Ernst & Young, said in an e-mail statement. “We hope that an agreement can be reached between U.S. and Chinese regulators that will enable our compliance with all applicable laws and regulations.”
Geoffrey F. Aronow, an attorney for KPMG at Bingham McCutchen LLP, declined to comment. KPMG China spokeswoman Nina Mehra said in an e-mailed response to questions that the firm is “hopeful” that talks between the regulators will result in a diplomatic resolution.
An e-mail to a lawyer for BDO wasn’t returned.
“The fact that the action is being taken collectively against all of the four largest audit firms and one other firm demonstrates that this is a profession-wide issue,” Caroline Nolan, a PricewaterhouseCoopers spokeswoman, said in an e-mail statement. “For its part, PwC China has cooperated with the SEC at every opportunity. However, PwC China will, and must, comply with its legal obligations under China law.”
Lauren Mistretta, a Deloitte spokeswoman, also said in an e-mail that the issue needs to be resolved on a “profession-wide basis.”
Ernst & Young didn’t conduct audits of Sino-Forest in accordance with accounting industry standards, the Ontario Securities Commission said this week in a statement of allegations. Deloitte Touche Tohmatsu resigned as auditor of China MediaExpress five weeks after Block’s accusations in 2011, saying it was “no longer able to rely on the representations of management,” a filing said.
“Nobody really understood the consequences of listing Chinese companies in the U.S.,” Peking University’s Gillis said. “There was an assumption that the normal process would continue to work. I don’t think there was any belief we’d see the number of frauds we’ve seen.”