A complex spat between America’s securities regulator and the Chinese affiliates of five multinational accounting firms has led to multiple media reports that all Chinese companies could be forced off of US stock exchanges. Investors in such firms are puzzled over why a disagreement between regulators about potentially dishonest companies is affecting the shares of well established Chinese firms that have not been accused of fraud.
Shares in companies such as search giant Baidu and social-media behemoth Sina Corporation have slumped in the last few weeks because of this accounting issue, even though these companies are not involved in the dispute. (A Baidu spokesman could not be reached. Sina declined to comment.)
Here is why all Chinese firms listed in the US are now caught in the crosshairs:
The US Securities and Exchange Commission has for over two years been investigating a group of Chinese companies for fraud. First, the Chinese securities regulators did not help the SEC do its work (paywall). The SEC then tried to examine the books and records of these companies but was told that Chinese companies’ audit records are state secrets. The Beijing authorities have supported that position.
This enraged the SEC to the point that it has charged China affiliates of five of the world’s biggest accounting firms (KPMG, PwC, Deloitte, Ernst & Young and BDO) with violating securities laws. It is this case that could lead to Chinese companies being forced off US stock markets.
The hypothesis has a few twists and turns. So here is a summary in our own words, followed by a fuller explanation by an expert lawyer:
This seems ludicrous. But the problems are very real.
Jacob Frenkel, a former SEC enforcement lawyer who now leads the white collar crime, corporate investigations, and corporate governance practice at US law firm Shulman Rogers, explained the legal and regulatory position more fully. Here are a selection of his comments from an interview:
“There is a legitimate concern that this action [against auditors by the SEC] could take off US exchanges all China-based companies.”
“If the SEC cannot review an auditor’s work papers [for a Chinese client], then it is conceivable the SEC will find the audit non-compliant.”
“If it is not possible for China-based companies to submit complaint audit papers, it would not then be possible for them to meet the filing requirements to be a reporting issuer.”
Frenkel adds he things it is very unlikely that the judge in the SEC case rules China based auditors are exmpted from US securities, rules.
“The SEC case is against these five accountants, but in reality it affects any accountant practising in China. In the case, the judge will decide whether or not these Chinese audit firms can practice in front of the SEC, so whether the SEC would accept audited financials from these firms. If the answer is no to these five, it will be no to everyone else.”
“I really cannot see the possibility of an American judge saying Chinese laws should apply ahead of American laws.”
And when asked why a US listed Chinese company could not simply move its China audit out of China, Frenkel says that will not be possible.
“The issue is entirely about access to the [China] work papers. No auditor can access the Chinese work papers and give them to the SEC. So it doesn’t matter if the auditor [who cannot access the papers] is based in Hong Kong or Macau or Kazahstan.”
This inability of US securities watchdogs to access Chinese papers has always been the case. “But it was certainly not a visible issue before,” Frenkel says.
The SEC’s move to disbar auditors, which could lead to mass de-listings of Chinese companies, is something the regulator has tried hard to avoid.
Earlier this month, Peking University accounting professor Paul Gillis, who has been a leading voice of the US-China auditing debate, also raised the possibility of a mass, forced departure of Chinese companies from American stock exchanges. Here are extracts from his blog post on the topic:
“If no significant progress is made the PCAOB is going to move to deregister Chinese accounting firms that it cannot inspect.”
“Deregistering Chinese accounting firms leads to delisting Chinese companies from U.S. exchanges. That will significantly damage the role of U.S. capital markets in the world. Yet, carving out an exception to U.S. securities laws for Chinese companies is equally unattractive.”
There could yet be a compromise. No doubt multinationals and honest US-listed Chinese companies are lobbying Beijing hard to change the state secrets law. The auditors face an extremely uncomfortable choice. If they press Beijing to allow them to hand over records on Chinese clients to the SEC, they open themselves up to class actions and negligence lawsuits over any Chinese company the US regulator finds committed fraud.