I have given a few speeches in the last couple of weeks that have provoked considerable discussion. I have said that I believe there is a not insignificant risk that a decision will be made that Chinese companies should not be permitted to list in the United States, and that this decision will be implemented through audit regulation, based on the failure of both the PCAOB and the SEC to inspect Chinese accounting firms or obtain records from these firms. Here is how I come to this conclusion.
China’s private sector has used the U.S. stock markets as a major source of capital. That has happened largely because China failed to timely develop its own institutions to serve the needs of entrepreneurs. While China’s stock markets reopened in 1990, they were initially used to reform state-owned enterprises. Only in 2001 did Jiang Zemin push through reforms through his Theory of the Three Represents that legitimized entrepreneurship and welcomed entrepreneurs to join the Communist Party. In the years that followed, there has been a rapid development of domestic venture capital, private equity, and stock markets focused on privately owned business. Until recently, however, many private companies looked to the U.S. for capital, resulting in over 200 Chinese companies listed on the NYSE and NASDAQ and hundreds more that came to market through reverse mergers and which are thinly traded on the OTCBB and Pink Sheets.
The Chinese Institute of CPAs issued a public consultation paper on April 1 to solicit public comment on proposed changes to the CPA law. One of the proposed changes will specifically prohibit the sharing of audit working papers with persons outside of China.
That has, of course, already been China’s position. Previously this rule was in the form of Pronouncement (2009) 29 issued jointly by the China Securities Regulatory Commission, the State Secrecy Bureau and the State Archive Bureau. Putting it into the CPA law buttresses China’s arguments with the PCAOB and SEC.
The proposed law applies to Chinese CPA firms. I expect that Chinese regulators will take the position that it also applies to foreign CPA firms operating in China under Temporary Audit Practice Certificates. It will bring into question the practices of the U.S. CPA firms that come to China to audit reverse merger companies. These firms likely cannot show their working papers to the PCAOB without violating Chinese law. Deloitte has argued that if they provided their working papers to the SEC their partners could face life in a Chinese prison. Are U.S. CPAs doing audits of Chinese companies willing to take that risk?
The Big Four are busy preparing for the restructure of their practices in accordance with the new MOF guidelines that limit the number of expatriate partners. The deadline is based on the date the current joint venture runs out its 20-year life. KPMG, first to obtain a JV license in 1992, faces the first deadline of August 17. E&Y follows in September. PwC has until March 2018 because it formed a new joint venture in 1998 when PW and C&L merged, but I have heard that PwC plans to reorganize next year.
The new rules require that at least 60% (increasing over five years to 80%) of the partners of the firm are locally qualified. In order to be locally qualified the partners need at least five years public accounting experience with three years in China. Those without Chinese qualifications can make up 40% (reducing to 20% over five years) of the partners. Those without Chinese qualifications must be at least 40 years old but less than 65 years old, and must hold recognized foreign qualifications and have ten years of experience. The senior partner must be a Chinese citizen (not including Hong Kong, Macau or Taiwan), although that requirement appears to violate China’s WTO commitment of national treatment for accountancy. I don’t see the firms letting any foreign partners go because of these rules. They will first figure out how many locally qualified partners they have, then select the maximum number of expatriates to be partners, and classify the rest as principals – non-partners with partner status.
There is a bill working its way through the Hong Kong legislature that would criminalize certain audit failures. Under the bill, auditors would face criminal liability if they knowingly or recklessly omit a required statement in the audit report. Naturally, Hong Kong accountants are up in arms over the proposal. Keith Pogson, President of the HKICPAs (and an E&Y partner) says the effect of the rule will be to “drive more business offshore” and to “create unnecessary barriers for business operations and companies set up in Hong Kong”. The main concern is that the proposed law would not require any dishonest intent, but rather "knowingly or recklessly” omitting a required statement.
A government spokesperson told the South China Morning Post: “the new proposal was an important step towards enhancing the reliability of financial statements and improving the regulatory regime for auditors”. Concerns about audit quality increased significantly after the Financial Reporting Council put 13 listed companies on watch for alleged auditing problems.
William McGovern of Kobre and Kim in Hong Kong has penned an editorial in China Daily calling for the resolution of the present standoff between China and the SEC over enforcement of subpoenas related to stock frauds of Chinese companies to be settled through diplomacy rather than the courts. I agree with this sentiment, but I am increasingly pessimistic that diplomacy is going to work. While I understand that SEC officials will have discussions with Chinese regulators next month in Beijing, their respective positions may be irreconcilable.
John Hempton’s kleptocracy blockbuster adds further intrigue to the issue, since he asserts that the Big Four firms have signed off on frauds that are connected to princelings. I don’t see the Chinese looking for any help from U.S. regulators as they sort out the issues raised by the Bo Xilai case.
So what happens if the SEC/Deloitte case is not resolved?
I have heard that SEC subpoenas have been issued to the other Big Four firms in China as well, so the issue is unlikely to be limited to Deloitte. The PCAOB faces a December deadline to complete inspections of Chinese accounting firms that are registered with the PCAOB. It seems highly unlikely that they will meet this deadline, since Chinese regulators will not let them come to China. While the PCAOB could extend the deadline, they have already been under political pressure to act. In this election year, where China bashing might become a tool for either party, it seems unlikely an extension will be well received. The argument that Chinese companies that want to access U.S. capital markets must follow U.S. laws resonates with most people. Without resolution, the only meaningful option for the SEC, and the PCAOB, is for the PCAOB to deregister the firms and for the SEC to ban them from practice before the SEC.
John Hempton of Bronte Capital has posted an inflammatory post (it is outside the Great Firewall) alleging that China is a massive kleptocracy and that the beneficiaries of the wave of stock frauds by Chinese companies listed in the U.S. include the children and family of CPC Central Committee members. He offers no evidence to back up these assertions yet says they are based on his personal experience.
He also claims personal experience of this assertion:
When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big 4 audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably especially the big four) are co-opted for the benefit of Chinese kleptocrats.
Those are strong accusations. If Hempton actually has personal experience and direct evidence of Big Four corruption as he says he does, he needs to turn that evidence over to the SEC and the PCAOB. It is simply unfair to investors and the Big Four firms if this issue is not run to ground.