European regulators have submitted new rules to the European Commission that, if adopted, will significantly change the accounting profession globally. The rules propose several significant changes.
First, the rules would ban auditors from performing consulting services to their clients. The draft says “audit firms of significant dimension should…not be allowed to undertake other services unconnected to their statutory audit function such as consultancy and advisory services." For 2009, tax and advisory services made up 52% of the global revenue of the Big Four. The rules would likely lead the Big Four to spin off their consulting and tax practices. We have been through this before with U.S. regulators. When Sarbanes Oxley was being developed all of the Big Four except for Deloitte spun off or sold their consultancy practices, but they have all gotten back into the lucrative business as the non-compete agreements expired.
Secondly, the rules will limit auditors from serving big companies for more than nine years. Mandatory audit rotation has been debated for some time, but the firms have usually succeeded in just rotating engagement partners.
The CSRC paper that Reuters reported on a couple of weeks ago has been leaked onto the web. This paper has led to some strange things over the past week, from big drops in the stock prices of internet companies to overreaching claims that “VIEs are 100% legal”. Here are my observations and speculations.
The CSRC paper appears to be a well reasoned document that is likely motivated by its frustration with criticism over overseas listed Chinese companies that has landed on the CRSC despite its general lack of jurisdiction over these companies. Accordingly, the document appears to apply to all overseas listed Chinese companies rather than just those that use the VIE structure. Using national security as a talisman, it seems to me that a key objective is for the CSRC to gain regulatory oversight over these companies.
There are four key recommendations. First the CSRC advocates tougher regulation of overseas listed companies, focusing on new listings rather than existing listings. Existing regulations related to foreign investment, currency and taxes are probably adequate, but enforcement has been uneven and often circumvented by VIE structures. The paper proposes to deal with this by engaging with the SEC in helping to make sure that the rules are followed, and threatening lawyers and accountants with penalties if they permit clients to circumvent the rules. Presently, U.S. listings depend on the accountants and lawyers looking the other way when they pass these regulatory problems. Simply enunciating this threat as the CSRC have done will likely chill the IPO market and force the companies to comply with the spirit of existing regulations. That is good news and will protect investors.
There appears to be significant change in the winds for VIEs. Reuters is out with an article that reports on a CSRC document sent to the State council that has apparently been read by at least four law firms.
Rumors I have been hearing all day say it recommends policy changes to bring the VIEs home in a manner similar to my recommendations on cleaning up the VIE sector.
I made these recommendations in April, and perhaps I have a reader at the CSRC:
1. Make it easier for Chinese companies to directly list overseas without using an offshore entity. Many companies have chosen the VIE approach as a way of getting around cumbersome Chinese regulations.
2. Recognize the reality that there already is significant foreign investment in prohibited sectors, and find a way to regulate this investment instead of pretending to prohibit it. Prohibition has not worked, and China needs entrepreneurial companies like Baidu, Dangdang, CTrip and Ambow Education.
3. Bring the offshore structures back onshore. Encourage U.S. listed Chinese companies with offshore parents to merge the offshore company into the Chinese operating company. This will give China better regulatory control over these companies and it will give the shareholders real ownership of the operations. That is a good tradeoff for investors. China needs to develop rules to make this possible.
There was a major escalation today in the battle between U.S. and Chinese regulators over the accounting profession in China. The SEC has filed a subpoena enforcement action against Deloitte Tohamtsu CPA Ltd (Deloitte Shanghai). Deloitte Shanghai is Deloitte’s member firm in China.
The SEC seeks to have Deloitte Shanghai turn over its working papers on Longtop Financial Technologies, which has been alleged to be a major Chinese accounting fraud. The SEC argues that the working papers related to prior year audits may reveal how any fraud schemes at Longtop were able to continue undetected for years. There is no indication that Deloitte Shanghai is under investigation, although the SEC points out its objective is the ferret out whether there was a fraud, and if there was, who was behind it, how significant it was, and how it was conducted.
According to the court filings, Deloitte has refused to produce the working papers for two reasons. First, they argue that the recent Dodd Frank legislation that makes it clear that they must produce this information was not effective when these working papers were prepared (these provisions of Dodd Frank became effective on July 21, 2010). The SEC argues that they were entitled to the information even before Dodd Frank. Secondly, and more significantly in my view, Deloitte Shanghai argues that producing the information would violate China’s state secrecy laws. Deloitte Shanghai unsuccessfully sought authorization to produce the documents from the China Securities Regulatory Commission (CSRC), which the filing says told Deloitte to seek authorization from the Ministry of Finance, the State Secrets Bureau, and the State Archives Bureau.
The market for auditing U.S. listed Chinese companies is dominated by the Big Four. In 2009 the Big Four collected 96% of the audit fees for Chinese companies listed on the NYSE and 72% of the fees for Chinese companies listed on NASDAQ. During the boom in U.S. IPOs in the middle of the last decade the Big Four were completely tapped out and did not have the capacity to serve many smaller IPOs, even if they had wanted to. While they took on some of these companies as the market slowed with the great recession, they have come to regret most of those decisions. Smaller listed companies, and the many companies that came to market as reverse mergers, have used smaller accounting firms. Few Chinese CPA firms have shown any interest in the market serving U.S. listed Chinese companies, so most of this work has gone to small U.S. accounting firms that specialize in smaller public companies.
Some of these smaller U.S. based CPA firms were found to have outsourced most of the work to local Chinese CPA firms. In 2010 the PCAOB issued a Staff Audit Practice Alert that indicated that some firms were outsourcing substantially all of the audit work. The PCAOB also found that some audit partners were not capable of reading or speaking Chinese and accordingly could not communicate with their clients or read source documents. In the wake of that Alert several firms decided to open offices in China