Four fronts in regulatory war | China Accounting Blog | Paul Gillis

Four fronts in regulatory war

This post is an update of the continuing struggle over accounting regulation for Chinese companies listed abroad. There are currently four fronts in this battle.

SEC v. Deloitte

This was the first case and relates to Deloitte’s refusal to provide audit working papers related to alleged fraud Longtop Financial Technologies Ltd. The case was back in federal court this week for a 90-minute hearing. The SEC wants to lift a stay that the judge imposed back when the SEC still hoped for a negotiated settlement with Chinese regulators. The SEC gave up on that last December and wants the court to force Deloitte to turn over the papers.  Deloitte argues that lifting the stay would put the court in the middle of an international dispute between China and the U.S., and might undermine negotiations for a settlement. The judge asked both sides whether the opinion of the State Department ought to be sought. U.S. Secretary of State John Kerry was in China this week, but I expect he was too busy talking about Kim Jong Un to spend much time on audit working papers. 

This case is dragging on, which is probably the result that both sides want. Even if the SEC wins, it is unlikely to get the working papers. That would leave it to seek to punish Deloitte alone, which is probably not fair. 

It was not all bad news for Deloitte on Longtop. The firm won dismissal of a shareholder suit. The case was dismissed once before and the judge tossed it out for good this time. It is very difficult to sue an accounting firm under U.S. securities laws.

SEC v. Big Four & BDO

On December 3, 2012, the SEC initiated administrative proceedings to determine whether to deny practice rights to the Chinese member firms of the Big Four and BDO. The SEC ordered that public hearings be held for purposes of taking evidence. This hearing is not listed as being scheduled on the SEC’s website. The order requires the administrative trial judge to issue an initial decision no later than 300 days after December 3, which I think is September 30th.  

The failure to schedule a hearing indicates to me that neither party is anxious to move this along. 

PCAOB 

The Public Company Accounting Oversight Board (PCAOB) has been silent on its failure to reach agreement with Chinese regulators for joint inspections. The PCAOB put an offer on the table in November. Chinese regulators made a recommendation to the State Council in December (content unknown), and nothing has happened for five months. China handed over power to new leadership during that period, and that new leadership has its plate full.  

The PCAOB has been incredibly patient with Chinese regulators as it tries to find a solution. I still expect that the PCAOB will soon act to begin the process of deregistering auditors. It may have already begun that process.  

There are two ways the PCAOB could deregister Chinese audit firms. First it could change its rules to say that it will terminate the registration of any firms that it cannot inspect. I think this is the preferable way since a rule change must go through a public process before it becomes effective.  

The other way the PCAOB could act is to commence disciplinary proceedings against the accounting firms individually. Unlike the SEC, the PCAOB is forbidden from disclosing disciplinary actions against accounting firms until they are final. Investors are unaware that an accounting firm faces PCAOB sanctions until the sanctions are imposed. That is unfair to investors, since firms with alleged serious quality problems can continue to audit while dragging out PCAOB sanctions through appeals. In the case of the China firms, this approach risks a big surprise when the PCAOB suddenly announces that it has deregistered a firm and the firm’s clients are left without an auditor. Congress should change the law and allow the PCAOB to disclose the commencement of administrative proceedings in the same manner that it permits the SEC to do so. 

I expect the PCAOB is also in a go-slow mode, hoping to reach a breakthrough with Chinese regulators. As I have said, I believe the decision is entirely up to China; does it want to allow its companies to list overseas? If so, it must accommodate foreign regulation. 

SFC v. Ernst & Young

This is the Hong Kong version of the SEC case against Deloitte. Ernst & Young Hong Kong (EYHK) has refused to turn over working papers on failed IPO Standard Water to the Securities and Futures Commission (SFC). EYHK says that although it is the auditor of record, the work was actually done by its mainland affiliate Ernst & Young Hua Ming (EYHM). EYHM refuses to cough up the working papers based on the same arguments the firms are using with the SEC.  

There was a hearing in the Hong Kong High Court last month. While I did not attend this, I have heard that the E&Y partner who testified did himself no favors. E&Y apparently left the engagement partner off a list of people who would have information about the case and sent a risk management partner to testify. The engagement partner was a Hong Kong partner who was seconded to the mainland, but who has now returned to Hong Kong. The partner apparently brought his laptop back to Hong Kong with him and it might contain relevant documents. I expect that SFC's lawyers are going to get into the issue of exactly how much access people in the Big Four offices in Hong Kong have to electronic workpapers on the mainland, given how these firms often share an IT infrastructure. That issue opens up a whole new can of worms for the firms. The hearings will continue on May 16th, and I think that is going to be a tough day for EYHK. 

It appears that EYHK has let its mainland affiliate use its letterhead to issue opinions. In the Standard Water case EYHK received 0.2% of the fee, so it obviously did not do any auditing, yet it serves as auditor of record. In my view, the real scandal of this case is not the refusal to turn over working papers, but the way that EYHK has mislead investors into thinking that it, rather than its mainland affiliate, conducted the audit. Under U.S. auditing standards only the principal auditor can sign the report. International standards used to be clear on this point as well, but the rules were changed and current standards are difficult to apply to this situation. 

This behavior is commonplace among the Big Four in China. It is rooted in two issues. First, the Big Four themselves look at China and Hong Kong as a single market – at least when it is in their interest to do so. The Big Four globally have tried to position themselves as seamless global organizations – until they get sued, in which case they argue that they are a collection of independent franchises. 

Secondly, Hong Kong regulations have long required that Hong Kong listed companies use a Hong Kong based auditor. That has worked well to protect a lucrative market for Hong Kong CPAs. The rule was loosened a bit when some big companies like Jardine Matheson and HSBC fled Hong Kong before the handover, allowing the London office of the Big Four to sign off on these accounts. A major change took place in 2011 when the mainland pushed Hong Kong to accept mainland auditors of H-shares. In that case, most H-shares changed auditors from the Hong Kong affiliate to the mainland affiliate of the same Big Four firm. I expect that the mainland affiliate was already doing the audit, just as in the Standard Water case, and all that really happened was that the letterhead on the opinion now reflected the reality of the situation. What needs to happen is for Hong Kong to accept mainland auditors on all red chips and p-chips as well. Investors deserve to know the identity of their auditor.

That would not fix the problem with access to the audit working papers of Standard Water. Hong Kong is in a pickle here. Hong Kong’s raison d'ętre is its rule of law. If Hong Kong cannot enforce its securities laws because of Chinese interference, why should the Hong Kong stock exchange exist? The fundamental question here, as in the U.S. cases, is whether Chinese companies should list only at home. If they wish to list in the U.S. or Hong Kong, they will need to follow the rule of law in those locations and that means cooperation with U.S. and Hong Kong securities regulators. 


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