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.
American politics
China’s rising power in the world has attracted its share of critics, and bashing China is catnip for American politicians. Chinese companies that have raised capital in the U.S. have been implicated in numerous frauds and accounting scandals, which makes the practice of allowing Chinese companies to use the U.S. capital markets controversial. The House Financial Services Committee sent a letter to the PCAOB and the SEC on September 9, 2010 complaining of the quality of auditing of U.S. listed Chinese companies. On November 22, 2011, Senator Chuck Schumer sent a letter to PCAOB Chairman James Doty complaining that American investors had lost billions while the PCAOB had for six years pursued fruitless negotiations with China for access to inspect accounting firms.
I expect the political pressure regarding U.S. listed Chinese companies will increase in the upcoming political season. I offer this speech for politicians of either party: “First the Chinese stole our jobs. Then they came and used our stock markets to raise money and they stole that too. Chinese companies want to use our stock markets but they do not want to follow American laws. President Obama has appeased the Chinese and it is time we stop letting the Chinese rip us off (R version). Governor Romney’s friends in investment banks want to keep letting Chinese companies rip off Americans. I will stop letting the Chinese rip us off (D version)”.
Kicking Chinese companies off U.S. stock markets is serious matter. One of the building blocks of American exceptionalism is that it has become the stock market for the world. Banning Chinese companies would clearly diminish the current leading role of American markets in global finance, and it would be a decision that is likely permanent and wide reaching. That alone might be enough reason for the Chinese to resist cutting a deal.
Chinese politics
Americans often make the mistake of looking at the Chinese as a monolith, failing to recognize the diversity of opinion and policy even within the Communist Party. An area where there seems to be great divergence within Chinese society is how China should participate in the world. Some clearly view that China should follow the neoliberal ideal of a global economy, and that China should accept both the benefits and burdens of open markets. Those who accept this worldview would agree that those burdens include accepting transnational regulation if they want the benefits of transnational finance.
Others take more nationalistic views that are often rooted in China’s deep scars of past foreign hegemony. This group would prefer that China become self-sufficient and that Chinese companies use their own capital markets. Zhou Qinye of the Shanghai Stock Exchange voiced this sentiment last November when he suggested that a solution to the standoff with foreign regulators would be for the U.S. listed Chinese companies to come home and list. Others have expressed concern that the overseas listing of Chinese companies has transferred significant assets of the Chinese people to foreigners, a complaint rooted in Marxism that has also stalled the development of the international board that would list MNC companies in Shanghai. The MNCs want the right to use capital raised in China anywhere in the world, but some Chinese think that is the people’s money and it needs to stay in China.
I believe that it is China’s intent to end the use of overseas stock markets by Chinese companies. The problem is that China’s own stock markets are not sufficiently developed for all of the overseas-listed Chinese companies to return home. Absent an intervening event, like the one I am discussing, I think overseas listed Chinese companies would have all returned home in a decade.
Fei Guoping, President of the All-China Federation of Industry and Commerce argued last month that the current stage of development of the domestic capital market means that companies still need the ability to list abroad:
We cannot on one hand encourage enterprises to join in international competition, and on the other hand kill their chances to get the essential resources for competition. Given that the local capital market cannot satisfy the financing demand of different companies, we should straighten out the overseas IPO channels as soon as possible, and simplify the overseas IPO processes.
Fei is expressing concern that the IPO market for U.S. listed Chinese companies is dead. There are many reasons why offerings are not happening: 1) fear over China’s economy; 2) worries about accounting and auditing problems; 3) concern over the VIE structure; and 4) concerns that the regulatory struggle between the U.S. and China will not end well. The effect, however, is clear. Pre-IPO investors have considerable money tied up in China with no exit opportunity and they have stopped throwing good money after bad. While domestic funds and markets are filling some of the gap, some companies are starving for capital and that runs the risk of damaging indigenous innovation, which could have long-term negative effects for China.
I think many in China would see a crisis in U.S. listed Chinese stocks to be an opportunity. Many U.S. listed Chinese companies have already gone private, some with the financial backing of the State Council’s China Development Bank. A mass delisting of Chinese companies listed in the U.S. would likely drive them to the Hong Kong Stock Exchange (HKSE). There are reasons why these companies did not originally list in Hong Kong. Some of those reasons are no longer valid. The HKSE has grown significantly in recent years so liquidity is no longer an issue. The reluctance of the HKSE to accept companies without established track records is no longer a problem for the companies that have been around for a number of years. Hong Kong’s resistance to riskier versions of the VIE structure will cause problems for some. From China’s perspective, moving these companies to Hong Kong is attractive. China can continue to develop its own capital markets at its own pace, knowing that 35 years from today Hong Kong is just another city in China and that the Mainland and Hong Kong stock exchanges will likely have merged long before Hong Kong’s 50 years as a Special Administrative Region comes to an end. China gets its companies back, and it gets rid of American interference.
Why auditing is the battleground
Congress could act to ban Chinese companies from U.S. stock markets, but I think that is unlikely to happen. It is easier to make it happen through the regulators. There are three pending events that could provide the same result.
SEC v. Deloitte China
Deloitte has refused to provide working papers to the SEC on at least two Chinese companies. One has landed them in court for refusing to respond to a subpoena. The other has them charged with securities laws violations. It has been reported that the other Big Four firms have also refused to provide working papers to the SEC. Deloitte says Chinese regulators will not allow them to provide the working papers to the SEC, and that their partners face life in a Chinese prison and loss of their practice if they do so.
The SEC has the power to withdraw practice rights from accounting firms for violating SEC rules. Because these issues are now tied up in court, I think the SEC likely waits for the conclusion of those proceedings before they act. That is not likely to happen before the end of the year.
Big Four Localization
The Big Four face a deadline to restructure their audit practices in China into limited partnerships at least 60% owned by locally qualified accountants. The deadline is the date when the joint ventures that the firms currently use reach the end of their 20-year life. The first to face this deadline is KPMG, in August of this year. E&Y and Deloitte follow later this year, with PwC’s joint venture not expiring until March 2018.
When an accounting firm reorganizes, it must either transfer its existing registration with the PCAOB to the new firm or register anew. In order to transfer its existing registration it must be demonstrated that the new firm is a continuation of the old firm, with ownership being a key determinant. Because there is a significant change in ownership from the old joint venture to the new limited partnership, the Big Four may need to seek a new registration.
The problem with getting a new registration is that the PCAOB has a rule that says they will not process a registration for an accounting firm from a country that does not permit inspections. So, if the firm needs a new registration, they are really in a pickle. Without a PCAOB registration, they cannot audit U.S. listed Chinese companies or participate to a material extent in any audit of a U.S. listed MNC.
I am sure that the firms have been discussing this issue with the PCAOB. Lew Ferguson of the PCAOB answered a question about this process at an SEC Conference in Shanghai last week and it was clear that he understood the issue. Based on my reading of the rule, reasonable people could come to different conclusions.
We should know the result for KPMG by August. The other firms have nearly identical facts so they should obtain the same result. PwC has another five years, but I don’t see either China or the U.S. wanting to grant them a monopoly on that technicality.
PCAOB and inspections
The PCAOB has been negotiating with China for access to conduct inspections for the better part of a decade. Under PCAOB rules the inspections were to be completed by 2009. When it became apparent that the 2009 deadline would not be met, the PCAOB changed its rules to extend the deadline to 2012.
Since it now appears fairly certain that they will not meet the 2012 deadline, it seems to me that the PCAOB is faced with a binary choice. Extend the deadline again, or deregister the firms that it cannot inspect.
It takes some time to extend the deadline, since the PCAOB has a process it must follow to do this. Looking at the timeline for the 2009 extension, here were the key dates:
PCAOB votes to extend the deadline: June 25, 2009
Notification of rule change to SEC and opening of public comments: July 2, 2009
Final SEC approval of deadline change: March 4, 2010
Obviously, if the deadline is going to be extended, the PCAOB is going to have to start its process soon. But, starting the process removes any pressure (if there is any) that the PCAOB might have on China to agree to inspections. Agreeing to delay on the basis that the progress made so far by Chairman Doty indicates that more time should be given for negotiations to bear fruit may be politically tone deaf.
Probable outcomes
The most controversial aspect of my recent remarks on this issue is my assignment of probabilities to certain outcomes.
I think there is a 10% chance that diplomacy works and a breakthrough is reached. It won’t fail for a lack of trying by the U.S. side. However, I think that China has few incentives to reach a deal.
I assign a 70% probability that the can is kicked down the road. Sufficient progress will be made to dodge the political firestorm. The Big Four firms will keep their registrations, and the deadline for inspections will be deferred again.
I think there is a 20% chance that it all falls apart. The PCAOB and the SEC make no progress. The issue becomes political and widely known. Deregistration becomes the only option and it is the PCAOB that pulls the plug. That then forces the exchanges to decide how to enforce their rules that require companies to have auditors and audited financial statements in order to be listed. I expect in this scenario that the exchanges are forced to delist the companies, and the scramble to Hong Kong begins.