US and China reach stalemate over accounting practices

At one time, the common view in the US market was that if something was from China, it was good. Now sentiment has swung to the other extreme with fears that if it is from China, it must be bad. Investors have lost money, the US Securities and Exchange Commission (SEC) is enforcing transparency, and China is refusing to hand over the audit papers of its companies.

The dispute over accounting practices could be characterised as a regulatory power struggle between the US and the world’s new superpower. But it is much more than that, says Patrick Chovanec, associate professor of practice at Beijing’s Tsinghua University. When the US passed the Sarbanes-Oxley Act in 2002 it laid out accounting standards for all public companies in the US. “Those requirements set the table for a to and fro between US regulators and foreign regulators of all stripes. That kind of thing can be resolved or at least kicked down the road,” says Mr Chovanec. “What has really changed the dynamic is the fraud allegations. Investors lost large sums of money on Chinese stocks listed in the US under circumstances that demand investigation.”  

The most high-profile allegations of fraud came from Muddy Waters Research, headed by Carson Block, whose reports since 2010 have led to the shorting of Chinese stock. 

“A couple of years ago it was not really new that some institutions were shorting Chinese firms. This always happened,” says Dr Huainan Zhao, professor of corporate finance at the UK’s Cranfield School of Management. “The difference now is that the short sellers and SEC are acting simultaneously.”

The good and the bad

One of the issues with assessing Chinese companies is that they many have their core operations in China. “It is very hard for international investors to identify a good or a bad business. It is unobservable because it is in China,” says Mr Zhao. 

The SEC has investigated a number of Chinese firms, but without access to the work papers of the auditors the allegations of fraud are difficult to prove. In December 2012, after investigating nine clients of China-based auditors, the SEC took legal action against the auditors for refusing to hand over their work papers.

The SEC charged five auditors – Ernst & Young Hua Ming, KPMG Huazhen, Deloitte Touche Tohmatsu, PricewaterhouseCoopers Zhong Tian and BDO China Dahua – with violations of securities law and for “wilful refusal to comply” with requests made under the Sarbanes-Oxley Act. By this time, the SEC had already deregistered about 50 Chinese companies and filed fraud cases against 40 companies or individuals. 

A US-listed company needs to be audited by a firm that is registered with the Public Company Accounting Oversight Board (PCAOB), which was created with the Sarbanes-Oxley Act to oversee the auditors of US public companies. 

The PCAOB has similarly taken issue with access to work papers of the Chinese companies. Unlike the SEC, which has taken enforcement action in relation to fraud investigations, the PCAOB (at the time of writing) is still locked in negotiations with the China Securities Regulatory Commission and is pushing for inspections of the auditors. 

Restoring confidence

James Doty, chairman of the PCAOB, says: “To begin restoring investor confidence in financial reporting coming out of China, co-operation with other regulators on cross-border inspections and other audit oversight activities is an important step that Chinese regulatory authorities can and should take.”  

Mr Chovanec says on the predicament of the US authorities: “The SEC and PCAOB are in a difficult situation. They cannot say it is fine for a company to be listed in the US that they cannot investigate.”

Meanwhile, the Chinese auditors are in a difficult position because they are also subject to Chinese law and the auditors’ work papers are deemed to be state secrets. 

Drew Bernstein, managing partner at accounting firm Marcum Bernstein & Pinchuk, says that the auditors have a responsibility to respond to the SEC, but also face the threat of civil and criminal action if they turn over the documents. “They are not willing to risk jail time, no matter what the SEC says,” he says. 

Other observers say that the Chinese authorities' treatment of the work papers as state secrets is an issue of sovereignty. “Basically, what the Chinese are saying is they do not want US regulators running amok wielding subpoena power and conducting investigations on Chinese soil,” says Mr Chovanec, who adds: “It does not mean that there is not the potential for co-operation.” On the US side, there is frustration that the audit papers are being treated as sensitive to national security. 

State secrets

Many observers say that the definition of a ‘state secret’ in Chinese law is vague, and they speculate that the authorities may be blocking access to the work papers because some industries are considered to be sensitive, such as high-tech firms that are crucial to the country’s economic development, or because some companies are state-owned enterprises and are effectively an extension of the government. Others speculate that the Chinese authorities will not allow the documents to be handed over because of what is in them. 

On the issue of state secrets, Mr Zhao says: “From the China side, everybody knows the accounting books are problematic. If the SEC can access the listed companies’ information in China, then Chinese citizens will start demanding state-owned enterprises to reveal this information.” Chinese people, he adds, will argue that any information given to foreigners should also be given to them. 

From China's point of view, Mr Bernstein says that the issue is not about whether the work papers will be delivered, but whether the Chinese authorities would have control over how the information is used. “A number of Chinese companies were attacked by shorts that were not right,” he says, adding that there are concerns that the information in the work papers could be used in an inappropriate way. 

Mr Bernstein is a director and chairman of the audit committee at Orient Paper, the first company that was targeted by Muddy Waters, in 2010, with allegations of fraud – allegations that the company strongly denied. After appointing external investigators to examine the claims, Orient Paper said that it found no evidence to support the claims made by Muddy Waters.

For now, the wider regulatory dispute shows no sign of being resolved and Mr Chovanec describes it as a case of “irresistible force meets immovable object”. 

“In a nutshell, this is China and the US finding their respective positions in the world in the 21st century,” says Paul Gillis, an accounting professor at Peking University. “The US is used to making the rules and China is saying ‘we’re not allowing you to make all the rules’.” 

Nuclear option 

The Chinese companies, because they are also subject to Chinese law, must use auditors that are licensed in China. To comply with US securities law, the Chinese affiliates of the big-name accounting firms, which are separate legal entities, also need their own registration with the PCAOB. If the dispute is not resolved, the Chinese auditors could lose their registration, which has been referred to as the ‘nuclear option’. This would mean that the Chinese companies could not have their accounts audited to comply with US securities law and the companies would not be able to trade on US exchanges. 

“The end-game is that this could result in all the companies delisting, which would be pretty significant,” says Steven Winegar, a Hong Kong-based partner at law firm Paul Hastings. “Something has to give,” he says of the current dispute. 

If the ‘nuclear option’ is used, this could also have consequences for US-based multinationals that have operations in China. Such firms use Chinese affiliates of large accounting firms for their audits and if a US company was unable to file financial reports on its Chinese businesses because it did not have a PCAOB-registered auditor in China, its financial statements would be incomplete. This would be a violation of US securities law and the multinationals would also be unable to list their stock in the US. 

One of the reasons the issue has become so big is because of the large number of Chinese companies listing in the US. In 2010, for example, the New York Stock Exchange (NYSE) attracted a record number of 22 Chinese initial public offerings. “There was a rush and clustering of listings by Chinese companies, which enjoyed a good premium by listing in the US,” says Mr Zhao.

If these Chinese companies can be listed on the NYSE or Nasdaq, he adds, they could be treated as a first-class company at home. But many companies were not prepared for the market forces of the US. “In the Chinese market you do not have short selling,” says Mr Zhao. “And probably they have not really seen market volatility in China. Another problem is that bad news from any company will trigger very aggressive short selling across the board."

This volatility also makes the companies vulnerable to a hostile takeover and in the US, says Mr Zhao, the Chinese companies have no political umbrella to protect them. 

Another difference, points out Mr Zhao, is with the power of individual shareholders. “In the US it is completely different, any individual shareholder can sue the company and the company has to hire lawyers to respond.” The Chinese companies, he says, “may have never imagined these costs.” 

Credibility gap

In the current environment, even the good companies have been affected by negative market sentiment toward China and are cross-subsidising the bad firms because they cannot signal their quality. 

Mr Bernstein says: “The real problem in the market is the credibility issue among investors. You do not have to convince investors of the opportunities that exist, the one question they have is ‘how do I find the good companies?’.”

Michael Gisser, head of law firm Skadden’s Asia-Pacific practice, says: “There are companies that have not had any investigations, but nonetheless there is a loss of investor interest.” He adds that this has led to the recent wave of Chinese companies choosing to go private. 

When asked if the strategy of these Chinese companies is to eventually relist with a view to gaining a better valuation, Mr Gisser says: "I don't think they are going private with a plan to relist, but the option is clearly there.” Since a number of delistings in 2011 there has not yet been a relisting closed, but a few are well under way, he adds.

Mr Winegar explains that another option would be for Chinese companies to establish a secondary listing in another jurisdiction, such as Hong Kong, and then shift the trading volume to the secondary location while "going dark" in the US. 

Mr Zhao says that listing in Hong Kong may have the advantage in terms of overcoming information asymmetry because the market is closer to China. “The analysts there will understand more and do a better valuation and avoid cross-subsidisation,” he says. Aside from this, however, many of the problems will be the same for Chinese companies. “If they have had a large headache in the US, they will also [have one] in Hong Kong,” says Mr Zhao. 

China's gain?

If the China-US regulatory spat continues, it is argued that China would not lose out as the companies could go back to China, relist and boost the domestic capital markets there. Mr Gillis argues that one option could be for the Chinese to buy the stocks back. “The China Development Bank could quite easily fund the privatisation of the sector,” he says. One high-profile delisting was the $3.5bn agreement in August 2012 to privatise advertising company Focus Media. The Financial Times reported that the largest portion of the debt financing for this deal would come from the China Development Bank and China Minsheng Bank. 

Even if eventually relisting the companies in China is part of a strategy to boost the domestic capital markets, “it is still not an attractive capital-raising environment because of the concerns that investors have about the veracity and transparency of Chinese companies”, says Mr Chovanec. “They can say ‘we can list in China’ but the substantive issue is still there. Chinese companies are going to have a difficult time attracting global investors unless there is confidence in their disclosures and financial statements.

“If you bring them home, the reality is that investors will be demanding a discount on valuation because they do not believe the numbers. The bigger picture is not the SEC beating up Chinese companies. It is responding to a set of global concerns about Chinese companies.”