Posted by Nureen CHAN Wan Wei, Year 4 undergrad at the School of Accountancy, Singapore Management University
U.S. regulators inadvertently raise a question about who’s to blame for investor losses.
In a ruling last week, an administrative trial judge at the U.S. Securities and Exchange Commission suspended the Chinese branches of the Big Four accounting firms from practicing at the SEC for six months. As a consequence, these accountants will not be able to sign off on the books of Chinese companies listed in the U.S., which could force the Chinese firms to delist at least temporarily for lack of audited accounts. The Big Four are appealing the ruling.
This is set to turn into an illuminating study in unintended consequences. The case ostensibly turns on the fact that the firms have been less than cooperative as the commission investigates a flood of alleged accounting frauds at U.S.-listed Chinese companies. The China units of PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu and E&Y generally have resisted turning over audit work papers the SEC would need to conduct its probes. Under American law, the accountants are required to cooperate.
But the real problem is that the accounting firms, which would almost certainly prefer to comply with the SEC’s demands, worry that Beijing will punish them if they do. Chinese authorities have never definitively settled the question of whether the audit records of Chinese companies constitute “state secrets” under Beijing’s vague and expansive secrecy rules.
Partly this is a simple attempt by Beijing to assert its sovereignty over companies operating on its soil. But there’s also plenty of reason to suspect more cynical motives for obstructionism. Fraud investigations often implicate various forms of corruption, especially unduly close relationships between companies and officials at state-owned banks. A thornier question yet is what kind of access the SEC might gain to audit records at state-owned enterprises that are partially listed in New York—including major banks.
All of this puts the accounting firms in the position of deciding which of two countries’ conflicting laws they will follow. This isn’t a plea for sympathy. As Judge Cameron Eliot noted in his ruling, “to the extent [the firms] found themselves between a rock and a hard place, it is because they wanted to be there.” They chose to build up China accounting businesses understanding the legal bind they might face.
But the solution ultimately will be for regulators in Washington and Beijing to negotiate a deal allowing the information-sharing the SEC requests. The U.S. Public Company Accounting Oversight Board already has reached such a deal for some documents related to its own accounting investigations. Yet that deal is limited in scope and doesn’t apply to the SEC, whose attempts to secure its own unfettered access to accounting records have been stymied.
The SEC’s pursuit of the Big Four is best understood as a strategy to force Beijing at last to hammer out a regulatory deal. Chinese companies depend on overseas investors for capital, a situation likely to continue for the foreseeable future despite a recent loosening of restrictions on initial public offers. The SEC seems to hope that if it turns off this capital spigot by denying Chinese companies auditors for a spell, Beijing will have no choice but to come to the table.
But before the SEC’s commissioners decide on the accountants’ appeal of their suspension, it’s worth asking a heretical question: What’s the point?
If the SEC’s mission is investor protection, the horse is already out of the barn. Investors have paid their money and received their share certificates. To the extent that Chinese companies keep their listings by finding other, smaller accounting firms not affected by last week’s ruling, American investors will own shares in companies whose auditors potentially lack the experience and reputation of the displaced Big Four.
Nor will a mass delisting of those Chinese companies that don’t find new auditors restore to shareholders any value destroyed by frauds that may or may not have occurred at any particular company. Instead, the proposed SEC move leaves those investors worse off than they were before, their holdings shunted into over-the-counter markets.
Note that this will be true even for those investors who have done enough homework to have invested in entirely legitimate Chinese companies. This is a significant point since, while the SEC and other authorities have been spinning their wheels on the matter of Chinese frauds, market participants have started cleaning house. Alleged frauds have been exposed by a growing number of short-selling research firms specializing in Chinese companies, while sinking valuations for Chinese listings in general suggest investors are growing savvier about the risks such investments entail. Auditors themselves have grown steadily more sophisticated about rooting out suspicious behavior.
How ironic, then, that the biggest risk American investors in Chinese listings currently face seems to be American regulators. Recall that many alleged Chinese frauds sprouted in an environment where excessive Chinese regulation and corruption force even legitimate companies to adopt complex corporate structures and creative accounting—making it harder to tell when such tricks are merely a survival strategy and when they’re an outright fraud. One almost begins to think that policy makers on both sides of the Pacific are a bigger threat to investors than fraudsters are.
Mr. Sternberg edits the Business Asia column.