As 2012 draws to a close, two imminent issues hang over the world economy. The better known one is the so called fiscal cliff, which could result in simultaneous reductions in government spending and increases in taxes in the United States. The second lesser reported issue is the ongoing clash between the U.S. Securities & Exchange Commission (SEC) and the China Securities Regulatory Commission (CSRC), with the Chinese affiliates of the “Big 4” auditing firms PricewaterhouseCoopers (PwC), Deloitte, Ernst &Young (E&Y) and KPMG trapped in the middle, along with their clients. While some suggest that Chinese firms should no longer bother trading on tightly regulated U.S. markets, the problem is actually much deeper, with similar cases pending in Hong Kong, and the overall implications painting a picture that investors in Shanghai and Shenzhen should be wary of too.
To briefly summarize events up until now: two years ago “short-seller” research firms, such as Carson Block’s Muddy Waters or Citron Research, started investigating U.S. / Canada -listed Chinese companies for fraud or inaccurate financial statements/reporting. Teams of investigators travelled across China talking to the companies’ suppliers, customers, current and former staff, as well as examining public records, related filings and presence in relevant markets. If the investigations suggested issues or problems with the accounts and filings, then these firms would “short” the stock (by borrowing the shares and immediately selling them), and then publish their research for free, profiting as market participants digested the data and then sold down their holdings.
Investors in the U.S. and Canada lost billions of dollars as several such companies were found to be deceiving investors in one way or another and their share prices collapsed. Chinese accounting and reporting standards are still sometimes lacking. Although some big name firms which have listed in Hong Kong, New York or London have trusted financial statements, there are numerous difficulties within other companies. In China one joke goes that firms keep three sets of records; one for the tax collectors, one for the investors and the real ones for the managers’ use only. Rumors of corruption, fraud and deception are frequently confirmed.
As Chinese firms’ reputations became increasingly damaged, short sellers began reporting official harassment as they tried to carry out their research. What should have been public records were suddenly less available; researchers were prevented from doing their work, and in one case allegedly detained. Carson Block reported being informed of a “state-backed” attempt to access his Gmail account. Meanwhile, foreign media organizations, including Bloomberg and then the New York Times, published sensitive in-depth reports detailing the huge wealth that had been amassed by some of the Chinese Communist Party’s leading figures based in part on publically available records, which did not help the air of difficulty surrounding access to information.
The SEC, attempting to fulfill its duty to protect U.S. investors from fraudulent or dishonest companies selling shares, began to investigate several U.S.-listed Chinese firms who had got into markets using a complicated and quiet “backdoor listing” technique. Here the issue came to a head, since the SEC requires listed companies to be audited by accredited auditors, and for data to be available in the event of an SEC investigation. Unfortunately, China forbids any auditor from transferring information about Chinese companies abroad, ostensibly for fear of state secrets being leaked.
The SEC, after months of attempting to negotiate with its Chinese counterpart, lost patience and brought charges against the Chinese affiliates of the top accounting /audit firms, threatening to remove their accreditation if they failed to comply. Since all companies listed on U.S. exchanges must be audited by accredited accountants, if a deal cannot be reached Chinese companies would be forcibly delisted en masse form U.S. exchanges.
Some analysts have suggested that Chinese firms no longer need access to the more strictly regulated U.S. markets, implying that post crisis post Sarbanes-Oxley requirements are not worth the hassle that the SEC is creating. This perspective ignores that once a company is delisted from U.S. markets, other regulators/investors will be pressured into launching their own investigations, and for access to records. In fact, a similar situation has already emerged in Hong Kong, where the majority of Chinese firms have undergone “overseas” listings in recent years, and where many suggest firms delisted in the U.S. could eventually go public once again.
In August of this year, the Hong Kong equivalent of the SEC, the Securities and Futures Commission (SFC), brought legal action against Ernst & Young for refusing to provide required information about mainland firm Standard Water for similar “national security” reasons. Although Standard Water eventually decided not to list in Hong Kong, the case is highly reminiscent of the SEC’s current struggle with mainland divisions of the auditing firms. Also in August, HK listed shares in China High Precision Automation Group were suspended from trading after it announced it couldn’t provide its auditor KPMG with all necessary information because of concerns about “state secrets.”
In March 2013, the Hong Kong High Court is due to make a very important ruling on the E&Y / Standard Water case. The ruling could trigger further tensions between the SFC and the China Security Regulatory Commission, not dissimilar to the trouble between the SEC and China.
Here is the crux of the issue; Chinese companies that have listed abroad have put themselves (and their auditors) in an impossible position. Foreign (including HK) regulators have the authority to request accounting papers from listed companies, yet access to accounting papers is guarded too closely by the Chinese side. Companies which cannot follow the regulations where they list should not have listed and sold shares to public investors to whom they are accountable. It is pretty clear that China’s refusal to provide access to outsiders is the root of the problem. One can’t help but wonder why the Chinese authorities didn’t seek a compromise and allow access to specific (“safe”) company records, or joint observation of auditors, before the dispute reached this point. This question must give investors in Chinese firms anywhere (including Shanghai and Shenzhen) pause for thought.