US regulators move in on Chinese audit laws

Chinese companies could face delisting in the US under new anti-fraud action to force firms to share work documents with regulators

PUBLISHED : Thursday, 06 December, 2012, 12:00am
UPDATED : Thursday, 06 December, 2012, 3:16am

Regulators in the United States have potentially jeopardised the listing of more than 100 stocks from the world's most populous nation, in a move to sanction auditors for blocking investigations at companies based in China.

In an enforcement action against the China-based affiliates of the Big Four accounting firms, the Securities and Exchange Commission escalated a three-year impasse between the two nations over whether auditors can share work documents with regulators investigating possible accounting fraud at companies selling securities in the United States.

"Chinese companies listed on US exchanges are being held captive in a sovereignty dispute," said Jim Feltman, a senior managing director at Mesirow Financial Consulting in New York.

"This is a step in the process to deregister companies that can't comply with US audit rules.

"They'll have to leave the US marketplace if their auditors cannot - or will not - be responsive to the SEC."

Of about 400 Chinese companies that trade in the US, at least 115 have been audited by the subsidiaries of the Big Four accounting firms, according to data on stocks with market values of at least US$5 million.

More than half are audited by units of Deloitte, Ernst & Young, KPMG or PricewaterhouseCoopers.

The auditors say Chinese law prevents them from complying with the SEC's demands, hindering US efforts to probe allegations of fraud that have wiped 61 per cent from a gauge of Chinese and Hong Kong stocks traded in North America since January last year.

Failure to reach an agreement on cross-border access to records might prompt US regulators to seek to deregister the firms, said Paul Gillis, a professor at Peking University's Guanghua School of Management.

"I don't think there's a resolution in sight," said Gillis, who is also an adviser to the Public Company Accounting Oversight Board. "China is hypersensitive to the idea of foreigners operating within its borders and enforcing foreign law.

"The next step is likely to be the PCAOB trying to deregister accounting firms it can't inspect. It's eventually all leading to the delisting of Chinese firms in the US."

The SEC, PCAOB, China's Ministry of Finance and the China Securities Regulatory Commission have been unable to resolve differences over the inspection of audit documents. Chinese law bans the removal offshore of audit papers, while foreign regulators are not allowed to work inside the country's borders.

PCAOB chairman James Doty said talks with the Chinese government were proceeding.

"I continue to believe the Chinese regulatory authorities have every reason to resolve these issues of transparency and access to audit work papers," Doty said. "There is no question that we are nearing a crossroads, a decision point."

Auditors who do not comply with SEC demands face temporary or permanent deregistration in the US, according to the rule under which the proceedings are being brought. China-based auditors signed off on 26 per cent of the 159 so-called reverse mergers by Chinese companies in the US between January 1, 2007, and March 31, 2010, Lewis Ferguson, a PCAOB board member, said in September.

Ferguson, one of the key negotiators with the Chinese, said the PCAOB gave its Chinese counterparts a draft proposal last week that could open the door for joint inspections.

"We presented them with a draft memorandum of understanding … and we talked about some approaches that I am hopeful will lead to a breakthrough, at least on the inspections," he told Reuters.

"Only with access to work papers of foreign public accounting firms can the SEC test the quality of the underlying audits and protect investors from the dangers of accounting fraud," SEC enforcement director Robert Khuzami said.

"Firms that conduct audits knowing they cannot comply with laws requiring access to these work papers face serious sanctions."

The CSRC did not respond to requests for comment. Questions faxed to the Ministry of Finance were not answered.

The SEC has deregistered the securities of almost 50 companies and filed fraud cases against more than 40 issuers and executives as part of its investigation into the non-US based firms.

Many of them entered US capital markets through reverse mergers, in which a closely held firm buys a shell company already public on an exchange, allowing them to list shares without the scrutiny of a public offering.