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Foreign Policy: Clash of the Balance Sheets

December 12, 2012
I had a new article this week in Foreign Policy magazine on what may seem like an awfully arcane topic — a standoff between US and Chinese regulators over audit standards — but in fact has potentially huge implications for the future relationship between the world’s two largest economies.  You can read it below, or check out the original here.  You can also read my earlier blog post on this topic (from back in June) here.

Clash of the Balance Sheets

The most important showdown between China and the United States isn’t happening in the Pacific. It’s happening at the SEC.

BY PATRICK CHOVANEC | DECEMBER 10, 2012

China and the United States are on a collision course — over accounting. Last week, the U.S. Securities and Exchange Commission (SEC) charged the Chinese affiliates of the world’s top five accounting firms with violating securities laws for refusing to hand over information on suspect Chinese companies to investigators. The move is the latest, most dramatic step in an escalating standoff that could easily lead to a financial version of Armageddon: the forcible (and unprecedented) delisting of all Chinese shares currently traded on U.S. exchanges, including big-name stocks like Baidu, Sinopec, and China Mobile — causing losses of billions of dollars and damaging the perception that the United States is friendly to Chinese businesses.

Accounting audit practices may seem like a topic more likely to lull nations (and magazine readers) to sleep. But as anyone who lost money investing in Enron or with Bernie Madoff knows, playing fast and loose with accounting rules can have huge consequences. Accounting is the language of business, and lying about revenues or liabilities is fraud. Washington created the SEC in the wake of the Wall Street Crash of 1929 to ensure that companies that offer their shares to the public are what they claim to be.

To meet that objective, the SEC requires that all companies selling securities to the public to submit annual financial statements audited by a qualified third party. If a company doesn’t file reports that have an auditor’s stamp of approval, its stocks and bonds cannot be traded on a public exchange. After the scandal following the 2001 collapse of energy giant Enron, in which the company’s auditor, Arthur Andersen, faced criminal charges for covering up dodgy accounting practices, Congress passed the Sarbanes-Oxley Act to tighten up regulation of auditors and the audit process. The new law created the Public Company Accounting Oversight Board (PCAOB), a quasi-public entity that reports to the SEC and is responsible for policing the auditors. Now, in order to perform qualified audits, an audit firm must register with the board and submit to rigorous and regular inspections by its staff.

Over the past decade, roughly 400 Chinese companies have listed their shares on U.S. stock exchanges. A few are multi-billion dollar state-owned enterprises, such as China Life, China Telecom, and PetroChina. More than 100 were so-called backdoor-listed companies that circumvented the cost and scrutiny associated with an initial public offering by buying and merging into a U.S. firm whose stock was already listed. As U.S.-listed stocks, all of them have chosen to submit themselves to SEC regulation in order to tap U.S. and global investors for funds via U.S. markets.

Because the bulk of their operations are in China, these companies must rely on auditors licensed in China — in many cases the Chinese subsidiaries of the top global audit firms — to audit them. For the SEC to accept their audits, these China-based auditors must register and maintain good standing with the board.

The problem is that the Chinese regulator, the China Securities Regulatory Commission (CSRC), refuses to allow the board to inspect the U.S.-registered, China-based auditors, as required by Sarbanes-Oxley. It sees the idea of a U.S. regulator overseeing a Chinese auditor as a violation of China’s national sovereignty. For some time now, the board has been negotiating with the CSRC, trying to get them to accept some form of cooperative inspections, or even allow it to observe Chinese inspections. So far, these talks have gone nowhere.

It’s not unusual for the United States to get pushback from foreign countries or foreign companies on new regulations. When Sarbanes-Oxley first passed, several U.S.-listed European firms (as well as many U.S. companies) objected to a provision requiring listed firms to perform an annual audit of internal controls, in addition to the traditional audit of financial statements. They argued that this extra requirement was so costly and burdensome, they might no longer bother to maintain their stock listings in the United States, seriously undermining the position of the U.S. capital markets on the world stage. In response, the SEC temporarily suspended the rule for foreign companies, and eventually scaled down the requirement for all companies to a less onerous “top-down review.”

Recent events, however, have made it a lot harder for the SEC to show similar flexibility toward China. Since 2010, a number of short-sellers researching in China have leveled high-profile accusations of fraud against Chinese firms listed on U.S. markets. Five companies targeted by Muddy Waters, the best-known of those short-sellers, lost almost $5 billion in market value through June 2011. Several others have seen their shares rendered nearly worthless or been forced to declare bankruptcy. These firms allegedly engaged in malfeasance ranging from questionable accounting practices to inflate revenues and profits, making up numbers out of thin air (and hoping no one has the resources to prove otherwise), embezzling funds, and even being total shams.

The SEC has also raised concerns about a popular holding structure, called the Variable Interest Entity, that many U.S.-listed “China stocks” use to operate in certain industries in China, such as media and education, where foreign ownership is prohibited. The U.S.-listed company exercises operational and financial “control” via contracts, allowing it to claim the China business as its own. Virtually all Chinese Internet start-ups listed in the United States are structured this way. The SEC worries that Chinese authorities could someday invalidate the contracts as illegal, leaving U.S. investors holding completely worthless shares.

In response, the SEC has launched fraud investigations into several U.S.-listed Chinese companies and their executives, ordering their China-based auditors to hand over confidential documents to examine for potential evidence of wrongdoing. In the most visible case, the SEC in May 2011 handed lawyers for Deloitte China a federal court subpoena to turn over its audit work papers for Longtop Financial Technologies, a Hong Kong-based maker of financial software that short-seller Citron Research had accused of fraudulent accounting (prompting Deloitte to resign the account, citing “recently identified falsity” in Longtop’s financial statements).

Deloitte China fired its lawyer for accepting the subpoena, and refused to comply. In a court filing explaining why, Deloitte claimed that Chinese regulators had issued an extraordinary threat, telling auditors that handing over audit work papers would violate China’s (vague and draconian) State Secrets law, allowing China to “dissolve the firm entirely and to seek prison sentences up to life in prison for any [Deloitte] partners and employees who participated in the violation.”

The refusals come at a time when Chinese local authorities, embarrassed by the allegations, have been cracking down on short-sellers’ researchers, shutting off access to company disclosure filings and sometimes harassing and even jailing research teams conducting due diligence within China. The SEC, for its part, asked the judge in the Deloitte case for a stay until this coming January, to see if it could work out some kind of solution with its counterparts at the CSRC.

Last week’s decision to file charges against all five top global audit firms in China appears to signal an end to the SEC’s patience. In its court filing, the SEC expressed frustration, noting that since 2009, the CSRC had refused to provide any meaningful assistance on 21 information requests arising from 16 securities investigations into U.S.-listed Chinese firms. The Chinese, it has concluded, are simply stonewalling.

While the details may seem arcane, the ramifications can hardly be overstated. Chinese auditors could face financial penalties, but they could also be disqualified from conducting SEC audits. If Chinese auditors get de-registered, U.S.-listed Chinese companies won’t be able to find anyone to sign off on their audits, leading all of these firms to have their shares forcibly delisted, en masse, from U.S. markets. Shareholders would still own their shares, but those shares would be much harder to buy and sell, making them worth considerably less.

Some domestic players think China has outgrown its need to rely on U.S. capital markets. State-owned China Development Bank has put together a $1 billion war chest to help buy out U.S.-listed Chinese companies and take them private. Rather than caving in, their defenders argue, Chinese companies should come home and relist on domestic or Hong Kong stock exchanges, where they might command even higher valuations. Given that China’s Shanghai Index is down two-thirds from its peak five years ago, and with Hong Kong regulators raising similar concerns about fraud, this path may not be as easy or as promising as it sounds.

Chinese companies won’t be the only ones affected if SEC-qualified Chinese auditors go the way of the dodo. Plenty of multinationals listed on U.S. markets, many of them headquartered in the United States, have substantial parts of their business in China. Yum Brands takes in 44 percent of its revenues from the KFC and Pizza Hut outlets it has in China. Car sales in China account for 34 percent of General Motors’ profits. These numbers matter to their global bottom lines, and to sign off on their SEC filings, their lead auditors in the United States need a PBAOC-registered Chinese auditor to vouch for them. If no such auditors exist, these companies have a problem. (There may be clever workarounds, such as dividing up the work among so many auditors that none of them is vouching for a “substantial” part of the business, but it’s a costly and cumbersome solution. Nor is it clear if easy loopholes can be created for multinationals with substantial China operations without tearing a big hole in the fabric of U.S. securities regulation).

The SEC, though, may feel it has no other option. China’s constraints effectively place Chinese companies completely beyond the reach of U.S. securities laws. If this were just a theoretical concern, there might be room to maneuver. But with dozens of Chinese stocks traded on U.S. exchanges dragged down by fraud allegations, costing investors billions of dollars in losses, the SEC has to act. And each action it takes brings the United States and China one step closer to an ugly financial divorce.

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13 Comments leave one →
  1. Orthodox permalink
    December 12, 2012 8:17 pm

    This seems to fall within the argument made in Red Capitalism, that financial reform ground to a halt in 2005.

  2. Peter Boodell permalink
    December 12, 2012 9:02 pm

    Good note.

    Peter Boodell
    Managing Partner
    Boodell & Company Capital Management LLC
    600 Lexington Avenue, 14th Floor
    New York, New York 10022
    Tel: +1.212.905.8608
    peter@boodellco.com
    [Description: Description: Description: cid:image001.gif@01CBF51B.5DEEBC00]

  3. December 13, 2012 10:36 am

    Great post. I can’t believe we haven’t heard anything about this in the mainstream press, not even from the “financial” newspapers (FT and WSJ).

    • December 14, 2012 3:15 am

      Actually, this was a top headline on both ft.com, Bloomberg and wsj.com on the day that the lawsuit was announced, and has been at least minor headlines on those sites as the dispute escalated prior to the lawsuit. In my opinion this will end in a was similar to the fiscal cliff–lots of bickering back and forth before some sort of last-minute negotiated settlement is reached.

  4. December 15, 2012 6:56 am

    Fascinating insights, as usual.

    There may be political pressures on each side that make agreement very difficult. From a US point of view, the SEC’s failures to act from Enron to Madoff have created a “must respond” climate. No US politician could do anything but support a tough SEC stance, especially as it relates to Chinese firms suspected of fraud.

    From a Chinese point of view, the problem may extend beyond the “national sovereignty” hot button. This level of intransigence suggests that there could be powerful national politicians whose ox could get gored, if the audit firms can be forced to provide audit details.

    There could be a really big story here waiting to unfold.

  5. Hua Qiao permalink
    December 15, 2012 9:41 am

    No matter how this plays out, the second most dangerous job in China (right behind being a miner) is being an auditor.

  6. Hua Qiao permalink
    December 15, 2012 9:44 am

    Patrick,

    How does it work with other countries? Is there a reciprocal agreement On information sharing or something?

  7. RICO permalink
    December 16, 2012 10:55 pm

    Actually there is an easier way out of this conundrum instead of delisting all China companies: Audit the audit firms. For example, Deloitte has cleverly created separate affiliates worldwide and has effectively fire-walled each affiliate off from lawsuits against the worldwide chain. Now is the time to use RICO on the auditors.

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