The recent suspension of the Chinese affiliates of the “Big Four” accounting firms from auditing U.S.-traded companies for six months has sent shares of many companies tumbling and strained relations between U.S. and Chinese regulators. The suspension order, issued by an SEC administrative judge on January 22, ruled that the four firms in question “acted willfully and with a lack of good faith” in refusing to hand over details related to audits of several Chinese-based issuers. The accounting firms—Deloitte Touche Tohmatsu, Ernst & Young Hua Ming, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian– stated that doing so would potentially be a criminal act under Chinese law, which treats such documents as “state secrets.” Skeptics of this stance question whether the auditors are attempting to protect themselves following bad audits of fraudulent companies, while the SEC’s chief litigation counsel Matthew Solomon more diplomatically told Bloomberg that the records are “critical to our ability to investigate potential securities law violations and protect investors.”
The suspension, if upheld, could lead to significant consequences for hundreds of U.S.-traded Chinese issuers, as they are required to file their annual reports on Form 20-F by April 30, 2014. A failure to provide shareholders with audited financial statements could lead to their delisting on U.S. stock exchanges. While this extreme scenario is unlikely given that the Big Four have pledged to appeal the ruling and that the suspension would not be in place during what could be a very lengthy process, investors certainly were spooked; the announcement triggered a sell-off that saw the Bloomberg China-US Index drop by around 4% the following day.
Concerns regarding the audit quality of some Chinese-based companies are not new or far-fetched. Investor demand for exposure to the rapidly-growing Chinese economy at the turn of the century increased following the poor performance of U.S. equity markets in the wake of the financial crisis. This demand was met by a large number of companies that gained listings on U.S. stock exchanges through reverse-mergers, which subject the companies in question to less scrutiny than a traditional IPO. A 2010 Research Note by the PCAOB noted that the audit environments at many companies were unlikely to be up to its standards, while the spectacular implosion and subsequent delisting of several fraudulent companies since 2011 paved the way to fame (and presumably fortune) for short-sellers specializing in due diligence, such as Muddy Waters LLC. A personal favorite is the case of Jiangbo Pharmaceuticals, a then-NASDAQ-traded company which received an SEC subpoena and began an internal investigation on site in China during 2011. Jiangbo’s entire audit committee and CFO resigned when management became uncooperative with the investigation, which descended into farce when a third-party investigator was allegedly unable to question a local manager when he entered a bathroom and refused to exit for several hours.
Two key questions arise from the announcement of the suspension. First, can U.S. and Chinese regulators reach a compromise that facilitates China-based companies’ access to U.S. capital markets? Second, even if regulators can find a middle ground to ensure that international audits meet PCAOB standards, what steps can be taken to improve these standards in the wake of a substantial amount of fraud? The answer to the first is political; formal talks between U.S. authorities and the China Securities Regulatory Commission (“CSRC”) began two years ago and resulted in the release of a Memorandum of Understanding (a cooperative framework between the CSRC and the PCAOB) in May of 2013 that should have facilitated a solution to the impasse. The SEC’s move to suspend Big Four auditors is indicative of frustration or at least impatience with progress in this regard. The CSRC, for its part, quickly criticized the ruling and stated that “the SEC should bear all responsibility to possible consequences arising from the decision.” Additionally, there are clearly holes in the way audits are being conducted at U.S.-traded foreign private issuers. Control deficiencies stemming from a lack of personnel with experience and qualifications in applying GAAP remain widespread at many foreign companies with U.S. listings, while current PCAOB standards only require one auditor inspection every three years.
The Big Four’s appeal of the suspension (which potentially tees up a showdown in federal court) should ensure that the annual reports for fiscal year 2013 reach investors, but concern remains that the information inside some of these reports will be inaccurate at best.