SEC Escalates Showdown With Chinese Audit Firms

The U.S. Securities and Exchange Commission (SEC) charged the Chinese arms of the five big accounting firms with violations on Monday for failing to turn over audit reports on U.S.-listed Chinese companies, according to Reuters:

The Securities and Exchange Commission began proceedings against the Chinese affiliates of Deloitte, KPMG, PricewaterhouseCoopers, BDO and Ernst & Young. The agency on Monday also moved to pursue a case they had put on hold against Deloitte.

It was the SEC’s widest enforcement effort yet to procure documents in connection with probes of possible accounting fraud of U.S.-listed Chinese companies, and raised questions about whether talks have stalled between the U.S. and Chinese governments to resolve the issue.

The SEC said it has been seeking documents related to investigations of possible wrongdoing at nine China-based companies. Chinese secrecy laws have stymied efforts to obtain audit documents that investigators need to determine whether there were accounting irregularities.

An administrative law judge will schedule a hearing to determine potential sanctions against the Chinese arms of the accounting firms, the SEC said.

The Financial Times reported that investors were spooked by the news, as shares in Baidu, Sina, Ctrip.com and others tumbled on Tuesday. Most of the accounting firms said they were cooperating with the regulators, according to Edward Wyatt at DealBook, though Kara Scannell and Shannon Bond of The Financial Times point out that the auditors are damned if they do, damned if they don’t, because they will violate U.S. laws if they withhold the documents and Chinese laws if they share them.

A number of U.S.-listed Chinese companies have come under fire over the past two years, as clouds of fraud have hung over the likes Sino-Forest, SinoTech Energy, and Focus Media. And while the SEC has subpoenaed for audit materials, Patrick Chovanec noted over the summer that Chinese regulators had blocked their information requests. Chovanec feared at the time that the SEC-appointed Public Company Accounting Oversight Board (PCAOB) would deregister the auditors in question, therefore leading to a delisting of all U.S.-listed Chinese firms because they would then lack a way to file audited financial statements with the SEC.

Ultimately, claims Ronald Barusch at the Wall Street Journal, The SEC had nowhere else to go in its clash with the Chinese and Monday’s action moves all sides toward a showdown. And while the SEC’s point is fair and might bring a moral victory, John Foley of  Reuters writes in DealBook that “a mass de-listing is no longer far-fetched:”

By escalating the issue to a 300-day court review, the S.E.C. may just prove that compromise is elusive. The agency is effectively asking Chinese auditors to flout local law, or China to cast off its preoccupation with state secrecy. Neither is plausible. Starting a fight as China prepares to hand over power to new leaders, who may wish to score easy political points by swatting away attacks on the country’s sovereignty, looks especially unwise.

It didn’t have to be this way. Back in 2000, when Chinese companies like Sohu and Sina first listed on U.S. exchanges, a tough stance on accountability might have worked. Instead, regulators foolishly turned a blind eye, despite the obvious contradictions in China’s state capitalist model.

Now the cost of taking a stand is high. Were the S.E.C. to refuse to accept accounts audited by Chinese firms, it might leave even established Chinese companies with no choice but to delist.

Both sides should seek a compromise to avoid the China delistings, according to a lawyer who spoke with Bloomberg’s Belinda Cao:

Should the auditors be barred from reviewing the financial statements of Chinese stocks listed in the U.S. the companies would have to withdraw from the market, Steven Winegar, a Hong Kong-based partner at Paul Hastings, which has represented companies including Nasdaq-listed Jiayuan.com International Ltd. (DATE), said on a conference call hosted by Jefferies Group Inc. today.

“That of course has a catastrophic effect on the market value and on the companies themselves.” he said on the call with investors. “It’s almost unthinkable that it will get to that stage.”

The key issue in this case is whether U.S. or Chinese regulators should have primary supervising responsibility for the accused auditing firms, according to Winegar. The SEC order “gives a fair amount of time for continuing negotiations and continuing settlements” between the Chinese and U.S. authorities, while “there’s no assurance this will be resolved any time soon.” he said.