Possible PCAOB deal
I am in Washington for the meeting of the Standing Advisory Group of the PCAOB, of which I am a member. This morning PCAOB chairman James Doty reported on PCAOB activities. He said this about China:
China, in particular, has taken considerable attention. We continue to discuss our need for a protocol to inspect PCAOB-registered firms in mainland China and Hong Kong. I am mindful that we cannot wait forever. Meanwhile, though, I am optimistic that we will soon be able to announce a protocol to exchange documents and other information necessary to enforcement investigations and disciplinary proceedings.
This would be an important start that, I believe, reflects the Chinese authorities’ understanding that investors in both our countries need to have confidence that allegations of fraud will be properly investigated. It would be an acknowledgement that access to relevant documents is fundamental to effective investigations. Access to documents will also, of course, be necessary to carry out an effective inspection regime.
Treaty shopping and auditor independence
Overseas listed Chinese companies mostly use offshore listing vehicles to avoid Chinese restrictions on overseas listings. These offshore vehicles are typically incorporated in the Cayman Islands for its favorable tax regime and well-established corporate laws based on English law. Companies listed through reverse mergers often have U.S. corporations at the listing vehicle, which has the unfortunate side effect of bringing the Chinese company under the U.S. tax system.
Overseas listed Chinese companies typically operate in China through subsidiaries known as wholly foreign owned enterprises (WFOE). A WFOE is a corporation and is also the normative form of operation in China for multinational corporations. When a WFOE has profits that it wants to distribute to its parent company, it must pay over a dividend withholding tax of 10% of the proposed distribution before it will get permission to convert the RMB profits to foreign currency and distribute them to the offshore parent company. In the case of Cayman Island holding companies, there is no further tax in the Cayman Islands so the profits can then be distributed to public shareholders with no further tax. In the case of U.S. parent companies (as in reverse mergers or MNCs) the U.S. may take another cut, although this is so complex I will not go into it.
SEC case against China firms advances
The SEC administrative proceedings against the Big Four and BDO in China have shown some life.
On April 30, the Administrative Trial Judge issued a ruling shooting down a request for summary judgment on a number of procedural issues. The accounting firms were mostly trying to get the case dismissed based on arguments they were not properly served.
The firms also argued that in a number of the instances in which they were charged they did not actually issue any audit reports, which under their legal theory ought to set them free. I have suspected that many of these cases related to companies that attempted to upgrade to Big Four firms when the reverse merger scandals began to appear in large numbers in 2011. Many companies that had to come to market using smaller accounting firms tried to change to a Big Four firm to distinguish themselves from other reverse merger companies. This was particularly common with former clients of Frazier Frost, which had a number of clients fail in the early running of the scandals. In a number of cases the attempt to upgrade failed when the Big Four firm could not get comfortable with their new client, and that often led to the company being delisted. The SEC probably asked for the working papers on these companies to figure out what went wrong.
PCAOB leniency program
The PCAOB has announced a new policy that offers leniency if firms turn themselves in for violations of PCOAB rules. The SEC has similar rules. These leniency programs make sense – they discourage firms from covering up and protect investors by getting at the problems quicker.
Given that the PCAOB cannot do inspections in China at present, I doubt many Chinese audit firms are planning to turn themselves in. They should probably think twice about that.
If there is a breakthrough in negotiations between U.S. and Chinese regulators over audit working papers and inspections, the problems of the firms may just be beginning. I expect that U.S. regulators will arrive loaded for bear. They will likely find a target rich environment, since I don’t believe most Chinese auditors have any idea about PCAOB inspections. Every U.S. audit partner I have talked to who has been through one says he would have traded it for a root canal any day.
My recommendation is that the firms start making a list. At the top of that list I would put violations of the principal auditor rule. There are a number of situations where the Hong Kong firm is signing off on the accounts of U.S. listings while all of the audit work is done on the mainland. I have previously written about that problem with Hong Kong listed companies, but it also exists with a number of U.S. listed companies.
Deloitte loses in federal court
A U.S. District Court judge has lifted the stay on the enforcement of the SEC’s subpoena of Deloitte’s working papers on Longtop Financial Technologies. The SEC had asked for the stay last July so that it could attempt to negotiate access to the working papers with Chinese regulators. The SEC gave up on that in December and asked the judge to lift the stay. Deloitte protested, pointing out it was already in the dock with the rest of the Big Four and BDO over the same issue and it was unfair to single them out for early punishment.
Unsurprisingly, the judge was unimpressed by Deloitte’s arguments and has lifted the stay. Now the SEC and Deloitte will be back in court on May 1 to argue whether the subpoena should be enforced. If that goes badly for Deloitte they will be ordered to cough up the working papers, and when they inevitably refuse to do that (since China has told them doing so would land them in jail), they will be back in court again talking about what penalty should be imposed for contempt of court. I expect that they get banned from auditing U.S. listed Chinese companies, but not the Chinese operations of their MNC clients like General Motors and Microsoft. But Deloitte inevitably appeals...
IFRS convergence in China
The global accounting association ACCA has released a report it commissioned on IFRS convergence in China. Chinese accounting standards converged with International Financial Reporting Standards (IFRS) by 2007. In layman’s terms, the study attempts to determine whether investors rely more on the new IFRS based financial statements than they did on the statements prepared under old Chinese accounting standards (CAS). In other words, does accounting information prepared under IFRS move the market more than accounting information prepared under old CAS?
Prior research results were inconclusive, so the authors added more explanatory variables, looking at industry classification, regional development, state control, foreign ownership, delisting regulations, and state subsidy.
The study finds that there is a significant increase in value relevance after IFRS convergence. That is, investors now pay more attention to financial statements than they used to. There are a number of secondary findings – the financial statements of firms in developed regions, those involved in manufacturing, and those with foreign ownership are relied on more.
Chinese CPA profession to step up?
Simon Rabinovich of the Financial Times has an interesting article about comments recently made by Zhang Ke, senior partner of ShineWing, one of China’s leading local accounting firms.
Zhang Ke is reported to have said that his firm has all but stopped signing off on bond sales by local governments over concerns that the debt may have become unserviceable.
At first blush it appears that Zhang is simply stating the obvious – local government debt is out of control. What is remarkable is that his firm is standing up to local governments, and that Zhang is talking so openly about it. I think this may mark the beginning of a new era for CPAs in China. Are CPAs about to take a greater role in governance in China – speaking the truth to power?
In my opinion, Zhang Ke is the top CPA in China, more powerful than any of the Big Four senior partners. He once headed Coopers & Lybrand’s joint venture in China, only to leave in 1998 to start his own firm after a falling out upon the merger of Coopers & Lybrand and Price Waterhouse. His firm, ShineWing, has prospered, even though he eschewed aligning with second-tier international firms, as have most other large Chinese CPA firms. Instead, Shinewing has tried to build its own international network, a quixotic adventure given the 150-year head start of the Big Four.
Four fronts in regulatory war
This post is an update of the continuing struggle over accounting regulation for Chinese companies listed abroad. There are currently four fronts in this battle.
SEC v. Deloitte
This was the first case and relates to Deloitte’s refusal to provide audit working papers related to alleged fraud Longtop Financial Technologies Ltd. The case was back in federal court this week for a 90-minute hearing. The SEC wants to lift a stay that the judge imposed back when the SEC still hoped for a negotiated settlement with Chinese regulators. The SEC gave up on that last December and wants the court to force Deloitte to turn over the papers. Deloitte argues that lifting the stay would put the court in the middle of an international dispute between China and the U.S., and might undermine negotiations for a settlement. The judge asked both sides whether the opinion of the State Department ought to be sought. U.S. Secretary of State John Kerry was in China this week, but I expect he was too busy talking about Kim Jong Un to spend much time on audit working papers.
Beware of large dividends
The variable interest entity (VIE) structure has many problems. Every Form 20F of a Chinese company using the VIE structurewarns investors that Chinese regulators may decide that the VIE structure is ineffective at circumventing Chinese rules that restrict foreign investment in certain sectors, effectively putting the company out of business. Or the shareholder of the VIE might just decide to disregard the VIE arrangements and take the operations for himself. That has happened a couple of times, often enough to put a permanent VIE discount on the value of these stocks.
One of the other problems with asset heavy VIEs is that they become impossible to operate over time. The idea behind a VIE is that the public company can get access to the VIE's profits through service charges. That does not work well in practice. It is difficult to explain to tax authorities that all of the profits of the business should be extracted through service charges by a wholly foreign owned enterprise (WFOE) that does not actually do much to deserve them. If the tax authorities disallow a deduction for the service charges to the VIE, the tax rate soars. Even if the deduction is allowed, service charges are subject to business tax at 5%. The other problem is that if all the profits are taken out of the VIE, the cash ends up in the WFOE. The business scope of the WFOE will not allow it to loan the cash back to the VIE, where it is needed for working capital. Because of these problems, many VIEs just continue to accumulate cash in the VIE.
EDU's VIE disclosures
New Oriental Education & Technology Group Inc. (NYSE: EDU) filed an amended Form 20F for the fiscal year ended May 31, 2012 on February 22, 2013. The amended 20F has been reported in the Chinese press as having been filed on April 3, but I think that is the day they discovered it. The stock was hammered yesterday, but I doubt that relates to the discovery of the filing.
The amended filing was a consequence of continued SEC attention to EDU’s VIE structure. EDU says the document “does not reflect events after the filing of the original report” but then immediately discusses the reorganization of Deloitte into an LLP, which happened on January 1, 2013. From my review of the document, the most significant change is the signing of a new power of attorney on December 3, 2012 (also after the original report). The power of attorney is between EDU’s WFOE and Century Friendship, Chairman Michael Yu’s private company. The power of attorney allows the WFOE to unilaterally act for Century Friendship on New Oriental China, EDU’s master VIE. The new power of attorney replaces one signed on April 23, 2012, which was presumably not strong enough for the SEC.
Jack Lew in Beijing
I published an opinion piece in the March/April edition of China Law and Practice on the standoff between U.S. and Chinese regulators. I make the point that China could lose out if it fails to make a deal with U.S. regulators on audit matters.
Treasury Secretary Jack Lew is in Beijing today. He met with Xi Jinping and new MOF minister Lou Jiwei this morning, and is scheduled to meet with Li Keqiang. Lew has a lot to talk about, with cyberspying, currency and intellectual property certainly high on the agenda. I hope he also is able to discuss the SEC/PCAOB standoff with Li Keqiang. I don't think the PCAOB can justify holding off much longer in hopes to reach a bilateral deal with China on joint inspections. If a deal is not soon reached, I expect the PCAOB will be forced to begin the process of deregistration of accounting firms that would lead to Chinese companies being delisted from U.S. stock exchanges.
Customizing punishment for the Big Four
Aruna Viswanatha of Reuters has an interesting article this week about how the SEC is testing customized punishments. George Canellos, the SEC’s acting enforcement director is quoted as saying: “We want to use all the tools available to us to specifically discourage repeat misconduct and go beyond the injunctions we traditionally obtain”.
This new approach could be appropriate when the SEC decides on how to punish the Chinese accounting firms should it win its case against them.
In their testimony last week before the U.S.-China Security and Economic Commission both the Center for Audit Quality’s Cindy Fornelli and the U.S. Chamber of Commerce’s Tom Quaadman both warned of the risk of a blanket ban against Chinese accounting firms by the SEC. Such a ban could mean that U.S. multinational corporations (MNCs) like General Motors could not be audited since they have significant Chinese operations.
I pointed out in my testimony, as I have before, that it is unlikely that any action by the PCAOB will threaten the audits of U.S. MNCs because under PCAOB rules the auditor must play a substantial role in the audit before it must be registered with the PCAOB. The way substantial role is defined under PCAOB rules makes it highly unlikely in my view that the audit of any U.S. MNC operating in China trips the wire.
Another U.S./China regulatory battle
There is a battle brewing between U.S. and Chinese regulators that may be bigger than the current standoff between the PCAOB and SEC with Chinese regulators over audit working papers.
The Foreign Accounts Tax Compliance Act (FATCA) requires non-U.S. banks, investment funds and other financial institutions to tell the U.S. Internal Revenue Service about accounts held by Americans with more than $50,000. If financial institutions do not cooperate, they could be kicked out of the U.S. We are talking big institutions here, like Bank of China and HSBC.
Like in the auditing standoff, many other countries have also resisted providing this information, and also like the auditing standoff, bilateral arrangements have been negotiated with many countries, including most importantly the popular bank secrecy country of Switzerland.
Unsurprisingly, China is holding out, as is Hong Kong. China probably views this as another attempt by the U.S. to extend U.S. law to China that impinges on China’s national sovereignty. This is an action against U.S. citizens, not Chinese, so it is probably less offensive to the Chinese than the SEC/PCAOB actions which go after Chinese accounting firms and U.S. listed Chinese companies.
Independent directors and China
I was scheduled to testify before the U.S. China Economic and Security Commission last Thursday. Unfortunately my flight was cancelled due to the storm called Snoquester. I did watch the hearing, which is webcast here. The Commissioners did often reference my written testimony.
One of the more interesting lines of questioning came from Commissioner Jeffrey Fiedler. He noted that U.S. companies have said to U.S. courts that they cannot provide information to the courts, because that information is either a state secret or is private under the law of the other country. That “raises serious questions as to whether the boards of directors, the U.S citizen members of boards of directors of U.S. multinationals, are able in fact to perform their duties when companies have invested in China.”
Caterpillar recently was forced to write off $580 million after accounting irregularities were found at a recent acquisition in China. Reuter’s reported that a former Caterpillar board member said that the board was distracted and paid relatively little attention to the transaction.
New challenge to VIEs
I have learned from some investors that there has been a major challenge against the VIE structure of a U.S. listed Chinese company. The challenge relates to whether the VIE can be consolidated into the financial statements. The SEC has been aggressively examining VIE arrangements, but I have been unable to learn whether this challenge is a result of an SEC investigation, or who the company or auditor are.
Bear with me; this discussion has to get technical.
Under the VIE accounting rules, consolidation of the VIE is allowed if the public company is considered to be the primary beneficiary of the VIE (ASC 810-25-20). In a typical VIE arrangement, there are two potential beneficiaries of the VIE: 1) the Chinese individual who owns the shares in the VIE, and 2) the public company that has contracts with both that individual and the VIE that transfer control and economic interests to the public company. VIE arrangements are structured to make it clear that all of the control and economic interest flows to the public company.
Deloitte loses a round
The judge has lifted his stay in the SEC case against Deloitte over the Longtop working papers. This slowly moves the ball forward. Now there will be a hearing on March 13 to hear the merits of the case.
Eventually, I expect the judge will rule that Deloitte must turn over the Longtop working papers to the SEC. Deloitte will certainly refuse citing Chinese laws that criminalize doing so. The judge will likely find Deloitte in contempt of court and punish them, possibly fining the firm, ordering the arrest of its partners should they show up at the San Francisco airport, or banning them from practice before the SEC. The latter could cost Deloitte China all of its U.S. listed clients. But I expect Deloitte appeals and the issue is tied up in courts forever.
Unless the Chinese come around to making a deal with U.S. regulators, I expect that the SEC proceedings will be subsumed into a PCAOB process to deregister all of the firms. China’s new government could make a deal soon, but I think it is now more likely that the PCAOB begins the process of deregistration.
Market reform
On Thursday night I was honored to be recognized by the International Financial Law Review as the Market Reformer of the Year at their annual awards ceremony in Hong Kong.
I told the group that the award was undeserved. While I have been a voice for market reform, I cannot point to a single reform that I have helped to make happen. Nonetheless, there are three issues that I am focused on for the next year.
Transparency in Asia
First, I am concerned about recent changes by governments in Asia to reduce transparency. In China, it has become impossible to access basic corporate data from the SAIC. It is just not possible to do effective due diligence if you cannot confirm basic data concerning the identity of market participants. This information has also been used by short sellers to target companies, and by reporters to out corruption. The government has allowed the interests of the powerful to trump the legitimate needs of the public, and that never ends well for investors.
In Hong Kong, David Webb recently was forced by Hong Kong regulators to take down his useful website that provided identification information on corporate directors of Hong Kong companies. Hong Kong regulators may be well meaning in trying to protect the privacy of personal data. However, when someone wants to operate in the public space as a director of a public company, data privacy laws should not protect their identities. We need to know who these people are. If you want to stay out of the public spotlight, stay out of the public.
Two months - no action
It has been two months since the CSRC and MOF sent a recommendation to the State Council on audit regulation and nothing has happened. While I hope I am wrong, I don’t think the State Council is going to do anything.
The PCAOB is beginning to stir. James Doty gave an interview to Knowledge at Wharton:
“If the Chinese authorities continue to put up obstacles to legally required inspections of firms that have chosen to register in the U.S., the PCAOB will have to reevaluate the status of those firms in our system,” he stated. If the PCAOB can’t inspect auditors of U.S.-listed companies, by law, it has to deregister those auditors. That, in turn, may well lead to deregistration from U.S. exchanges of companies that employ those auditors, including the China-based affiliates of many U.S. and multinational companies. “We are mindful of the potential consequences,” said Doty. “The PCAOB will work to find the least disruptive solution. Any action the Board takes will be a result of thorough and thoughtful deliberation. But ultimately, our charge is to implement and enforce policy decisions embedded in U.S. law to protect the interests of investors in quality audits.”
Settlement pending?
We have had signals over the past few weeks that negotiations are continuing in the standoff between U.S. and Chinese regulators. There was an article in the Chinese press reporting that a proposal for cooperation had been sent to the State Council by the CSRC and the MOF.
Friday, PCAOB member Jeanette Franzel said during a conference at Baruch College that the PCAOB and SEC are making progress on negotiating a memorandum of understanding with the Chinese government.
Some of Franzel’s comments were reported by Accounting Today:
“Unfortunately we have seen a lot of fraudulent activities in those companies, and beginning in 2010 and since then, about 67 of those companies have had their auditors actually resign, and 126 of those issuers have either been delisted from the U.S. exchanges, or they’ve gone dark and are no longer tapping into capital,” said Franzel. “We don’t know how many more are out there and may need to remove themselves from the U.S. markets. Both we and the SEC are trying to negotiate with the Chinese government right now. We’ve been negotiating for quite some time, so there could be some more out there. It is a serious issue for investors who have invested in these companies if we and the SEC do not have oversight, so we continue to work on that.”
State Council and PCAOB/SEC
Securities Times reports today that the Ministry of Finance and CSRC submitted recommendations to the State Council on how to resolve the impasse over regulation of auditing. There is no report on the nature of the recommendations, only that the State Council attaches great importance to the matter. Bloomberg has reported on this.
The recommendations were apparently submitted before the end of last year.
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