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.
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.
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.
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.
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.
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.
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.