Second-tier accounting firms have long complained about provisions in financing agreements that require the use of Big Four audit firms. These “Big Four clauses” are viewed to give an unfair advantage to the Big Four over second-tier firms like BDO, RSM, Crowe Horwath, and Grant Thornton. In the United Kingdom, the Office of Fair Trading has been ordered to investigate whether these clauses are stifling competition in the market. The Big Four firms, while agreeing that the clauses are inappropriate, maintain there is little evidence that they exist.
In China, the dominance of the Big Four is mostly because of the mutually reinforcing behaviors of investment bankers, international lawyers and the Big Four firms, who insist on their mutual participation as a means of managing their risk. In my academic work I call these professionals members of the “transnational capital class” who are a major force in globalization. I have not seen any evidence of Big Four clauses in China – until now.
I have been reviewing the SEC filings for Harbin Electric’s (NASDAQ: HRBN) going private proposal. (It is under attack by shortsellers). HRBN’s CEO has proposed to take the company private with $400 million of funding provided by China Development Bank (CDB). CDB is a state owned bank directly under the supervision of the State Council. It has been described as the engine that powers the national government’s economic policies. Certainly CDB would follow State Council policies for the accounting profession and not use Big Four clauses?
Think again. In CDB's loan commitment to HRBN this general undertaking is required:
No Group Member may replace the Auditors, unless the new auditor to be appointed is any of Deloitte & Touche, PricewaterhouseCoopers, Ernst & Young and KPMG.
So, CDB is precluding HRBN from hiring any of China’s top local accounting firms, including the affiliates of BDO, RSM and Crowe Horwath who rank in the top 10 in China and globally. But HRBN can keep its existing auditor – California based Frazer Frost. Frazer Frost is currently serving out a suspension from taking on new clients that the SEC imposed because of shoddy accounting work in China.
I doubt that CDB made a conscious decision to insert the Big Four clause in HRBN’s loan commitment. I suspect it was boilerplate inserted by White & Case, CDB’s U.S. legal counsel, which itself is evidence that these Big Four clauses are more widespread than the Big Four would like you to think. (the fact that the firms are not in alphabetical order, but in the order of size in the U.S. market, not in China, lends further support to that argument). There is a lesson in here for CDB, however – it is important to read the agreements and when adopting western practices to make sure they actually are the best practices for China's development.
Update: Jeremy Newman, CEO of BDO International Limited, has published some observations on this post in his blog.
Further update: The loan commitment of CDB to China Surveillance and Security has the same Big Four clause.