A call to action

A call to action: Plugging the regulatory holes

China MediaExpress Holdings, Inc. (NASDAQ: CCME) reported that its registered independent accounting firm, Deloitte Touche Tohmatsu (DTT) has formally resigned as of March 11, 2011.    CCME CFO Jacky Lam subsequently resigned.   CCME had been under attack since February 3, 2011 when Muddy Waters Research issued a report alleging that the company was a fraud.  Muddy Waters and other short sellers have created a cottage industry outing fraudulent Chinese companies listed on U.S. exchanges.  

According CCME’s press release, Deloitte advised the company that it was no longer able to rely on the representations of management – code words that suggest that management was less than truthful in statements made in the all important representation letter where management takes responsibility for the financial statements.  Auditors have limited responsibility for detecting fraud and rely heavily on management integrity when they conduct their audits.   If you cannot trust management, you cannot trust the financial statements. DTT also told the company that it recommended that certain issues encountered during the audit be addressed by an independent investigation. DTT's resignation letter also stated that these issues may have adverse implications for the prior periods' financial reports and that, in their view, further investigatory procedures would be required to determine whether the prior periods' financial reports are reliable.  The  company has launched the necessary investigation and says their annual report might be delayed a month or more while they work through that and find a new CFO and auditor.  Good luck with that. 

CCME is the latest in a series of recent accounting scandals at U.S. listed Chinese companies. China based companies with  U.S. listings were hit with 12 class action lawsuits in 2010 and at least two have already been filed in 2011 – including one against CCME. China Agritech, Inc. (NASDAQ: CAGC) fired Ernst & Young last Friday alleging that E&Y’s SOX 404 work for the company had impaired the auditors independence, a surprising finding given that most companies use their auditors to help with SOX 404 compliance.  The day before CAGC had appointed a special committee to deal with fraud allegations against the company, and a related class action lawsuit has been filed.  There is undoubtedly more to this story.     Most of the earlier accounting scandals of U.S. listed Chinese companies had involved small accounting firms from the U.S., that were auditing small companies that listed through reverse mergers. The latest scandals involve firms on NASDAQ, and which were audited by the Big Four.  

I think it is time that we say we have had enough.  The problems with audits of U.S. listed Chinese companies are now threatening the integrity of the capital markets.  Good, honest companies that need capital are getting tossed into the “sin bin” with some real scoundrels.  The SEC has started a crackdown on Chinese companies, and I have heard on the street that “comment letters” have been coming out with some regularity.  U.S. regulators, however,  are hamstrung when investigating Chinese companies.   China has refused to allow the SEC and PCAOB to conduct inspections in China, citing national sovereignty.  This has created what I call a “regulatory hole”, where firms that audit U.S. listed Chinese companies are essentially unregulated.  The PCAOB cannot come to China to examine the work of China based auditors.  The CSRC is only interested if the company has a dual listing in China (most do not) and the CICPA only looks after CPAs licensed in China and at filings done under Chinese accounting standards.  Most of the partners signing U.S. listings are licensed in the U.S. or Hong Kong, but not in China. 

I call for the SEC, PCAOB, CSRC and CICPA to come together and fix this crisis.  They need to put aside any nationalistic interests and recognize that functioning capital markets are critical for the health of both countries.  We need a strong, competent, and honest audit profession.  There are bad apples among Chinese companies that are stealing investors blind, at the same time destroying the reputations of many good Chinese companies and auditors.  Audit firms have an important role in ensuring the integrity of the markets, and they are falling short.  Effective regulation of audit firms is a start towards making audit firms accountable. The audit firms, particularly the Big Four, need to help find a way to make the regulatory process work, and help to restore confidence in the capital markets. 

Here are my suggestions.

1. Require all foreign accountants (both firms and individual partners) practicing in China to register with the CICPA and consent to its regulation. The foreign accountants would not become Chinese CPAs, but would be permitted to do foreign work only.

2. Require all firms auditing U.S. listings to participate in a peer review program directed by the CICPA in consultation with the PCAOB. The peer review teams should be made up of experienced SEC partners from the U.S. CPA firms.  The peer reviews would take the place of PCAOB inspections and should satisfy China’s national sovereignty concerns. This is a compromise solution that is vastly better than the nothing we have today. 

3. China and the U.S. should coordinate enforcement and disciplinary actions. 

4. The audit firms with offices in China should agree to fund this process. 

Regulatory reforms alone will not fix this crisis, but by putting in place the proper systems of accountability we can begin the process of restoring confidence in the markets. 

Paul Gillis 
March 15,2011

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