U.S.-China Auditing Spat Turns Ugly

The latest twist in a long-running dispute between Beijing and Washington securities regulators over Chinese audits is threatening to boot Chinese companies from America stock exchanges.

The plot thickened on December 3, when the U.S. Securities and Exchange Commission announced administrative proceedings against the Chinese affiliates of five global accounting firms working for nine U.S.-traded Chinese companies suspected of financial fraud.

SEC charged the Chinese divisions of Deloitte, Ernst & Young, KPMG, PricewaterhouseCoopers, and BDO with violating the U.S. Securities Exchange Act and the Sarbanes-Oxley Act by refusing to turn over to SEC working papers attached to the targeted companies’ audits.

The auditing firms have claimed their hands are tied: Turning over a Chinese company’s audit papers to the SEC or any other foreign entity would violate China’s law and regulations.

Debates over conflicting Chinese and U.S. auditing rules have for years embroiled not only the SEC and auditing firms, but also China Securities Regulatory Commission (CSRC) and an industry group called the U.S. Public Company Accounting Oversight Board (PCAOB).

The SEC apparently gave the firms the December ultimatum after losing patience with the progress of negotiations with the CSRC over access to Chinese company audits, according to Albert Arevalo, the SEC’s assistant director for international affairs.

Testifying recently at an administrative law hearing, Arevalo said that since 2009 the SEC had asked CSRC to cooperate with audit probes twenty-one times. In three requests, U.S. regulators asked their Chinese counterparts for access to audit working papers. But never once, he said, did CSRC provide “substantial” assistance.

SEC says its investigators need audits before deciding whether to press charges against U.S.-listed companies accused of defrauding investors.

“Only with access to the working papers of foreign public accounting firms can the SEC test the quality of underlying audits and protect investors from the dangers of accounting fraud,” said the commission’s enforcement director, Robert Khuzami.

Khuzami did not name the nine Chinese companies currently under SEC investigation whose audits remain off-limits to anyone off the mainland.

Ongoing Disputes

Meanwhile, the dispute between CSRC and PCAOB, whose members include each of the five audit firms and their Chinese divisions, has also reached a boiling point.

Unless PCAOB officials and Chinese regulators settle before the end of December, the board may decide the auditors and their China divisions no longer qualify to audit Chinese companies that trade on U.S. stock exchanges, said Paul Gillis, a professor at the Peking University Guanghua School of Management.

And if the auditors are disqualified, Gillis said, the companies would have to delist for failing to meet a key SEC rule, which says every listed company must be regularly audited by a PCAOB-registered auditor.

PCAOB Chairman James Doty said the board would move unilaterally to protect investors if its discussions with CSRC officials failed to yield results.

Indeed, the board may have already taken action against the auditing firms, said a source close to the U.S. regulator, but has kept the moves confidential.

Each auditing firm has called for all parties to reach an agreement and end the regulatory conflicts dividing the United States and China.

A settlement would likely serve the best interests of the firms, too, which have been targets of SEC fire before.

For example, last May the SEC announced administrative action against Deloitte’s Chinese affiliate for refusing to turn over financial documents related to its Chinese client Longtop Financial Technologies Ltd., a software company.

A few months later, SEC asked a U.S. court to subpoena the firm for the documents. A decision was still pending while the administrative proceedings continued, the SEC said.

In connection with the Longtop case, the CSRC in April had agreed to let SEC access some files on condition that the information was not used for legal action without the Chinese regulator’s permission. SEC officials rejected that condition, though, and the CSRC likewise refused to budge.

For several months, Arevalo told the court, SEC officials stopped communicating with the CSRC about the case.

In November, though, it appeared a breakthrough was imminent. CSRC said it was considering standardizing procedures for foreign regulators seeking Chinese audits. CSRC then agreed to turn over a ten-page file on Longtop, but repeated the stipulation that none of the information could be used for legal action without its permission.

SEC officials rejected the file, saying it was only a fraction of what they wanted. And they refused to accept CSRC’s terms.

Two Interpretations

CSRC did not publicly respond after SEC announced its actions against the five auditors. But one commission official, speaking on condition of anonymity, called the U.S. regulator’s move “a negotiating tool,” and said any effort to pressure the auditors “may eventually fizzle out.”

Another CSRC official noted that negotiations between the Chinese and American officials were continuing.

CSRC and the SEC officials have offered different interpretations of a multilateral memorandum of understanding that they have both signed, which is designed to guide cooperative efforts in cross-border securities regulation.

The SEC claims the memorandum lets Chinese companies hand over audit documents. China disagrees, claiming a sovereign right to withhold audits and calling for the two sides to negotiate a separate bilateral agreement to tackle the issue.

Besides, the memorandum “is not legally binding,” said a CSRC official. “We have to obey the Chinese legal system.

“It concerns national sovereignty and is against the (Chinese government’s) secrecy law for foreign regulators to get China-based accounting firms’ auditing papers as they wish,” the official said. “We have different thinking on securities regulation” than the SEC. “China cannot give the U.S. the freedom to enter China and investigate wherever they want.”

A government policy effective since November 2009—jointly issued by the CSRC, the State Secrecy Bureau, and State Archives Administration—says working papers attached to audits of Chinese companies that have listed on overseas stock exchanges must be kept confidential without special regulatory permission.

It also says China’s regulators will always have the final say in any case involving cross-border regulatory issues.

A Chinese regulatory official defended the policy, saying it’s based on the principle of reciprocity. He said CSRC would certainly respect the U.S. regulator if the tables were turned.

CSRC representatives traveled to Washington in November for face-to-face meetings with their SEC counterparts. That’s when they learned the U.S. regulator had decided to take administrative actions against the auditing firms’ Chinese affiliates.

According to Arevalo, SEC officials felt they had no choice but to charge the auditors with breaking the law.