SEC spat needs diplomatic solution

The Big Four global auditing firms intend to appeal their Chinese affiliates' six-month ban from servicing any US-listed Chinese clients. The US Securities and Exchange Commission (SEC) handed down the ban last week after the affiliates' persistent refusal to disclose documents – a violation of the Sarbanes-Oxley Act.

“None of the work-arounds the Big Four are considering are long-term solutions,” said Gene Buttrill, a partner at Jones Day. “It doesn't matter if they create new auditors, reincorporate affiliates, or shift audit work around affiliates.”

“This is a diplomatic matter to be resolved through cooperation by the PRC and US governments, not an issue to be fought out in the courts,” he added.

Buttrill added that the SEC was “absolutely in the right” and is likely to win the appeal on merits.

Hong Kong is a model, but not a refuge

Tailoring business objectives to global values remains a big challenge for Chinese businesses. Practitioners have noted that Hong Kong could be a good model for China to follow. Though it roughly follows the US model, the Hong Kong Stock Exchange (HKSE) has more stringent provisions.

The US allows any company to list as long as it meets the financial and corporate governance requirements of the stock exchange. Hong Kong takes a rules-based, prescriptive approach which requires proof of compliance, including legal opinions. These rules impose requirements as to management and shareholder continuity and related-party transactions.

Many of the HKSE's rules are based on the activity of Chinese companies as it has spent the last 30 years listing them and trying to deal with attempts to exploit loopholes.

Though several companies on the US IPO waiting list are now looking to go public in Hong Kong, the ban may upset all capital markets if nobody – both existing and potential players – can get audited.

Some market participants predict that the companies affected by the ban will turn their audits to the Big Four in Hong Kong instead, but Professor Paul Gillis of Peking University claimed this won't work.

The accounting professor explained in his blog that doing most of the audit of a Chinese company requires a temporary audit practice licence from China, and despite being relatively easy to obtain, this means complying with Chinese laws.

“Any US or Hong Kong firm that would venture into China to do audits would be setting themselves up for the same problem that the China member firms have – they cannot turn over work papers to the SEC,” he wrote. Refusal to do this would risk losing the right to audit US listed companies anywhere, a risk no auditor would take.

Hong Kong member firms of the Big Four have already signed some audit reports on Chinese companies, according to Gillis. He pointed out that although KPMG has historically signed all of the reports on US-listed Chinese companies in Hong Kong, it had recently signed a US IPO in the name of its mainland member firm KPMG Huazhen.

KPMG Hong Kong had also signed the audit opinion as principal auditor for two companies, yet the SEC discovered that KPMG Huazhen was actually responsible for more than 90% of the audit work. Gillis saw no way KPMG Hong Kong could be treated as the principal auditor, and stated that the mainland firm should have signed the reports.

Diplomacy is needed

Beyond all the market concerns is a political disagreement that needs to be resolved. Cooperation between the regulatory bodies is key, but only diplomacy can create a long-term solution.

The SEC's decision has actually come at a bad time, said Buttrill. “The PCAOB [Public Company Oversight Accounting Board] and CSRC are engaged in a reconciliation process, that has resulted in PCAOB receiving access to audit papers of some PRC issuers accused of fraud.”

The two parties signed an MOU about nine months ago and although progress had been made, it was only a test solution to the bigger problem. “The appeal of this recent ruling will take two or three years; the two governments need to reach a compromise within that time,” he added.

China's government is insisting that its data must be protected, and has recently cracked down on corporate information providers like Standard & Poor's. Without a diplomatic resolution, even if accounting firms avoid further sanction this time, an immediate or even permanent suspension is possible in the future.


By Katherine Jo