The ongoing stand-off between securities regulators in China and the US keeps auditing firms hostage and might eventually lead to the delisting of Chinese companies at US stock exchanges. Beida accounting professor Paul Gillis tries to map out a way out of the maze in Forensic Asia.(pdf)
A slew of frauds at US-listed Chinese companies have highlighted flaws in the attempts of US regulators to provide, what they believe is, adequate investor protection. The US Securities and Exchange Commission (SEC) demands the audits of all US-listed companies meet the standards established by the US Public Company Accounting Oversight Board (PCAOB). Unfortunately, Chinese-based auditors are unable to release their audit working papers to US regulators without breaching Chinese law. As such, complying with US regulations could land Chinese auditors in Chinese jails and failure to comply could land them in US jails.
In order for overseas auditing firms to audit US-listed companies, they must submit to an inspection by the PCAOB to ensure they are following US standards. Chinese regulators have been reluctant to offer joint inspections as they believe this is a breach of national sovereignty and have pushed for the equivalent of the audit oversight systems in third countries, similar to the agreement China has struck with the EU. Unfortunately, the PCAOB has little statutory authority to offer this.
The China Securities Regulatory Commission (CSRC) may well cede to some form of joint inspections between Chinese and US regulators but on the condition that only they will be allowed to administer punishment to wayward Chinese auditors. However, approval from the Ministry of Finance is questionable given the issue of “face”.
And Gillis – at the end of high detailed article – cautions, as the situation is still developing:
The biggest risk is to China. If Chinese entrepreneurs are unable to obtain access to capital, indigenous innovation may suffer, and China’s long-term competitiveness may be affected. Chinese stock exchanges are not ready to replace U.S. markets for entrepreneurial companies. The CSRC recently announced it was liberalizing rules for Chinese companies to list overseas, motivated in part by a huge backlog of pending IPOs in China.
The only scenario that resolves the situation without kicking Chinese companies off of U.S. stock exchanges is where the United States and China reach a diplomatic solution. From the U.S. perspective, the PCAOB and the SEC have likely put their best offer on the table. Both regulators are bound to follow U.S. laws, which generally require them to regulate auditors as they have proposed. A law change seems unlikely, given it would propose a lower standard for Chinese companies than that imposed on other companies, including American companies. James Doty has pointed out that the Supreme Court case that upheld the constitutionality of the PCAOB established that the PCAOB is in a reporting line to the President, but it is unlikely, and perhaps not legally possible, for the President to settle the dispute in another fashion.
Investors should watch this situation closely. The market is likely to move significantly if the issue is either resolved or the likelihood of deregistration and delisting increases.
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