Additional reporting by Rachel Armstrong and Dena Aubin at Reuters
Beijing and Washington are once again at loggerheads. U.S. regulators are pressing their Chinese counterparts for audit records of Chinese companies listed in the U.S. But the Chinese regulators seem unwilling to comply. This reticence is creating doubts over the future of U.S.-traded Chinese stocks, some of which have been rocked by accounting scandals in recent months, denting investor confidence and putting their financial records under the microscope.
The Securities and Exchange Commission (SEC) of the U.S. and the China Securities Regulatory Commission (CSRC) have engaged in lengthy talks, but have yet to agree upon a solution. If they are unable to find common ground, China can expect the U.S. to stall or refuse to cooperate in other ways in the future, James Zimmerman, a Beijing-based partner at Sheppard Mullin Richter & Hampton, tells Reuters. “Then it becomes tit for tat.”
One of the sticking points has been the CSRC’s refusal to budge on its law that Chinese company records can be claimed as state secrets. The law also has had a legal impact closer to home – in a landmark case in August last year, Hong Kong’s Securities and Futures Commission (SFC) took Ernst & Young to court after the auditing firm failed to disclose the accounting records of a former China-based client. Meanwhile, the number of battered Chinese companies delisting from the U.S. exchanges is snowballing, and changing the nature of work for some corporate lawyers in Asia.
Assessing the options
The SEC’s most recent offensive came in December last year, when the regulator requested the Chinese affiliates of the “Big Four” accounting firms – KPMG, Deloitte, PwC and Ernst & Young – as well as BDO, an audit firm, for access to the financial records of nine U.S.-listed Chinese companies suspected of wrongdoing. The affiliates argued that they were unable to release audit papers due to China’s state secrecy law.
If the SEC’s demands are thwarted, accounting experts say the U.S. watchdog agency could ban the Chinese affiliates from auditing U.S.-listed companies. The global dominance of the Big Four and BDO is such that if their Chinese affiliates were barred, multinational companies would face severe difficulties in finding suitable alternatives. In a note to clients, Thomas Shoesmith, a partner at Pillsbury, said that if the SEC barred the five accounting firms from practising in China, companies with major Chinese operations might find it difficult or impossible to find accountants.
Indeed, some U.S. multinationals are already starting to show signs of concern. “It would impact us and any other U.S. company with significant operations in China. Essentially, there would be no auditors in China that the U.S. government would recognise. It will require a diplomatic resolution,” Jonathan Blum, a spokesperson for Yum! Brands, told Reuters.
Many accounting and legal professionals are more optimistic, however. Despite the ongoing dispute between the regulators, they believe a solution will be reached before the SEC resorts to banning the Chinese affiliates from auditing U.S.-listed companies. The CSRC has indicated recently that it is working closely with other regulators on this issue. “Audit papers are very important to maintain market integrity, and the CSRC is ready to cooperate with other jurisdictions on this issue,” said Tong Daochi, CSRC’s director general of international affairs, at Thomson Reuters’ third annual Pan-Asian Regulatory Summit in November last year. “We have engaged with the SEC, SFC and PCAOB (Public Company Accounting Oversight Board) on audit working papers, and we are making progress.”
But this progress needs to be speeded up. While the two regulators search for a solution, many U.S.-listed Chinese companies are seeing their share prices being hammered, and are finding it harder to raise new capital. As a result, some are seeking to delist from the U.S. exchanges and go private. According to Roth Capital Partners, an investment bank, 27 China-based companies listed in the U.S. announced plans to go private through buyouts in 2012, up from 16 in 2011 and just six in 2010. Meanwhile, just three Chinese companies went public in the U.S. in 2012, down from 12 in 2011 and 41 in 2010.
Coming home
After pulling out of the U.S., some Chinese companies may seek to relist elsewhere, with Hong Kong or mainland China being the top choices, say corporate lawyers in Greater China. “The idea is that the markets here understand the China story better and therefore will hopefully assign a higher valuation to the stocks,” Mark Lehmkuhler, a partner at Davis Polk in Hong Kong, told Reuters. Most of the recent transactions have been management-led buyouts, but cheap share prices have also led to several private equity deals. For example, a Carlyle Group-led consortium bought Focus Media Holding for $3.7 billion, marking the largest ever private equity deal in China. A host of law firms advised on the purchase in August last year of the display advertising company, including Simpson Thacher & Bartlett, Fried, Frank, Harris, Shriver & Jacobsen, Skadden, Arps, Slate, Meagher & Flom, Weil, Gotshal & Manges, Kirkland & Ellis, Sullivan & Cromwell and China’s Zhong Lun Law Firm.
The companies delisting from the U.S. may face similar regulatory scrutiny should they choose to go public in Hong Kong. The territory’s accounting and legal community is examining the issue of whether Hong Kong-listed Chinese companies are subject to China’s state secret rules. In the case brought against it by the SFC, Ernst & Young is facing a tricky decision - either comply with the SFC’s request and risk a possible breach of China’s state secrecy laws, or suffer a regulatory backlash in Hong Kong. This case marks the first instance of an accounting firm being taken to court in Hong Kong over China’s state secrets law, and will set a precedent for similar cases in the future.
The SFC has ordered Ernst & Young to hand over its audit records for Standard Water Ltd, a Chinese water treatment company, on the grounds that “accounting and audit working papers relating to private companies applying for listing in Hong Kong must be capable of being produced either directly to the SFC, or via the relevant mainland authority under the standing arrangements for cooperation,” according to an SFC statement.
For its part, Ernst & Young claims that the papers are held in China, and the country’s state secrecy laws prohibit the firm from disclosing these documents to the SFC. “State secrecy laws are often invoked by [mainland Chinese] companies as the reason for not responding to SFC enquiries. This is at odds with the expectations of transparency in regulated markets like Hong Kong’s,” Tom Fyfe, a partner at Simmons & Simmons, told Reuters. The Hong Kong High Court is set to rule in March whether Ernst & Young must hand over the papers to the SFC.
Ernst & Young is not alone in encountering problems with China’s state secret rules. In November 2011, KPMG resigned as auditor of China High Precision Automation Group (CHPAG), after finding discrepancies in the company’s figures. CHPAG announced that it could not provide the information due to the state secret laws. As a result, the SFC suspended trading of CHPAG shares on the Stock Exchange of Hong Kong in August last year.
The Hong Kong High Court’s decision should provide some guidance on the validity of China’s state secrecy laws in Hong Kong. Meanwhile, the standoff between the U.S. and China’s regulators should continue to hurt investor confidence in Chinese public companies, edging more of them to privatise. Hong Kong and China-based lawyers – especially at U.S. firms – can expect to handle more such transactions down the year. Accountants and businesspeople also will closely follow the dispute. One thing is sure – the different communities are hoping the regulators reach a consensus swiftly.
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