Professor Paul Gillis, professor of practice at Peking University reflects on the struggle to regulate the auditors of China’s overseas listed companies.

Investors have been pummeled by a seemingly unending run of accounting scandals with overseas-listed Chinese companies. Short selling research firms spawned a new industry attacking Chinese companies for problems real and imagined and found ways to profit regardless of whether the allegations were ultimately proven to be true. Auditors came under fire for failing to catch these alleged frauds and regulators were criticised for not effectively regulating the sector. US and Hong Kong regulators clashed with their China counterparts putting the overseas listings of Chinese companies at risk.

The US Securities and Exchange Commission (SEC) sprung into action with a task force focused on Chinese frauds. The task force ran into a roadblock trying to get information from China. Sarbanes-Oxley requires auditors to cooperate with the SEC, so they were asked to turn over working papers on suspected frauds to the SEC. The auditors refused because China does not permit audit working papers to leave China or to be given to foreign regulators.

The SEC filed charges, and last February an SEC administrative trial judge banned China’s Big Four firms from practise for six months. The firms have appealed, briefs are not due until December, and final resolution seems some distance away.

The US Public Company Accounting Oversight Board (PCAOB) has been negotiating with China for more than a decade for permission to inspect Chinese accounting firms that audit US-listed companies.

China blocked PCAOB inspectors from coming to China (or to Hong Kong to look at Chinese audits) because China considers allowing foreign regulators to enforce foreign laws against Chinese persons on Chinese soil to impinge China’s national sovereignty. The PCAOB did finally reach an agreement to obtain selected documents in connection with investigations, but the PCAOB’s main mandate, inspections, remains blocked.

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Soon the problem spread to Hong Kong. Hong Kong’s securities regulator, the Securities and Futures Commission (SFC) sued a Hong Kong Big Four firm after it refused to turn over working papers on a failed initial public offering. The Big Four firm said it had outsourced the audit to its Mainland affiliate which would not give it permission to release the papers to the SFC. The SFC won the case, and the judge has ordered the firm to turn over the papers by 20 July.

New rules
China has hardened its position. The Ministry of Finance (MOF) recently announced proposed rules to require overseas auditors of overseas-listed Chinese companies to use a top-tier Chinese accounting firm to do all audit work in China. The proposed rule presents few problems for the Big Four, since they already use their Mainland affiliate for most work on the Mainland. But for the many small US and Hong Kong firms that audit smaller overseas-listed Chinese companies, the new rules may put them out of business.

The proposed MOF rules cut two ways. By requiring all audit work on the Mainland to be done by Mainland firms China ensures that state secrets will not be leaked to foreign regulators by overseas CPA firms. But the MOF is also seizing regulatory control over the audits of overseas-listed Chinese companies, helping to fill what has been a regulatory hole. MOF had not been regulating the audits of most overseas-listed Chinese companies, yet it had blocked foreign regulators from filling the gap.

The move by MOF to capture regulatory control of the auditors of overseas-listed Chinese companies strengthens its hand in arguments with US and Hong Kong regulators. China has reached regulatory equivalency with the EU, which means that EU accounting regulators can treat the work of Chinese regulators as if it were their own. China wants the US and Hong Kong to accept regulatory equivalency also. China is now promising to regulate the audit of overseas-listed Chinese companies and it wants the US and Hong Kong to back off.

Regulatory equality
US regulators do not buy into the concept of regulatory equivalency. The PCAOB has insisted on no less than joint inspections, with the PCAOB and local examiners working side-by-side. The MOF proposal might facilitate that, since it requires Chinese auditors of overseas-listed companies to comply with foreign requirements. That could facilitate an agreement between the PCOAB and the MOF to allow the PCAOB to "ride along" on inspections to make certain both domestic and foreign rules are followed.

For the SEC and SFC, however, the prospects of an agreement appear bleak. US-China relations are particularly tense at present, and Hong Kong’s relationship with the Mainland is strained over issues of universal suffrage.

The issues will no doubt be negotiated at the July strategic and economic dialogue between the US and China in Beijing. Failing a diplomatic solution, the SEC ban may ultimately come into effect. While the firms will be punished, it’s their clients who will face the brunt of the pain.

If the clients cannot find auditors they face delisting from the US exchanges. Delisted companies may end up in Hong Kong, but only if Hong Kong regulators accept the Mainland’s views on the limits of their authority.