One Way Or Another: The SEC Versus The Chinese Big Four FirmsBy Francine • Jan 25th, 2014 • Category: Latest, Pure Content, The Case Against The Auditors
That’s how, in so many words, most media described the decision by Securities and Exchange Commission Administrative Law Judge Cameron Elliot to ban the China units of the Big Four accounting firms—Deloitte Touche Tohmatsu CPA Ltd. (DTTC), Ernst & Young Hua Ming LLP, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian CPAs Ltd— from auditing US-listed companies for six months.
Dina ElBoghdady, Washington Post, January 22, 2014, Judge rules Chinese accounting affiliates of Big Four ‘willfully’ violated U.S. law
In a strongly worded decision, Judge Cameron Elliot said the affiliates should be sanctioned for “willfully violating” the law, “flouting” the agency’s regulatory authority and failing to “recognize the wrongful nature of their conduct.”
Allan Katz, Bloomberg, January 23, 2014, China Auditors Barred for Six Months for Blocking SEC
The auditors’ “actions involved the flouting of the commission’s regulatory authority, which may not be as egregious as, say, accounting fraud, but is still egregious enough that it weighs against leniency,” the judge said in the decision. The firms “acted willfully and with a lack of good faith.”
Professor Paul Gillis in his China Accounting Blog:
While he may have been kind to the CSRC, he took the hide off of the Big Four. The firms, especially PwC, were probably feeling a little raw already from the blistering they received in the ICIJ report yesterday on how they aided Chinese elites to get money offshore.
These additional major media stories provide a good summary of the case and the history behind it.
Michael Rapoport, Wall Street Journal, January 23, 2014, Judge Suspends Chinese Units of Big Four Auditors
Sara Lynch, Reuters, January 23, 2014, SEC judge bars “Big Four” China units for six months over audits
I was quoted extensively on the front page and inside of Epoch Times.
They went to China knowing the operations were at risk, and if something went wrong they would have to answer for it. But they never intended to answer for it.
The bottom line for Judge Elliot?
…I agree with the Division that, to the extent Respondents found themselves between a rock and a hard place, it is because they wanted to be there. A good faith effort to obey the law means a good faith effort to obey all law, not just the law that one wishes to follow… I have not found a lack of good faith merely from the fact that Respondents registered with the Board while knowing of legal impediments to full compliance with Sarbanes-Oxley 106. Respondents could have stopped auditing U.S. issuers after Dodd-Frank was enacted, but they did not.
China activist investor Carson Block, who leads Muddy Waters Research and was right about the Sino-Forest fraud and confident he’s right a about a fraud at China’s NQ Mobile, is happy.
“Glad to see this. If the Chinese believe the SEC is serious they’ll blink. Too many gov’t guys have billions of dollars in (undisclosed) holdings of US-listed China companies to risk it.”
Some, like Professor Paul Gillis and Jason Flemmons of FTI Consulting who were quoted by the BBC, were surprised. Rather, they believe the Big Four and the Chinese were surprised the SEC went this far. (I am, too.)
BBC, January 23, 2014, ‘Big Four’ accountants’ China units face US suspension
While the firms are appealing, it could have huge consequences if it the initial decision ultimately stands. It could complicate audits of various Chinese firms listed in the US, as well as American firms operating in China.
“This decision will be a huge shock in Beijing,” said Paul Gillis, an accounting professor at Peking University in Beijing. “The Securities and Exchange Commission has pushed a lot of chips out on the table.”
He added that if the big accounting firms were unable to sign audits it would leave companies in “a hell of a pickle” as the relatively smaller accounting firms may not have the capacity to serve big clients…
“I think the decision came totally unexpected to the firms,” said Jason Flemmons, a senior managing director at FTI Consulting.
Legendary jurist Oliver Wendell Holmes, Jr. once said:
“The prophecies of what the courts will do in fact, and nothing more pretentious, are what I mean by the law.”
Holmes view of the law is that it is simply, and empirically, judicial behavior. Louis Menand, in his 2002 Pulitzer Prize winning book The Metaphysical Club said with regard to Holmes comments:
“A rule may be written down, it may express the will of the sovereign, it may be justified by logic or approved by custom; but if courts will not enforce it, it is not the law, and lawyers who bet their cases on it will lose.”
I would argue that lawyers who bet their case that a law will not be enforced will also lose.
I’m going to focus, for now, on two issues Judge Elliot’s decision raises: 1) The impact on multinationals, those listed in the US and those listed on other worldwide exchanges; and 2) The examples of a clear case of “cooperation” between the Big Four firms in defending this case and protecting their businesses.
Let’s break down the companies affected by the judge’s decision. I am assuming it will eventually be implemented in some form.
The PCAOB site lists 151 companies with mainland China auditors. That compares with 132 companies with audits signed by Hong Kong firms. (Numbers are skewed for KPMG which reports all issuer audits on one form, filed by Hong Kong, but PCAOB attributes all KPMG China issuer audits to mainland China.) The mix is different. PwC dominates on the mainland but an independent firm, Albert Wong & Co, has the most audits of Chinese issuers in Hong Kong.
I agree with Professor Paul Gillis that the ban will not affect US-listed companies audited by Hong Kong firms immediately, unless or until those companies start requiring SEC fraud investigations, too. In that case, the SEC and PCAOB will run into the same problem they have on the mainland. The PCAOB is prohibited from inspecting its registered firms auditing US issuers in Hong Kong. The SEC will run into the same “Chinese secrecy law” when trying to get audit work papers out of Hong Kong to investigate frauds as it has out of Shanghai or Beijing.
The PCAOB site does not provide a list of the US-listed multinationals who depend on a mainland or Hong Kong (or Macau) firm to perform a “substantial role” in an audit of a US issuer, one that is signed at the consolidated level by a US or even a non-US audit firm.
(Think about a multinational such as US-listed GSK plc with a UK audit firm opinion provided by PwC which depends on a “substantial role” to be played by its China firm because GSK has substantial operations in China. Alternatively you can think about US-listed NQ Mobile which is China-based, has an audit opinion signed by PwC China but requires a “substantial role” to be played by PwC’s Dallas office to audit the US revenue and Appendix K review and perhaps also counts on PwC offices outside of China and outside of the US.)
The Sarbanes-Oxley Act and PCAOB Rules say an audit firm must be registered with PCAOB to prepare or issue, or to play a substantial role in the preparation or furnishing of, an audit report with respect to any US issuer.
The PCAOB’s defines “substantial role” in PCAOB Rule 1001(p)(i) as an auditor who performs “the majority of audit procedures with respect to a subsidiary or component of any issuer the assets or revenues of which constitute 20% or more of the consolidated assets or revenues of such issuer necessary for the principal accountant to issue an audit report on the issuer.”
We can also look at the audit of NuSkin, a US-based, US-listed company recently in the news for its troubles with China over its multi-level-marketing business model. News reports put its China revenue at 31% of the consolidated revenue. NuSkin’s final audit report is signed by the PwC firm in Provo, Utah. However, PwC’s mainland China office is, presumably, supporting the audit of a significant portion of NuSkin’s revenue. (And, presumably, missed the fact NuSkin was flouting China’s MLM laws, putting the viability of its China operation and the validity of balance sheet representations related to that operation in serious doubt. Maybe that’s because PwC earned more in tax fees than audit fees from NuSkin in the last two years.)
How will PwC Provo and NuSkin get that work done if PwC mainland China is banned?
Other US and foreign multinationals with a US exchange listing that may require a substantial role to be played in their audit by Chinese Big Four firms? Caterpillar, Yum Brands, Bayer, Eli Lilly, Merck, JP Morgan, Avon, Morgan Stanley, GM, IBM, P&G, Coca-Cola…
The list is long…
Let’s look at another variation on this theme, the Hong Kong connection. The audit report for Las Vegas Sands (LVS) is signed in Las Vegas, Nevada, US but 70% of its revenue comes from Macau. The China-related operation is a wholly owned subsidiary, listed on the Hong Kong Stock Exchange with an audit signed by Deloitte Hong Kong. (LVS last year fired long time auditor PwC and hired Deloitte in the US and Hong Kong. I jokingly, not, suggested they should move the final audit opinion to Hong Kong so they could ignore any investigation by the SEC or PCAOB.)
If Hong Kong audit firms start resisting SEC investigators requests, too, or if the PCAOB gets a spine and starts de-registering firms it will not be able to inspect in person in the near future, how will LVS get an audit opinion that meets its requirement for a US listing for 70% of its revenue from Hong Kong ?
Mainland China audit firms would also, presumably, refuse the SEC if investigators asked for work papers for a US-listed company with a Hong Kong audit opinion and Hong Kong and mainland operations.
The Hong Kong audit firms and their clients, China-based and multinationals with a substantial portion audited by Hong Kong, will inevitably be affected by Judge Elliot’s decision. The SEC and, perhaps, the PCAOB have upped the ante. Hong Kong exchanged listed wholly owned subs of US companies which, for example, all the US-listed casino companies have, have not yet refused to provide work papers to the SEC. But, the mainland China affiliate of one Hong Kong audit firm, which that Hong Kong firm depends on to audit mainland operations for a Chinese company, has already refused to provide work papers to Hong Kong authorities in fraud investigations.
Reuters, August 28, 2012, HK regulator takes Ernst & Young to court for work papers
Hong Kong’s securities regulator, in an unprecedented move, took Ernst & Young to court after the audit giant failed to turn over accounting records related to a former China-based client.
The auditor now faces the dilemma of whether to comply with the order by the regulator and risk a possible breach of China’s state secrecy laws or face regulatory sanctions in Hong Kong.
If mainland Big Four are banned for any inconvenient period and companies and firms start moving those audit opinions and audit work to Hong Kong, including for new IPOs, it’s only a matter of time until the chickens come home to roost and Hong Kong becomes the home of the fraudulent dreck pile.
In addition to emphasizing fear of Chinese regulators personal and professional sanctions for defying “state secrecy” laws, the Big Four plus one defended “flouting” US regulators’ authority with an economic argument.
Judge Elliot was not persuaded.
In fact, the judge basically dismissed former SEC Commissioner Paul Atkin’s expert testimony about “the Commission’s current and historical efforts to attract foreign private issuers to U.S. markets and to otherwise facilitate capital formation; the Commission’s implementation of Sarbanes-Oxley, including approving PCAOB rules related to non U.S. accounting firms; the Commission’s historical approach to the use of memoranda of understanding to attempt to resolve international conflict-of-law issues; the significance of the recently executed MOUEC between the PCAOB, CSRC, and MOF; the inconsistency of this proceeding with the Commission’s historical approach…”
Other than his opinion regarding the effect of sanctions, Atkins’ report and testimony were entirely irrelevant.
Michael Rapoport for Dow Jones News Wire, sums it up.
Judge Elliot’s 112-page ruling sided squarely with the SEC and lambasted the firms, saying they essentially have no one to blame for their predicament but themselves. They built their businesses in China knowing that they might be called upon to cooperate with the SEC and that Chinese law might interfere with that, the judge said, and yet they complained that they should be relieved of their legal responsibilities because of the money and effort they spent building their businesses.
“Such behavior does not demonstrate good faith, indeed, quite the opposite — it demonstrates gall,” the judge said.
The Judge was also not convinced by competing experts who recreated the wheel trying to quantify the impact of any ban, in particular a ban on performing more than a 50% role in a multinational audit.
Chinese regulators are already warning the SEC of “consequences “ of its decision.
BloombergBusinessWeek, January 24, 2014:
“We hope the SEC will take into consideration the big picture of China-U.S. regulatory cooperation, make the right judgment to resolve the situation properly,” the CSRC, the nation’s securities body, said on its microblog. “The SEC should bear all responsibility to possible consequences arising from the decision.”
Will the SEC and PCAOB back down, roll over and play dead the way the China Big Four apparently did, more worried about doing business in China than protecting global capital markets and investors?
Professor Paul Gillis warns on his blog that the timing of the ban matters a lot.
The worst possible time for the suspension to begin would be in the next month or two. Most of the calendar year companies file an annual report on Form 20F that requires an audit opinion. That report is due on April 30. If the firms are suspended, they cannot issue audit reports, so the clients cannot file Form 20-F. Under exchange rules, this should lead to the companies being suspended from trading since investors do not have the data they need to be able to trade. Any company planning to do an IPO using a Big Four firm as auditor is out of luck if the auditors are suspended.
Big Four Take Coordinated Approach To Defense
The China Big Four (plus one, the former BDO affiliate, Dahua) presented their case via the same expert witness, Xin Tang, Associate Professor of the Law School of Tsinghua University in Beijing, China. Mr. Tang testified about 1) which Chinese laws, if any, the firms may violate if they provide audit work papers to the US regulator without going through the Chinese regulators; 2) what type of sanctions and liabilities, if any, the firms will encounter if they violate these Chinese laws; and 3) how the US regulator may obtain the audit work papers under Chinese law.
Unfortunately, the court redacted Mr. Tang’s testimony so we don’t know what defenses he offered on behalf of the firms. The judge wrote:
“I have redacted large portions of the factual findings and legal discussion pertaining to Chinese law and interactions between the Commission and the China Securities Regulatory Commission (CSRC)…some passages of this Initial
Decision discuss the Commission, the CSRC, and their interaction more candidly than is customary in diplomatic circles.”
The two Chinese regulators involved are the China Securities Regulatory Commission (CSRC) and the Ministry Of Finance (MOF). The CSRC has the authority to stop an audit firm from auditing China-listed companies, and the MOF has the authority to revoke an audit firm’s license to practice in China.
KPMG registered with the PCAOB in 2004. According to its testimony, KPMG and KPMG Hong Kong are organized separately under their respective country’s laws, but KPMG Hong Kong is responsible for registering both KPMG and KPMG Hong Kong and filing KPMG’s annual PCAOB reports. KPMG did not sign the “Consent to Cooperate With the Board and Statement of Acceptance of Registration Condition” in its PCAOB Form 1.
“KPMG’s lack of consent was based upon an April 16, 2004, letter from Century-Link, which opined that Chinese law prevented KPMG from complying with PCAOB testimony and document requests.”
PwC registered with the PCAOB in 2004. According to its testimony, PwC did not sign the “Consent to Cooperate With the Board and Statement of Acceptance of Registration Condition” in its PCAOB Form 1.
“PwC’s lack of consent was based upon an April 16, 2004, letter from Century-Link, which opined that Chinese law prevented PwC from complying with PCAOB testimony and document requests.”
PwC sent via counsel, a letter dated December 2, 2011 in response to a Sarbanes-Oxley 106 request for work papers from SEC investigators regarding one of its clients. The letter also attached a letter dated December 1, 2011, from Linklaters, which supplemented a Linklaters opinion letter dated November 2, 2011 obtained in response to the earlier SEC investigator request about the same client.
The letter of November 2, 2011, from Linklaters, a law firm in Hong Kong affiliated with Linklaters LLP of London, provided an opinion that “Chinese law prevented PwC from giving work papers directly to U.S. regulators.”
E&Y maintains its work papers in mainland China. This is pursuant, according to EY’s testimony, to Chinese law, namely, CSRC announcement 29 of 2009 (Reg 29), which prohibits work papers from leaving China without approval of the regulatory authorities. E&Y registered with the PCAOB in 2004.
E&Y stated in its application to the PCAOB that it “might not be able to comply” with PCAOB requests for documents or testimony, because of Chinese law.
“This statement was based at least in part upon an April 29, 2004 letter from Century-Link, which opined that Chinese law prevented E&Y from complying with such requests.”
DTTC registered with the PCAOB in June 2004. DTTC did not sign the “Consent to Cooperate With the Board and Statement of Acceptance of Registration Condition” in its PCAOB Form 1.
“DTTC’s lack of consent was based upon an April 16, 2004, letter from Century-Link, which opined that Chinese law prevented KPMG* from complying with PCAOB testimony and document requests.”
BDO Dahua registered with the PCAOB in 2006. Dahua stated in its application to the Board that it could not provide work papers or related documents directly to the Board.
“This statement was based at least in part upon a June 15, 2005, letter from the Century-Link & Xin Ji Yuan (Century-Link) law firm, which opined that Chinese law prevented Dahua from giving work papers directly to U.S. regulators.”
See the pattern of “cooperation” in the defense of the Big Four plus one business model in China? (*The error in the transcript of putting “KPMG” in the DTTC statement above leads me to believe someone cut and pasted, since all the statements were essentially the same.)
All five firms also used the same small local Chinese law firm, Century-Link, to prepare the legal opinion—maybe it’s one letter they all photocopied— that supported their refusal to affirm the requirement to cooperate with regulatory authorities when they first registered with the PCAOB between 2004-2006. Law firm Linklaters is also a common on the ground go-to firm to support the firms on conference calls with US regulators and other counseling.
Reminds me of the way Lehman Brothers went opinion shopping to London to find a law firm that would agree that Repo 105 transactions were true sales, allowing Lehman to take the liabilities off its balance sheet, thereby juicing leverage ratios.
Which firm did Lehman use? Linklaters.
How did DTTC think the work paper issue was supposed to be resolved? From the judge’s decision:
“Chiu and two other DTTC partners met with the CSRC and MOF in February 2013. The Chinese regulators explained that they had consulted with different government agencies, including the State Council, which is a “very high level of government,” and had formulated procedures for handling requests for audit work papers from overseas regulators.
The procedure, in summary, was: the regulators determine whether a request is appropriate to process; the regulators ask accounting firms to search for state secrets in the audit work papers and submit them to the CSRC within a specified period; and the regulators further process the papers and coordinate with the overseas regulators.
The regulators emphasized that in screening audit work papers, accounting firms should use “sound judgment” and redact matter only because it contains state secrets, and not because it contains matter that would cast the accounting firm in a bad light.”
Ok, then. We trust the auditors to be ethical.
One former Big Four partner I spoke to, who worked in China for several years and left in disgust, told me:
I’m sure all of the partners in the Big Four in China are happy to have the Chinese government protecting them from the scrutiny of the SEC!
It is certainly true that Crowe Horwath (with a Hong Kong affiliate as component auditor), GHP Horwath, Patrizio & Zhao, Frazer Frost, and PKF (collectively, the “five firms”) all conducted audit work, including audit reports, and produced audit work papers without raising any issues regarding state secrets or archival material and without even the need for a Sarbanes-Oxley 106 request. (All are located in the U.S. except PKF, which is located in Hong Kong.)
In addition, these firms did what I’ve always said was possible: Created, sent or brought work papers for auditors of the Chinese side to the US even if it is technically, according to the Big Four, illegal.
“Rana understood that GHP Horwath’s work papers were prepared in China and transmitted electronically to the U.S.”
PKF produced audit work papers in response to a voluntary request in early 2011, apparently without objection. Client I, through counsel, produced a “limited” amount of documents at some point in the investigation.
Were these firms ignorant of the law the Big Four say they must follow under threat of banishment, personal and professional? Professor Paul Gillis gave me another reason why non-Big Four firms may have quickly capitulated:
“They are more afraid of the SEC than the Chinese government.”
We’ve already seen the Big Four plus one have lawyers and a key law firm opinion in common. The judge’s opinion also contains many mentions, via the firms’ testimony, of joint meetings between the firms and the regulators in China to discuss the regulatory impasse and their approach to US regulators requests. Here are a few examples:
Another meeting took place the next day, October 10, 2011, at CSRC headquarters. A request went out in the morning for a meeting in the afternoon. Attendees included at least one official from the CSRC and MOF, and representatives of Dahua, E&Y, DTTC, PwC, Grant Thornton, and KPMG, with KPMG represented by Yan [[Len Jui (Jui), who heads KPMG’s regulatory and public affairs unit] and Tian [Belinda, another KPMG partner]. The accounting firms briefed the CSRC and MOF regarding the requests they had received and their responses, which included whether each accounting firm had produced any work papers to overseas regulators.
According to PwC, in December 2012, after issuance of the OIP, PwC and the other Respondents (except Dahua) attended a meeting with the CSRC and MOF.
On June 4, 2013, representatives of all Respondents, including Yan for KPMG, met with the CSRC and MOF to discuss the present proceeding, in particular, to discuss it in light of the announced hearing date and to find out if the recent MOUEC changed anything. The CSRC and MOF told the accounting firms that they “just have to wait for instruction” from the CSRC and MOF.
When the judge’s decision was announced, the China Big Four even issued a joint statement to media:
It is regrettable that the SEC’s administrative law judge has recommended sanctions against the big four firms in China for failing to produce work papers to the SEC in circumstances where such production would have violated Chinese law and regulations. However, the firms note that the decision is neither final nor legally effective unless and until reviewed and approved by the full US SEC Commission. The firms intend to appeal and thereby initiate that review without delay. In the meantime the firms can and will continue to serve all their clients without interruption.
The firms are heartened by the significant progress on information sharing between the Chinese and US regulators over the past year, which the firms have worked hard to support. The firms continue to support this co-operative working relationship and believe it is in the best interests of all parties.
(My copy of the statement came for a spokesman at DTTC.)
If the US and UK Government is looking for another reason to investigate the China Big Four auditors and their international leadership they might want to try collusion and anti-trust.
Nota Bene: I just got a note from Professor Don Clark who provided expert witness testimony on behalf of the SEC in this case. He pointed me to his post on the case from earlier in January that has useful citations for background on the relevant law.