US regulators seek Chinese help to counter stock scandals
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US regulators seek Chinese help to counter stock scandals

US regulators face a struggle in enlisting China to stamp out stock frauds.

China stock scandals

On July 11 and 12 China’s finance ministry and the chief regulator, the China Securities Regulatory Commission, entertained the US SEC and the Public Company Accounting Oversight Board in Beijing. James Doty, chairman of the PCAOB, described the visit in a statement as "the commencement of our accelerated efforts with the People’s Republic of China to forge a cooperative resolution to cross-border auditing oversight".

The visit comes after a wave of highly publicized China-related stock scandals, in which short sellers worldwide have issued critical reports on overseas-listed Chinese companies, accusing them of fraud and mis-statement of earnings. The US wants China’s help in closing the regulatory loophole that allows Chinese companies listed in the US to employ the services of China-based accountants that are not subject to US audit oversight.

As Paul Gillis, visiting professor of accounting at Peking University’s Guanghua School of Management points out, China has refused to allow the SEC and the PCAOB to conduct inspections in China, for reasons of national sovereignty. Stratfor, a US-based intelligence service, says in a report on the issue that Chinese auditors have been hiding behind the country’s vague state secrets law as a means of avoiding opening their books. The suspicion is that were they to do so, many more instances of fraud among overseas-listed Chinese companies might be exposed.

With the resignation in March of Deloitte Touche Tohmatsu (DTT) as auditor of China MediaExpress Holdings, one of the original firms embroiled in these scandals, the issue spread from small accountants in the US and China to the big four audit firms. DTT, the China arm of the global big-four audit firm Deloitte Touche, then quit as auditor of NYSE-listed Longtop in May, again citing management interference in its attempts to audit the company.

Regulators in the US and China have an interest in preventing these frauds, which have damaged the reputation of the US stock markets and tainted Chinese companies’ reputations overseas, dragging down the share prices of many firms that have not been accused of any malpractice. The problems both sides face in reaching a practical solution, however, are vast. On a practical level it will take time for the SEC and PCAOB to develop a sufficient roster of Chinese-speaking professionals versed in Chinese business and accounting practices, even were they to be granted access to the audit firms’ books. It will be difficult to overcome China’s reluctance to cede any part of its sovereignty over the onshore audit industry, even via some sort of partnership with the US regulators.

Finally, as officials from both countries’ regulators have pointed out in public by way of deflecting blame from themselves, there are plenty of other participants in the scandals whose activities need to be examined. These range from the investment banks that promote Chinese stocks offshore, to the exchanges that allow them to list – often via the backdoor reverse merger process – to the corporate chief executives who run these companies.

Many of these reverse merger companies were audited by US-based companies under PCAOB oversight, suggesting that the US regulators are not in any position to present themselves as blameless champions with their hands tied when dealing with their Chinese counterparts.

The China stock scandal saga has unfolded as a classic modern international capital markets fiasco, in which the increasingly cross-border nature of capital markets and the lack of cooperation between suspicious and territorial sovereign regulatory bodies have combined to leave investors again the victims.

Meanwhile the managers of those companies thus far exposed unequivocally as frauds, and the various financial professionals that helped them, have not suffered in proportion. Peking University’s Gillis calls in his report for China and the US to put aside nationalistic differences and cooperate on regulatory oversight, perhaps by requiring foreign accountants operating in China to register with the regulator there (CICPA) and for US audit firms to submit to a peer review programme run by CICPA in coordination with PCAOB.

In other words, both sides should work together in each other’s jurisdictions. While the recent history of Sino-US relations does not suggest this level of cooperation will be easily arrived at, the task is well worth undertaking. 

Follow the latest developments on twitter at #ChinaStockScandals

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