The US China Accounting War

The U.S. and China are at war -- over accounting. Megan McArdle reports.

Will the Treasury name China a currency manipulator? Will we allow military technology to be sold to the Chinese? Those are the standard "US v. China" stories that perc up every six months or so, and nothing much ever comes of them. But Patrick Chovanec says that we're missing a real showdown, one which looks likely to erupt into an ugly dispute: the SEC versus Chinese companies.

After Enron, the US slapped a lot of onerous requirements on companies and their auditors, including the requirement that companies which list in the US have to be audited by US monitored firms. After a wave of scandals involving companies with accounting practices that ranged from "a wee bit dodgy" to "scams", the SEC has demanded that the auditors open up their files to US inspectors. Here's what happened next:

In response, the SEC has launched fraud investigations into several U.S.-listed Chinese companies and their executives, ordering their China-based auditors to hand over confidential documents to examine for potential evidence of wrongdoing. In the most visible case, the SEC in May 2011 handed lawyers for Deloitte China a federal court subpoena to turn over its audit work papers for Longtop Financial Technologies, a Hong Kong-based maker of financial software that short-seller Citron Research had accused of fraudulent accounting (prompting Deloitte to resign the account, citing “recently identified falsity” in Longtop’s financial statements).

Deloitte China fired its lawyer for accepting the subpoena, and refused to comply. In a court filing explaining why, Deloitte claimed that Chinese regulators had issued an extraordinary threat, telling auditors that handing over audit work papers would violate China’s (vague and draconian) State Secrets law, allowing China to “dissolve the firm entirely and to seek prison sentences up to life in prison for any [Deloitte] partners and employees who participated in the violation.”

The refusals come at a time when Chinese local authorities, embarrassed by the allegations, have been cracking down on short-sellers’ researchers, shutting off access to company disclosure filings and sometimes harassing and even jailing research teams conducting due diligence within China. The SEC, for its part, asked the judge in the Deloitte case for a stay until this coming January, to see if it could work out some kind of solution with its counterparts at the CSRC.

Last week’s decision to file charges against all five top global audit firms in China appears to signal an end to the SEC’s patience. In its court filing, the SEC expressed frustration, noting that since 2009, the CSRC had refused to provide any meaningful assistance on 21 information requests arising from 16 securities investigations into U.S.-listed Chinese firms. The Chinese, it has concluded, are simply stonewalling.

While the details may seem arcane, the ramifications can hardly be overstated. Chinese auditors could face financial penalties, but they could also be disqualified from conducting SEC audits. If Chinese auditors get de-registered, U.S.-listed Chinese companies won’t be able to find anyone to sign off on their audits, leading all of these firms to have their shares forcibly delisted, en masse, from U.S. markets. Shareholders would still own their shares, but those shares would be much harder to buy and sell, making them worth considerably less.

It's hard to see how the SEC can agree to let this one slide. But will the Chinese back down? I've been on exactly one 10-day junket to China, so I'm hardly qualified to answer that question. But my brief experience was that even quite senior Chinese officials who had traveled abroad simply didn't get the domestic political constraints that make it impossible for the President to tell the SEC to cool it. I don't even mean that they didn't believe us when we'd suggest that the President really and truly could not simply order the train tracks in the northeastern corridor straightened out so that they'd run faster; I mean that they seemed to find it hard to imagine how such a system would work. I found it very difficult to explain, for example, the relationship between the Fed and the rest of the government.

I don't mean to suggest that they were some sort of unsophisticated rubes; the Chinese government has its own domestic institutional constraints which are just as complex and delicate as the ones in the US. But they seem to be different; I'm sure I asked questions which seemed somewhere between bewildering and hopelessly naive precisely because I don't understand how their system works. And indeed, when people tried to explain things like the banking system to me, I floundered. China does not have anything like a banking system, as I understand it. The system does work, at least after a fashion, but I find it hard to imagine how; my imagination is constrained by what I'm used to.

It's possible that both countries are demanding something that it is internally impossible for the other side to deliver. Fireworks to follow.