U.S.-China Audit Dispute: Wrong Time to Pick a Fight?

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I know I said recently that I would limit my comments on the ongoing fight between the U.S. Securities and Exchange Commission (SEC) and its Chinese counterparts over access to audit materials, but an Op/Ed in yesterday’s Financial Times forced my hand (or mouth, as it were).

I’ll just do the lazy man’s cut-paste-comment method instead of trying to summarize the thesis of Ann Lee, the author. Suffice it to say that Lee believes now is not the time for the U.S. to be picking this fight and that the downside of doing so might be significant. I find her arguments to be less than persuasive.

Let’s have a look.

[T]he SEC move will strain a bilateral relationship with China that is already on the rocks.

[ . . . ]

Corporate America would not thank its government for risking access to China’s growing middle-class market.

Fair enough. One could bring this up with just about any bilateral issue. The U.S.-China relationship is important and America should think twice before ratcheting up tensions. That being said, this cannot be a blanket reason for inaction on all fronts. Moreover, there is a need for additional oversight of U.S.-listed Chinese companies, many of which have been caught cooking the books. Surely the SEC, whose primary job is, or at least used to be, to protect investors (particularly non-institutional investors), can justify the need to act here.

If this dispute ends up with numerous Chinese companies de-listing, would Beijing retaliate against American foreign investors? I doubt it. China is big on reciprocity, but on a proportional basis. There is no reason to believe that China would somehow institute broad ranging market access restrictions against U.S. foreign direct investment. Perhaps something narrowly targeted (whatever that might be), but “corporate America” need not worry about this dispute too much.

By creating a situation where Chinese companies will be forced to delist, the SEC risks depriving US citizens of lucrative opportunities to invest in fast-growing companies. The US economy may also suffer in the long term if it earns a reputation for legal hostility to Chinese companies.

Lee, who used to work for a hedge fund, seems very concerned with investment opportunities. That’s fine, but she doesn’t seem too worried about consumer protection. That’s why we have securities law in the first place, and even hedge funds benefit from greater transparency. Yes, it’s possible that this fight might result in some Chinese companies de-listing, but does Lee really prefer that the SEC look the other way and simply trust that these companies and their auditors will cease tolerating fraud?

As to a U.S. reputation of hostility towards Chinese companies, I think that horse left the barn years ago (Huawei? ZTE? CNOOC?) and this dispute will neither be the genesis of such a reputation nor the end of its existence. Besides, in contrast to the treatment of companies like Huawei and ZTE, many of these U.S.-listed Chinese companies have already been found guilty of wrongdoing. Surely some of this “hostility” is warranted?

Obviously the US must honour its laws and treat everyone equally under them. However, two problems arise. First, laws themselves can be flawed. Some US laws have the effect of reducing competition so that large companies, which may have helped influence their passage, can maintain dominant positions on their turf. The Sarbanes-Oxley act, for example, imposed such onerous requirements that many young companies chose not to access public markets.

OK, my first reaction to this is to admit that yes, it is possible that the rules at issue here are flawed. Unfortunately, Ms. Lee never provides any details on what those flaws are or how the law might be rewritten to ameliorate the situation.

Additionally, Ms. Lee is once again showing off her investor mindset here by complaining about Sarbanes-Oxley. Look, I’m no fan of that law either, and I’ve had more than one Chinese company here tell me of how it shelved its U.S. IPO plans after factoring in the time and expense of legal compliance.

Yes, Sarbanes-Oxley may have resulted in fewer Chinese companies listing in the U.S. Ms. Lee sees this as lost investment opportunities. But it’s also possible that some of these companies never belonged on a U.S. exchange to begin with and that Sarbanes-Oxley scared off some bad actors, a victory for consumer protection.

Second, regulators often have their own agendas. For instance, regulators may be tempted to punish small companies so that they can achieve quick recognition for being tough, while leaving larger companies alone. It is curious that the SEC is choosing to go after Chinese companies when the regulator so conspicuously failed to prosecute the Wall Street firms, or their auditors, responsible for the financial crisis. Again, the ones who lose out are the entrepreneurs, investors and society at large, while the privileged few benefit.

Uh, wow. Some real cognitive dissonance here. This whole dispute is about transparency and consumer protection. This benefits smaller investors more than the big boys, who should have sufficient resources to fully vet some of these dodgy Chinese companies. Ms. Lee is absolutely right that the SEC has been asleep on the job when it comes to prosecuting the folks responsible for the Great Recession, but how is that at all related to this dispute? Moreover, if some Chinese companies are forced to de-list as a result of this fight, how does this enrich the “privileged few” and deprive “society at large”? I’m genuinely puzzled by that statement.

Rather than pick fights with everyone, US regulators should learn to see the wood from the trees. As the world gets smaller, we must all make a greater effort to get along with each other. Understanding and respecting each other’s laws would be a good place to start.

It is inevitable that at times the legal principles of two countries will clash. But in these cases a diplomatic solution ought to be the first course of action, rather than naming and shaming.

Blah blah blah. Why can’t we all just get along and sing kumbaya around the campfire? Please.

The U.S. government is not picking fights with everyone, but it is trying to fix an outstanding problem that has already led to significant investor losses, not to mention across-the-board valuation problems for many U.S.-listed Chinese companies that have done nothing wrong (i.e., guilt by association).

And what’s this about respecting one another’s laws? These companies are coming into the U.S. to avail themselves of the American capital market. Shouldn’t they have to follow U.S. law? I’ve represented U.S. companies in China for well over a decade, and believe me, they all have to follow China law when they come here. What’s the difference? Moreover, note that when Ms. Lee says that nations should respect one another’s laws, in this instance she is really suggesting that the U.S. should defer to China’s laws, but she has not explained why.

Yes, there is a conflicting China law here, involving the disclosure of information that may be deemed state secrets. I personally think this state secrets argument is a pretext, but either way, if a compromise cannot be reached, we’re dealing with U.S. listings, and U.S. legal concerns should prevail. Remember that the U.S. law at issue here is not discriminatory; it applies regardless of nationality.

Finally, Ms. Lee talks about a “diplomatic solution” as the first course of action. She must have been busy or something, because the authorities in both countries have been discussing this issue and looking for a solution for a year already. So far, diplomacy hasn’t worked, but it definitely has been tried.

Try as I might, I’m not persuaded by any argument that places all the blame on the SEC and calls for some sort of unilateral disarmament. That might be acceptable to certain large, savvy investors, but not for everyone else.

6 responses on “U.S.-China Audit Dispute: Wrong Time to Pick a Fight?

  1. Ollumi

    I did a double take and went back to confirm this came from a financial times op/ed. I thought I was reading something from the global times.

    The real core issue is that the companies in question want(ed?) access to U.S. financial markets, and in doing so they need to comply with the rules of the place in which they wish to gain access, or already gained access to by circumventing the rules. Just as you pointed out, the reverse is true. “Back in my country we do things this way” doesn’t even fly in a private lodge, why would it fly in a financial exchange? It’s not as if they’re asked to adhere to higher/different requirements than anyone else listed on the same exchange, something you could have at least argued for in CNOOC, Huawei et al. To take this and twist it around, framing it as if U.S. regulators are the ones trying to impose their will in a foreign country (within the first sentence no less) is amusingly familiar, as is the straw man she made out of FATCA.

    Unlike you, I don’t know the first thing about Ms. Lee. But she sounds charmingly familiar in so many ways.

  2. Hua Qiao

    Can’t agree with you more Stan. Having seen the practice of chinese auditors including the Big 4, the SEC should stick to its guns.

  3. Ander

    Thank you very much for this post.
    Firstly, I don’t have an FT subscription and I could not read the article in full. So, thank you for the excerpts!
    Next, I had issues with the headline straight away. To be fair, it does grab one’s attention, as I suppose headlines are supposed to.
    Sure enough, her piece left me with more questions than answers. The most glaring one of all must be: Do foreign companies which list on US exchanges not get that no one has forced them to do so? And that when they list on said exchanges – in the US (FFS!) – that there are American laws to follow?
    Finally, to what end would it serve the SEC in not wanting US companies to invest overseas?
    Such an important issue deserves a much better analysis from an opinion piece on the FT.

  4. Hua Qiao

    If Ms. Lee has her way, we will quickly go to the lowest common denominator for professional standards throughout the world. Audit, appraisal, consulting etc: anyone living in China knows that there is a great lack of respect (if not contempt) for these professions. Fee collection is abysmal because of the disregard for value of their services. They are a necessary part of the window dressing, the veneer you put on your package to get someone to buy it.

    Ms. Lee, you would have the world go that way…the route of zero standards, every man for himself, buyer beware, a place where lies and deceipt on an epic scale are commonplace.

    I Have a friend that worked for a respected mainland financial company. When he entreated the Ceo to be more forthcoming with reserving for credit losses on specific accounts, he said that if they showed any problems, the analysts and regulators will be concerned and investigate. My friend told him that in the west, any lending firm that showed zero problems would become a target because it is not possible to have a perfect portfolio. He said that everyone in China knows that. Everyone also knows that everyone cooks the books on asset quality. So if you show any problems, that must mean you are REALLY BAD.

  5. Chris Devonshire-Ellis

    Stan one of the issues omitted from this debate has been the Chinese MoF’s regulations concerning the re-issuing of JV licences to the Big Four. In order to have these renewed, they were required to lose most of their foreign audit partners and replace them with Chinese nationals. While on one hand this is an apparently racist move, on the other it has two effects; greater State control and potential punishments, including criminal prosecution, for any Chinese partner who steps out of line, and secondly, a deterioration of audit standards by the Big Four. They are being forced to loose huge amounts of foreign audit partners just to comply.
    These latter effect is welcomed in many quarters by both the Chinese and American regulators, who view the Big Four increasingly as a cartel with a de facto unhealthily monopoly on global audit. It would suit many, in both the Chinese and American camps, if they were broken up. There are numerous medium sized audit practices in both countries who are chomping at the bit to compete (it would require China to liberalize the audit profession for foreign investment to do so) however as part of the end of the “Great Audit Game” I suspect that underlying issues here, including the very existence of the Big Four, have more pertinent potential impacts upon the industry than merely arguing over who gets to evaluate financial records. In this regard, the Chinese and American regulators may be rather closer in opinions in driving the global audit profession forward than may appear at face value. Food for thought. – Chris