12/4/12 - SEC Gets Serious on Chinese Company Fraud

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Dec 4, 2012 11:07:49 AM

and tagged Yesterday's News

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I wrote in the other post today about the fiscal cliff, which is one front-page story. The other is something that would not normally be considered front-page news—corporate audit policy. What makes this important are the systemic, as well as the geopolitical, implications.

The underlying issue is a conflict between U.S. and Chinese law. U.S. law requires foreign public accounting firms to provide the SEC with the paperwork involving U.S.-traded companies. Chinese law prohibits this.

The problem is as follows. In recent years, many Chinese companies have listed in various ways on U.S. exchanges in order to access U.S. investor capital and benefit from our clear legal and regulatory structure. Many of these companies had serious financial issues or were frauds. Thus far, 50 China-based companies have been delisted from U.S. exchanges, and another 9 are under investigation. This has cost U.S. investors billions of dollars in losses. Reportedly, many other companies are also under investigation.

In order to protect investors against the proven potential for fraud, the SEC is demanding that Chinese audit firms, including subsidiaries of global accounting firms, provide the narrative notes of the audit working papers to investigators. Because Chinese law prohibits this, the accounting firms are caught in the middle.

This is a real problem, and the SEC is right to take this step on the grounds of market stability and investor protection. It should continue on this road to ensure that financial information is as complete and as accurate as possible, and audit information is essential to that goal. In principle, the SEC is doing the right thing.

But what makes it complicated beyond the effects on Chinese firms is that all four major accounting firms, plus one other large one, have been named in this case. It is not one bad firm, it is every firm. If the Chinese subsidiaries of these firms were all placed under sanctions, it would make the lives of multinationals with Chinese subsidiaries more difficult until they found a new way to get these subsidiaries audited. This would be a systemic problem, as it would affect most major U.S. firms in one way or another.

Beyond that, it is a China/America problem. Many of the Chinese companies listed in the U.S. are large and successful. For the U.S. to essentially throw these successful companies out of our financial markets is in no one’s interest. Besides the economic damage, it would certainly create more political damage.

China has been asserting itself in many ways. This is the wrong one. It is in everyone’s interest for the SEC to stick to its guns.

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