What The SEC And PCAOB Fail To Acknowledge About Chinese Fraud

There have been significant developments on the issue of Chinese frauds and in the efforts by the SEC and the PCAOB to investigate and bring responsible parties to justice, including the auditors of the companies under investigation.

But none of these developments will have any significant impact on the bigger problems facing China and investment in China.

The SEC can delist questionable Chinese companies or even all China-based listings that came through reverse mergers or traditional means, as some have suggested it might do. US exchanges can increase scrutiny of new listings based in China and reject those that do not meet or continue to meet existing standards, to the letter. (This cooperation from the exchanges is less likely given political rhetoric for expanding IPOs here and their desire to reap listing fees or be “beaten” by competing exchanges in London or Asia.)

The PCAOB can work on finding a way to see into the quality of Chinese-based audit firms, first through inspection observations and eventually via on-site inspections.

The SEC’s futile enforcement efforts for reverse-merger frauds reveals even bigger problems for investors and US capital markets than the losses caused by few fraudulent China-based companies. There are two implications of the SEC’s limited enforcement and the PCAOB’s lack of ability to monitor the auditors that have been ignored, for the most part, by journalists and other pundits.

• China-based auditors are also performing audits of significant operations of US and non-US based multinationals with US exchange listings. Those audits can not be sufficiently monitored and supervised by the primary non-China audit firm and cannot be inspected by the PCAOB, either.

• An on-site SEC investigation of accounting manipulation, fraud, or illegal acts, such as under the Foreign Corrupt Practices Act by the Chinese operation of a US listed company  (or a China-based company with a US exchange listing) would be severely limited by the SEC’s limited authority in China.

The SEC recently issued another order to Deloitte to produce documents related to a Chinese client suspected of fraud, as I reported earlier. But the agency has now also requested all the China-based firms auditing US listed companies to produce workpapers related to audits of companies the SEC is investigating for fraud.

According to Reuters, “The Chinese arms of all of the Big Four audit firms have been asked by U.S. regulators to turn over documents related to audits of China-based companies listed in the United States…” The firms have either openly resisted the requests or declined to comment.

PwC told Reuters, “Like other firms who have received similar requests, in dealing with them we are confronted by conflicting laws between the United States and China.”

KPMG declined to comment on whether it has received requests for documents from the SEC and Ernst & Young did not immediately respond to Reuters’ request for comment.

China Accounting Blog author Professor Paul Gillis, a former PwC partner and a professor at a Chinese university in Peking, as well as now a member of the PCAOB Standing Advisory Group, says Chinese accounting regulators are working to shut down a loophole and further restrict access by those outside of China to Chinese auditor workpapers.

The SEC told US-based multinationals to start disclosing to shareholders when audits include a material portion that’s covered by a firm the PCAOB cannot inspect.

The SEC’s Nili Shah of Corporate Finance mentioned this development at Compliance Week this past June while speaking on the panel I moderated, SEC Reporting Updates. The Division of Corporation Finance has apparently been issuing comments on these fact patterns. The staff has also communicated this point at a CAQ SEC Regulations Committee meeting. The minutes of this meeting describe the situation where the principal auditor is located in a country where the PCAOB is not allowed to perform inspections. However, the disclosure may be equally relevant in other situations where a material part of the audit of a US-listed company may not be subject to the same regulatory oversight framework as the primary auditor is in the US or the UK, for example.

“Certain foreign jurisdictions do not allow the PCAOB access to inspect a registrant’s Independent Registered Public Accounting Firm’s audits and its quality control procedures.  In situations in which the principal audit firm of a registrant is located in a country or jurisdiction for which the PCAOB is not allowed to perform inspections, the SEC staff has issued comments requesting registrants to confirm that they will disclose this fact under a separate risk factor heading.  Mr. Olinger described the risk factor as a situation in which a portion of the regulatory oversight framework is missing and that investors who rely on the auditors’ audit reports may be deprived of the benefits of PCAOB inspections. The SEC staff may issue comments to include this type of risk factor disclosure in future filings. Mr. Olinger noted that the SEC staff would not object if registrants provide factual disclosure in the risk factor that the PCAOB does not have access to inspect any auditors in the particular country or jurisdiction and that the lack of access provided to the PCAOB is not limited to the registrant’s auditors.”

Based on the response the SEC is getting on access to auditor workpapers in China, it’s reasonable to assume that an SEC investigation of accounting manipulation, fraud, or illegal acts such as under the Foreign Corrupt Practices Act by a Chinese operation of a US listed company would also be severely limited by the agency’s limited authority in China.

Pam Chepiga of Allen & Overy was a panelist along with SEC Director of Enforcement Robert Khuzami at the Stanford Directors’ College last month. Khuzami said nothing, but shook his head in agreement, when Chepiga, a former US attorney, told the audience that FCPA investigations in China are difficult because, “you can’t take the documents out of the country.”  She told me after the session that not only does China restrict the dissemination of documents outside of China, but internal investigations by multinationals must be done by Chinese lawyers with support from the Chinese accounting firms. Given the experience that the SEC is having with Deloitte, it seems, “previous cooperation agreements are not in force”. The SEC would have a hard time going over and investigating a fraud or FCPA violation by the Chinese arm of a US based company  – and the complicity or culpability of the auditor – directly the way they did recently in India as a result of the Satyam fraud.

So, all this sabre rattling by the SEC is for nought. As I pointed out in the earlier post, the SEC opened this door by allowing the listings of questionable firms either via backdoor reverse mergers or a lack of due diligence of traditional listings like Longtop.

And the PCAOB allowed audit firms they could not inspect in China and the EU to register with the PCAOB, thereby lending them the air of legitimacy. The registration of audit firms by the PCAOB enabled new listings – and existing multinationals – to say they had an audit that complies with the Sarbanes-Oxley law.

In this case, I agree with China Accounting Blog author Professor Paul Gillis. The highest probability can be assigned to an outcome where SEC waits out their two legal proceedings and their recent requests to the other firms for workpapers on Chinese frauds they are investigating. In addition, most likely the PCAOB kicks can down the road and allows registration to pass to new Chinese audit firms as ownership transfers take place under the new requirements to make the firms majority Chinese owned and run. (By the way, this requirement is not new or a direct reaction to the reverse-merger frauds but has been anticipated for a while. Gillis wrote about it in November of 2010.)

Why do I agree with Gillis about this outcome? Because there is a more significant implication of the PCAOB de-registering existing firms and refusing to register new firms as ownership interests are changed per Chinese law. There is also a significant impact on multinationals and to the SEC’s own enforcement interests by any further SEC litigation that disparages audits done by Chinese firms, in general. By maintaining the status quo, the PCAOB enables existing US-based multinationals with significant operations in China (or other places PCAOB can not inspect) to meet the requirements of Sarbanes-Oxley for an audit by a PCAOB registered firm. By waiting out litigation and document requests that are futile, the SEC doesn’t further aggravate China in case they need their cooperation on a big accounting fraud like Satyam in India or a Walmart-like FCPA case that might occur in China.

In spite of Professor Gillis’ assertions and Chepiga’s, I believe documents and communications still flow readily between Chinese accounting firms and their US colleagues and from Chinese arms of multinationals and China-based companies and their US advisors. It’s how the work gets done. Assertions by the firms that partners will be subject to prison for cooperating with US regulators is the extreme position taken, with the support of the Chinese government, because both are being pushed to reveal incriminating information.

Global Capital Markets Group (GCMG), the unit at PwC that supports foreign firms who want to be listed on US exchanges and their colleagues who are auditing companies or portions of companies listed on US exchanges, is how it works at PwC and is stronger than ever. Many countries like the UK and China have a local GCMG with locals and expats that can help companies meet and manage US exchange requirements. The US group is a resource to these locals if the local group can’t answer a question, or meet a need of their clients.

PwC has a motto: Don’t make a decision alone. If there’s a question, consult. PwC GCMG professional in China supporting local audits of US listed companies, for example, hold conference calls between local China client CFOs, local audit firm relationship partners, US-based GCMG professionals and, sometimes, the PwC national office who can provide even more technical SEC reporting or GAAP technical advice.

Professor Gillis questioned my assumption in a previous post that entire workpaper files were sent between Chinese or European offices and US based professionals in order to perform the 20F reviews required Under Rule 3400T(b), Interim Quality Control Standards. Under this rule, audit firms must comply with portions of the Requirements of Membership of the AICPA SEC Practice Section (“SECPS”). Audit firms associated with international firms are required to seek the adoption of policies and procedures consistent with the objectives set forth in the Requirements of Membership of the SECPS at Appendix K, SECPS Section 1000.45 (“Appendix K”). See SECPS Section 1000.08(n). Those objectives include having policies and procedures for certain filings of SEC registrants that are the clients of foreign associated firms to be reviewed by persons knowledgeable in PCAOB standards.

Electronic workpapers, not summary documents or filings only, were the subject of GCMG’s activities to review 20-Fs in India for Satyam. In the SEC’s public administrative and cease-and-desist proceedings against the Price Waterhouse India firms for their negligence leading to the Satyam fraud, the SEC notes:

“Specifically, in May 2008, in response to questions raised by the ‘Appendix K filing reviewer’ of Satyam’s draft Form 20-F, PW India requested that the PwC Network Firm Partner review the electronic workpapers for the 2008 Satyam audit. In response to that request, the PwC Network Firm Partner provided the Satyam engagement team with a detailed set of comments, including remarks on the cash and interest bearing deposit confirmation workpapers. In particular, the PwC Network Firm Partner informed the Satyam engagement team that their cash confirmation procedures appeared inadequate because the working papers indicated that ‘the confirmation was obtained either directly or from copies obtained from the client. We can only take credit for confirms we send and receive directly.”

I have said that US GCMG and similar groups at other firms like Deloitte have access to electronic workpapers for the engagements they review and can request them or be given access to them by the local engagement team.  It is more common, as Professor Gillis and some firm professionals in these areas I have questioned since have told me, to see only the forms to be filed transmitted to the reviewer. Full workpapers would be accessed, electronically or as hardcopy, in only exceptional circumstances. But the fact remains that it is possible for US technical consultation resources in the US to access electronic workpapers from foreign member firms and it has been done in the past.

4. On April 9, 2010, staff served Deloitte LLP, the U.S. member firm of the Global Firm with a subpoena requesting audit work papers relating to the Global Firm’s audit of Client A’s financial statements for the period January 1, 2008 through April 9, 2010.

5. Between April 13, 2010 and May 18, 2010, staff had several communications with U.S. based counsels for both Deloitte LLP and the Global Firm.

6. Counsel for Deloitte LLP initially informed the staff that Deloitte LLP did not perform any audit work for Client A, that all audit work was conducted by Respondent, and that Deloitte LLP did not have possession, custody, or control of the documents called for by the subpoena.

7. Counsel for Deloitte LLP subsequently informed the staff that Deloitte LLP performed some review work of Client A’s periodic reports and produced certain documents relating to this review to the staff.

The PCAOB has been highly critical over the lack of full and effective use of this type of consultation process by the audit firms in the past, especially for supervision and review of significant portions of foreign audits. The PCAOB also recognizes that investors want to know more about who actually does the audit of multinationals, in particular when significant portions may be audited in countries where the PCOAB has no inspection rights.

To that end the PCAOB issued a proposed rule on October 11, 2011, Improving the Transparency of Audits: Proposed Amendments to PCAOB Auditing Standards and Form 2, that also includes a proposal for auit partners to sign audit reports in their own names. (The comment period on this rule closed on January 9, 2012.) The proposed rule describes the problem for investors of significant portions of audits done by non-US firms as such:

“In many public company audits, the accounting firm issuing the audit report (“auditor” for purposes of Section III of this release) does not perform 100 percent of the audit procedures. This may be especially common in, but not limited to, audits of companies with operations in more than one country. In these situations, audit procedures on, or audits of the company’s foreign operations are performed by other accounting firms or other participants in the audit not employed by the auditor.

Additionally, some accounting firms have begun a practice, known as off-shoring, whereby certain portions of the audit are performed by offices in a country different than the country where the firm is headquartered. For example, an accounting firm could establish an office in a country with a relatively low cost of labor and employ local personnel to perform certain audit procedures on audits of companies located in the country of the accounting firm’s headquarters or in a third country.

The Board is proposing amendments that would require the auditor to disclose in the audit report other independent public accounting firms and other persons not employed by the auditor that took part in the most recent period’s audit. The proposed amendments would require disclosure when the auditor (a) assumes responsibility for or supervises the work of another independent public accounting firm or supervises the work of a person that performed audit procedures on the audit; and (b) divides responsibility with another independent public accounting firm. Specifically:

– Disclosure when assuming responsibility or supervising – The auditor would be required to disclose the name, location, and extent of participation in the audit of (i) independent public accounting firms for whose audit the auditor assumed responsibility pursuant to AU sec. 543, Part of Audit Performed by Other Independent Auditors, and (ii) independent public accounting firms or other persons not employed by the auditor that performed audit procedures on the most recent period’s audit and whose work the auditor was required to supervise pursuant to Auditing Standard No. 10, Supervision of the Audit Engagement (collectively, “other participants in the audit” for purposes of Section III of this release),35/ and

– Disclosure when dividing responsibility – The auditor would be required to disclose the name and location of another independent public accounting firm that audited the financial statements of one or more subsidiaries, divisions, branches, components, or investments included in the financial statements of the company, to which the auditor makes reference in the audit report on the consolidated financial statements and, when applicable, internal control over financial reporting (“referred-to accounting firms” for purposes of Section III of this release).36/

The proposed amendments would affect AU sec. 508, AU sec. 543, and Auditing Standard No. 5. The proposal would require disclosure of all other participants in the audit and referred-to accounting firms regardless of their network affiliation37/ or registration status with the PCAOB.38/

The Board is proposing these amendments to provide investors and other users of the audit report with greater transparency into the other participants in the audit.

The 2007 inspection report for Deloitte was made public recently by the PCAOB because Deloitte had failed at that point to sufficiently remediate the criticisms cited. The PCAOB criticized two areas relevant to this discussion. Recall, Deloitte is the auditor of more than one China-based firm under investigation (Longtop, CCME, Boshiwa International, a maker of children’s wear, and Daqing Dairy Holdings, which produces milk formula, and others.

Consultations

The engagement reviews provide cause for concern that the Firm’s quality controls may not result in appropriate and effective consultations when necessary. * * * * Further, the Firm’s policy on consultations, * * * * which provides a tiered hierarchy of levels of consultations, appears to be deficient in that it lacks a mechanism reasonably designed to provide that significant, complex matters are raised to the appropriate level in the hierarchy in order to ensure a sufficient level of rigor in the analysis.

The inspection team identified complex fact patterns in significant accounting and auditing areas, which were associated with deficiencies noted in seven engagements, including five engagements discussed in Part I.A, where the engagement teams did not consult with the Firm’s National Accounting Research or Quality Assurance departments. In addition, * * * * engagement teams consulted in three instances at below “Level A,” and neither the engagement team nor the National Accounting Research personnel raised the issue to a higher level as allowed by the policies. Consultation at “Level A” may have entailed the precision and thoroughness needed to reach the appropriate conclusions. In each of these three situations, the issuer ultimately restated its financial statements to change the accounting in the area that was the subject of the consultation.

G. Foreign Affiliates

Deloitte Touche Tohmatsu (“DTT”) uses its global internal inspection program to assess and monitor the quality of the audit work of its member firms. However, the specific results of the inspections of member firms or practice offices are not disseminated to the Firm’s partners. Under DTT’s practices, a U.S. engagement partner would be notified of a deficiency in a specific practice office or member firm only if there was a finding from a global internal inspection on the work performed by the foreign affiliate on that U.S. partner’s issuer audit client. Accordingly, the global internal inspection program does not routinely provide a U.S. engagement partner with a basis for assessing a foreign office’s qualifications and familiarity with U.S. GAAP, PCAOB standards, and SEC reporting requirements.

In addition to its National Accounting Research and Quality Assurance groups, Deloitte also has a group like PwC GCMG specifically for servicing China-based companies that are listed or want to be listed in the US .

Meet the Chinese Services Group leadership, all in the US:

“Deloitte’s Chinese Services Group (CSG) coordinates with the Deloitte Touche Tohmatsu member firm in China and the appropriate subsidiary of Deloitte LLP to assist U.S. companies investing and operating in China. Whether contemplating market entry, M&A or optimization of existing operations, the CSG, in collaboration with the member firm in China, can help U.S. companies implement cross-border investment strategies and navigate the associated risks.

The CSG also co-ordinates with the China firm and the appropriate subsidiary of Deloitte LLP to assist Chinese companies seeking to access U.S. markets – expanding operations, raising capital and/or engaging in M&A. Our national network of bilingual professionals works closely with colleagues in China to deliver seamless service to globalizing Chinese companies.”

Note the words used to describe how the US professionals use “coordination”, “collaboration”, and “bilingual professionals [who] work[s] closely with colleagues in China to deliver seamless service…”  Seems like that would be pretty hard to do if you could not share documents or other “secret” information about Chinese companies across borders.

But let’s look instead at the “reality” that the SEC and the audit firm lawyers are portraying. If China companies and their audit firms – as well as law firms – have closed the drawbridge – all work is done locally, access to client information like workpapers limited to local staff, no emails or data sent out of country – what does that say about ability of SEC or PCAOB to enforce laws for US listings including multinationals with significant operations?  It says the audit firms have convinced regulators they are untouchable and above scrutiny in China. It says the SEC and PCAOB are impotent to enforce our laws or protect US investors if problems like accounting fraud or FCPA violations occur in their Chinese-based investments or in the China-based operations of US multinationals. It says the SEC and PCAOB cannot hold accounting firms that audit US listed companies or major operations of US listed companies in China or parts of Europe accountable if fraud or illegal acts occur under their watch and they are negligent or complicit in those acts.

To be fair, China has passed anti-bribery laws. And there has been SEC enforcement of FCPA cases related to conduct in China including at IBM, Morgan Stanley and Rockwell Automation and self-reporting of FCPA violations from China such as the Watts Water and Rae Systems cases that also resulted in enforcement actions.

For example, the Department of Justice and the SEC can go after the US company and US executives and fine or sanction them for an FCPA violation, but that leaves the corrupt non-US operation unscathed and unpunished.

More likely, in reality and in my opinion, information is shared across borders and, therefore, available in the US and from US based professionals for enforcement actions by the SEC and PCAOB.

I believe both the SEC and PCAOB have chosen not to pursue US audit firms and audit professionals vigorously.

In the meantime, the firms are continuing to tout and expand their business activities in in China.

Deloitte recently announced a $750 million investment in emerging markets including China.

Dateline Shanghai, China, 7 June 2012

At its annual World Meetings, Deloitte Touche Tohmatsu Limited (DTTL) announced today a commitment of US$750 million in investments in strategic markets over the next three years, a continuation of the prior three-year strategic market investment program (FY10-12), which totaled US$500 million. This sizeable, multi-year investment focuses on 11 strategic markets around the globe: Africa, Brazil, China, Commonwealth of Independent States (CIS), Germany, India, Japan, Korea, Middle East, Southeast Asia, and Turkey.

The investment program aims to expand client service and industry capabilities in select strategic markets, bolster the hiring and deployment of top talent, and cultivate innovative new services and multidisciplinary offerings. It also supports the Deloitte member firm network’s “As One” global strategy, which enhances the network’s ability to seamlessly deliver world-class services across borders, while leveraging the market-focused accountability of its member firm structure.

Looks to me like Deloitte is thumbing its nose at SEC and the PCAOB attempts to hold the firm accountable. Deloitte, and the rest of the global audit firms, do not believe the SEC or the PCAOB can stop them.

I don’t believe the regulators are willing to stop them.