Casino Industry Suffering From China Denial Syndrome

I warned at re: The Auditors in July that the U.S. Securities and Exchange Commission and the audit regulator, the PCAOB, were publicly ignoring more important implications of their restricted access to Chinese auditors than the delisting of Chinese companies or the invalidation of the audits of Chinese companies.

The U.S. casino industry is already facing the worst case scenario.

The SEC can delist questionable Chinese companies or even all China-based listings that came through reverse mergers or more traditional means, as some have suggested it might do. That would be sad but not tragic.

According to The Financial Times as of late September:

Since the latter part of 2010, when alleged financial frauds and accounting issues began emerging in small Chinese companies that are listed on US stock exchanges, 67 China-based issuers have had their auditor resign and 126 companies have either been delisted from US securities exchanges or have stopped filing regular reports with the Securities and Exchange Commission.

The PCAOB can start doing something by observing audits in China, as recent announcements have suggested might finally happen. PCAOB Chairman Doty has even warned he may start de-registering audit firms, according to Reuters, if the situation with China is not resolved in the next year.

Reuters recently interviewed PwC’s Global Chairman Dennis Nally on the subject. It was a disingenuous attempt by PwC to seem concerned about the regulatory stalemate. Seriously, folks. The Big Four audit firms do not for one “Hollywood minute” believe the PCAOB will deregister their Chinese member firms or any of the other member firms in other countries that restrict PCAOB inspections. A de-registration would render the audits performed by those firms unacceptable and invalid according to U.S. exchange listing standards. Dennis Nally knows that it’s not just China-based companies that will have a problem with their audits if that happens.

The Big Four leaders only seem worried. When faced with its first test of will, the PCAOB punted. The audit regulator recently re-registered KPMG China, the first firm to reorganize to meet Chinese requirements to be majority owned and run by Chinese partners. Professor Paul Gillis of the China Accounting Blog wrote:

“The PCAOB has said that the transfer of an existing registration using Form 4 is only available where the successor firm is under substantially the same ownership as the predecessor firm. Obviously that is not the case here, since KPMG has designated so few partners to own the new firm.”

It is extremely important, according to Gillis, that KPMG and the rest of the Chinese member firms of the Big Four and other global audit networks keep their old registrations as they reorganize their partnerships under the “localization” mandate. That’s because, “the PCAOB announced in 2010 that it intends to reject any new applications for registration from firms in countries that will not allow PCAOB inspections.”

The PCAOB approved initial registrations with the restrictions before but has already refused to register new firms under those conditions, especially in Hong Kong and China. The PCAOB renewed KPMG’s China firm registration based on a filing under its previous registration. The new KPMG firm was established on August 1. According to the latest filing, KPMG China again declined to agree to the requirements related to cooperation with the PCAOB and production of documents, citing Chinese secrecy laws. The new KPMG partnership is even called KPMG Huazhen, the same name that was used for its prior joint venture structure.

There are two implications of the SEC’s limited enforcement and the PCAOB’s lack of ability to monitor the auditors in countries that do not allow inspections. Reuters’ Dena Aubin touches on one of them in the last paragraph of her interview with PwC’s Nally:

“The Big Four firms, which also include Deloitte, Ernst & Young and KPMG, audit many of the China-based companies listed on U.S. exchanges, as well as the Chinese operations of multinational companies. Those multinationals could also lose auditors for their Chinese operations if no agreement is reached.”

That’s a significant understatement.

China-based auditors perform audits of significant, material operations of U.S. and non-U.S. based multinationals with U.S. stock exchange listings. Those audits are not being sufficiently monitored and supervised for quality and adherence to standards by the primary non-China  – usually U.S. – audit firm according to PCAOB inspection reports of the U.S. firms and the China audit cannot be inspected by the PCAOB.

In addition, an on-site China SEC investigation of accounting manipulation, fraud, or illegal acts, such as under the Foreign Corrupt Practices Act by the Chinese operation of a U.S. listed company (or a China-based company with a U.S. exchange listing) would be severely limited by the lack of authority and access of the SEC and Department of Justice in China to both the Chinese company and the China-based audit firm.

The U.S. casino industry has both problems. Fortunately, they get plenty of advice from the Big Four.

Casinos generate revenue on a cash basis when customers wager and when they pay for services like hotel rooms, food and entertainment with cash or credit card. Macau, a former Portuguese colony transferred back to Chinese control in December 1999, is now the casino gambling capital of the world. Revenue in Macau 2011 was up 42 percent to $33.5 billion, more than five times the amount recorded by Las Vegas. Macau, like Hong Kong, operates with a high degree of autonomy. That capitalist spirit has produced double-digit revenue growth until a recent economic slowdown in mainland China where most of Macau’s high rollers come from.

If that kind of growth seems too good to be true, it just may be. Macau-based operators like Melco Crown Entertainment and SJM, the world’s largest casino operator by revenue last year, are connected to Stanley Ho, “Mr. Macau”. Both are listed on the Hong Kong Stock Exchange and Melco also has NASDAQ-listed ADRs.

The three largest U.S. casino operators – MGM, Las Vegas Sands and Wynn have a material interests in Macau. Macau revenue numbers may be rosy but profit margins reported so far have been tiny all around, eaten up by the enormous costs associated with developing world-class resorts in a highly controlled, bureaucratic environment.

MGM, if you can believe it, is actually losing money. In the gambling business.  I know…

U.S. owned casinos also face new threats of costly investigations and the inevitable heavy fines for “accommodations” that are “business as usual” in countries where government and commerce are sometimes indistinguishable. There is also growing acknowledgment in the U.S. that gaming promoters, who play significant role in the Macau market because they bring the high rollers in via junkets, are part of the local organized crime elements called “triad” in Macau.

The Las Vegas Sands Corporation second quarter 10-Q announced that the company received a subpoena in February of 2011 from the SEC requesting documents related to its compliance with the Foreign Corrupt Practices Act (the “FCPA”). That’s the law that covers bribery of foreign government officials by employees of U.S. listed corporations. The Department of Justice is conducting a similar investigation of LVS. It wasn’t that long ago that Las Vegas Sands was on the verge of bankruptcy.

Also last February, the Las Vegas Review-Journal reported that SEC is investigating Wynn Resorts Ltd’s business practices in Macau, too, according to the company filings.

“The SEC’s probe relates to a dispute between Wynn Resorts and its largest shareholder, Kazuo Okada, which includes Okada’s demand for release of company records related to a $135 million donation pledged by Wynn Resorts to a foundation run by the University of Macau.”

Not only are U.S. casino companies operating in a highly competitive environment where government officials and sometimes shady characters can make or break multibillion dollar projects on a whim, there’s growing skepticism amongst US investors about any numbers reported by China companies. That’s because of all the recent frauds reported in Chinese companies that obtained their U.S. exchange listings via reverse mergers with U.S. based listings – that process cuts through a lot of red tape and review – as well as in Chinese companies with traditional listings on the New York Stock Exchange and NASDAQ. The SEC has launched investigations into fraud allegations and Chinese and U.S. auditors have resigned at mainland and Hong Kong based Chinese companies such as Sino-Forest, Longtop, China Media Express and Focus Media, amongst many others.

Each of the U.S. casino corporations uses a Las Vegas-based Big Four auditor to issue the overall opinion on its consolidated financial statements. Given the success of their Macau business initiatives, their China business is now a material portion of their operations. Macau represents 52% of revenue for Las Vegas Sands, 71% for Wynn and 19% for MGM. MGM owns 51% of the Macau joint venture with “Mr. Macau” Stanley Ho’s daughter Pansy. Pansy was deemed unsuitable by the state gaming board to be a partner in MGM’s New Jersey operations because of her father’s questionable affiliations.

In all three cases, the U.S. casino companies listed the Chinese operations separately on the Hong Kong Stock Exchange while retaining a majority interest in the operations. The China-based subsidiaries of the U.S. casino companies must have a China-based auditor for their Hong Kong stock exchange listing and to prepare a report for the U.S. auditor to depend on. Wynn uses Ernst & Young Hong Kong, Las Vegas Sands uses Price Waterhouse Hong Kong, and MGM China uses Deloitte Touche Tomahtsu in Hong Kong. Melco Crown Entertainment, the big Macau-based casino operator with ADRs listed on NASDAQ, also uses Deloitte Touche Tomahtsu.

What could go wrong? Since certain foreign jurisdictions such as China do not allow the U.S. audit regulator, the PCAOB, to inspect audit firms, the work of these firms for Chinese clients and their quality control procedures is not scrutinized. The SEC staff started issuing comments asking companies with operations in the foreign jurisdictions closed to PCAOB auditor inspections to start disclosing, under a separate risk factor heading, that a significant portion of their audit cannot be inspected.

None of the Big Four audit firms in Hong Kong used by these casinos  to audit their Chinese operations have ever been inspected by the PCAOB. The SEC recently sued Deloitte Touche Tomahtsu Shanghai in federal court to obtain the audit workpapers related to two alleged mainland China frauds. Deloitte’s China firm refused to cooperate, claiming Chinese state secrecy constraints. Ernst & Young Hong Kong is facing similar legal action from Hong Kong’s securities regulator to obtain their workpapers for another mainland China client, Standard Water Ltd..

Earlier this year the SEC requested all of the Chinese member firms to turn over documents related to audits of China-based companies that are listed in the United States. As far as we know, none have cooperated. Based on Deloitte’s refusal of the SEC’s request, it’s possible that an SEC or DOJ investigation of accounting manipulation, fraud, or illegal acts such as under the Foreign Corrupt Practices Act by a Chinese operation of a U.S. listed company will be severely constrained by the limited authority of all U.S. regulators in China.

U.S. based casino companies are accustomed to extra scrutiny from law enforcement because they operate a high risk, high reward business that’s been connected to a fair share of nefarious characters in the past. But U.S. casino companies doing business in China, in particular, and new media companies like Facebook and Zynga that actively seek to enter the online casino gaming business in the U.S. and abroad, present additional risks of fraud, bribery and other illegal acts given the nature of the business, where they’re going to be doing much of it and the type of people they have to do that business with.

Investors should be wary of investing in any U.S. companies with significant operations in China because those operations are immune to the jurisdiction of the SEC and Department of Justice and their auditor is not inspected by the PCAOB.

Main page photo of Casino Lisboa with Sun (C)opyright Derek Chan, All Rights Reserved