He Qinglian (何清涟) is a Chinese economist who lived in China before 2001. In her bestseller The Pitfalls of Modernization (《现代化的陷阱》), she argues presciently that, as the power of local governments grows, officials who have favored reform would come to oppose further reform because it would limit their ability to trade power for money and money for power. The book was banned in China, Ms. He forced to exile. In 2006, she published China Shrouded in Fog (《雾锁中国》) that studies how the Chinese government manipulates and, to some degrees, controls overseas Chinese-language media. Ms. He lives in New Jersey with her family. The Chinese original is here.
The Securities and Exchange Commission in December charged the Chinese affiliates of five big accounting firms Deloitte, Ernst & Young, KPMG and PwC and BDO for failing to comply with laws requiring access to the work papers of their audit on Chinese companies. The SEC was supposed to make a decision at the end of the December, including the possibility of delisting all Chinese companies in the US exchange. But the “deadline” has long passed and we haven’t heard the outcome of the suit. I am afraid it has probably disappeared into the black box called “diplomatic solutions.”
The fate and the practice of the five accounting firms in China are tied to one word: professional standing. In 2001 when native Chinese accounting firms were embroiled in fraud scandals, the Chinese government granted special audit concessions to the five largest US accounting firms for their trustworthiness, and the big five’s China business has subsequently skyrocketed. But now the Big Five are embroiled in alleged fraud in their Chinese business. Over the last 12 years, the Big Five’s attitude towards their own reputation has undergone quiet change, and it all has to do with them seeking gold in China.
In this article, I would like to examine four issues:
I. Did the Big Five know that Chinese companies had falsified their financial documents?
The SEC said that the Big Five refused to provide required documents partially because their accountants believed that “the law of the People’s Republic of China” prohibited them from providing them.
It’s very clever for the Big Five to place the burden of “Chinese law” that the SEC couldn’t do anything about. But the key issue remains: Did the Big Five know whether Chinese companies had falsified their financial documents when they conducted audits?
When a Chinese company issues an APO in the American exchange, it must hire American-trained professionals in order to understand financial literature. It was possible that, at the beginning of the APO business, the American executives of the Big Five didn’t know what their Chinese subordinates were doing, but it’s hard to believe they still didn’t know by 2004.
China’s APO industrial chain started around 2001. Some US-trained Chinese professionals, in cooperation with accountants, lawyers and investment banks in the US, scouted Chinese companies suited for reverse merger and acquisition. After a few years of practice, an APO industrial chain matured between 2003 to 2005 that helped Chinese companies to issue APOs in the US market. During this period, there had been a stream of bad news coming from the US market about Chinese stocks. In 2005, 90% of the 70+ Chinese companies had become trash stocks in less than a year after they had been issued. It’s hard to believe that, faced with such a deluge of bad news, the American executives of the five accounting firms did not suspect a possible audit on their Chinese subordinates. But common interest had already made it difficult for them to cut their connections.
II. Chinese business is an enormous gold mine for the Big Five
The five largest accounting firms entered China in the 1990s one after another. Arthur Andersen bankrupted in 2001 because of its involvement in the Enron scandal, so the Big Five became Big Four. But a few years later, BDO joined the other four, so it was the Big Five again. In their earliest days in China, the American brand and reputation brought these firms good fortunes. In 2001, the Chinese government dropped them a big piece of cake. That year, many native Chinese accounting firms were implicated in a series of accounting scandals such as Guangxia (银广夏), Baiwen (郑百文), Lantian (蓝田股份), and as a result, the Chinese Securities Regulatory Committee (CSRC) implemented supplementary audit policies requiring all public companies to provide not only the statutory audit by a domestic accounting firm, but also a “supplementary audit” by an international audit firm, when issuing an IPO or refinancing.
With the statutory requirement, in place to correct rampant accounting fraud in China, the business of these international firms exploded. According to statistics of the Chinese Institute of Certified Public Accountants, the total revenue of Deloitte, Ernst & Young, KPMG, and PwC (before BDO joined them) in 2002 was close to RMB1.7 billion, or 38.23% of the total revenue of China’s 100 biggest accounting firms. In 2005, the percentage increased to 49.46%. In a matter of a few years, while more than 5,600 Chinese accounting firms had to tear each other into piece to fight for piecemeal businesses, the Big Five had monopolized China’s high-end audit business and the entire audit business of all of China’s companies listed overseas. Of the 1,400 plus companies issuing RMB denominated common stocks (or the A stocks), over 40% of the assets were audited by the Big Five.
Director of Economic Security Research Center Jiang Yong (江涌), of China Institutes of Contemporary International Relations, thought this situation “seriously threatened the security of China’s financial information.”
In China where the government routinely fabricates statistics, it’s very difficult for outsiders to know just how strictly the Big Five have conducted their audits, and what they have done to stay clean of all sorts of accounting scandals. But this much I can say for sure: the Big Five would not be able to have so much business in China without conceding to China’s “hidden rules.”
Several hundred Chinese companies had gone public in the US exchange through “back-door listing,” each audited by one of the Big Five. But soon, accounting problems plagued Chinese stocks in the US, and many Chinese companies were suspended by SEC. In March 2007, CSRC announced that public companies in the category of finance were no long required to undergo supplementary audit by an international firm, the reason being “to ensure fair competition between international and domestic accounting firms.”
CSRC had thus far hoped to regulate Chinese stock market by granting special status to Big Five, knowing perfect well about accounting frauds among Chinese companies. Now, since the Big Five did the same things as their Chinese colleagues, CSRC had no reason to give them privileges. But CSRC would never let the US know what they knew, because China stood to benefit, without consequences, from disqualified Chinese companies going public in the US stock market.
III. Have the Big Five been knowingly engaged in helping clients to cheat?
The Chinese white-collar elites, who serve in the Big Five, would no doubt see problems in the books of Chinese companies, and they have chosen to “package” these companies, with the assent of their bosses, to make them meet the American requirements in appearance. Providing “packaging” is the business secret of the Big Five.
The Big Five know very well the truth about their clients. I will give Ernst & Young’s flip-flop on Bank of China’s bad debt for example. On May 4, 2006, Ernst & Young stated in an annual report that the Bank of China had a staggering $US 911 billion bad debt. The Chinese government protested angrily, as the Bank of China was due to be listed in overseas markets on May 25. Paul Ostling, Global Chief Operating Officer at Ernst & Young at the time, ordered an internal investigation on its report, and concluded that its report on the bad debts of China’s four biggest state-owned banks had errors, didn’t pass Enrst & Young’s formal review procedures before it had been issued, and promised “such an embarrassing situation will not happen again”(link in English).
However, Enrst & Young had its “Achilles’ heel”: its current report contradicted its audit report on ICBC the year before. If you look up news in 2005, you will know that China’s state-owned banks had been making preparations for listing in Wall Street, and hired American accounting firms for audit. Enrst & Young was the auditor of ICBC. Now, if Enrst and Young insisted its numbers of Chinese banks’ bad debts were accurate, then its audit on ICBC and a few other banks couldn’t possibly be true, and its reputation would suffer greatly. If it insisted the ICBC audit was correct, then the veracity of its report on the bad debts would be called into question. Between the two traps, Enrst & Young chose the one that hurt itself less.
Enrst & Young had issued hundreds of reports before and was highly regarded by its peers. And the conclusions of the 2006 report did not differ from other independent financial advisors, including PwC, that examined China’s bad loans. On May 16, 2006, Financial Times asked “Has Ernst & Young forgotten the importance of being independent?” wondering whether Enrst & Young had made a “Faustian bargain” with China as Microsoft and Google had done.”
The episode in 2006 might have faded into the past, but now, Enrst & Young and the other major international accountancies are facing fresh allegations from the SEC.
IV. Do China and the US have a legal compatibility problem, or have Chinese companies cheated on purpose?
China has never been known for information transparency, and it finds all sorts of excuses to evade it, security reason being a favorite excuse. This time around, the excuse is that the Chinese law prohibits handing audit working papers to the SEC. Inside China, there were people who defended China and the Big Five by claiming that the two countries’ laws have a compatibility problem.
This last defense is rather far-fetched. Chinese companies of course have to obey American laws if they are to be listed in the US market. In 2004, China’s Construction Bank and ICBC attempted to go public on Wall Street, but after about a year of public relation campaigns and lobbying, including the courting of the American banking industry by both Hu Jintao and Wen Jiabao, these banks failed to gain approval for not meeting SEC’s criteria.
I remember on August 11, 2005, Congress held a specific hearing on the issue of China raising capital in the United States. From the remarks of the participants, we get the sense that the accountants and lawyers involved in auditing Chinese companies knew very well that China’s state-owned banks fell short of the SEC requirements. But Donald Straszheim, former chief economist for Merrill Lynch, believed that the US decision makers should trust the judgment of the market, and should not impose special restrictions on Chinese state-owned enterprises seeking to be listed in the US stock market. Robert DeLaMater, partner at Sullivan & Cromwell, had advised many Chinese companies in their securities offerings, suggested in his testimony that, if the US set the threshold too high for overseas issuers, the American capital market might lose its attractiveness. Without naming the “special restrictions,” both Straszheim and DeLaMater were referring to the Sarbanes-Oxley Act, a law passed in 2002 after the Enron and Worldcom scandals. What the two were really advocating was to lower standards, and open up special channels outside the Sarbanes-Oxley Act, for Chinese companies.
Looking back now, the SEC was wise not to have done that, given that Chinese state-owned banks have been mired in loans by local governments. Or the American stock market would have been the best place for Chinese state-owned banks to rid of its bad loans and financial risks.
This time around, the question is, for the safety of the American capital market, should the SEC make concessions to the Big Five who are allegedly playing a part, along with Chinese corporations, in financial fraud?
To be sure, the Chinese players will not provide audit working papers, because those papers will only confirm the Big Five’s collaboration with China. It is in the interest of the Big Five to stay in sync with Beijing and to keep the SEC from finding out the truth.
The US really doesn’t have too much choice. It either relaxes its regulatory demands in exchange for temporary “Chinese interest”, or holds steadfast the principles and punishments for cheaters. How the US handles the case would be an indication of how much the US cares about its national credibility.