Scrutiny intensifies on Chinese corporations as SEC pressures Big Four auditors to hand over documents

Are we about to see a wave of accounting scandals involving Chinese companies listed on U.S. and Canadian exchanges?

It’s not out of the question. According to a recent Reuters report, the Big Four auditors (KPMG, E&Y, Deloitte and PwC) have so far failed to comply with requests from the U.S. Securities and Exchange Commission (SEC) for audit papers linked to investigations of Chinese corporations.

The reason? Apparently, Chinese law prohibits the transfer of certain documents across borders, which is making life difficult for the SEC and raising political tensions.

Already, Deloitte’s Shanghai arm has been charged with violating U.S. securities laws by refusing to produce documents from an audit of an unnamed China-based company. (The other auditors have received requests but haven’t been hit with enforcement action yet.)

PwC issued a statement referring to the impasse at which the auditor finds itself:

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

Firms that fail to comply with SEC requests for documentation face a number of sanctions, including the possibility of having their ability to practise before the commission revoked.

Both the SEC and the Public Company Accounting Oversight Board (PCAOB, the accountancy regulator) are working with Chinese authorities to resolve the dispute “before the end of 2012,” but if no agreement is reached, Chinese issuers on U.S. exchanges could very well be delisted.

“Without resolution, the only meaningful option for the SEC, and the PCAOB, is for the PCAOB to de-register the firms and for the SEC to ban them from practice before the SEC,” wrote Paul Gillis on the China Accounting Blog.

From a Canadian perspective, the standoff between Chinese and U.S. officials brings to mind Sino-Forest — the formerly TSX-listed forestry company that was bounced from the exchange in May after Muddy Waters Research analyst Carson Block raised suspicions over the company’s claim to own vast tracts of land in Inner Mongolia.

When Sino-Forest was unable to sufficiently satisfy regulators and shareholders that the company owned the assets it claimed to own (a claim that remains in dispute), the stock plummeted and shareholder class actions were filed. The Ontario Securities Commission (OSC) has alleged fraud in the matter.

Mindy Gilbert, a Toronto-based lawyer in the China practice of Davies Ward Phillips & Vineberg LLP, says it’s difficult to predict whether the recent troubles between the SEC and the Big Four auditors signal an impending wave of Sino-Forest-type accounting scandals.

She points out, however, that the OSC has already, as of last summer, launched a review of 24 issuers with operations in emerging markets, and proceedings have commenced against two of these issuers.

“The OSC report,” says Gilbert, “highlights that in certain jurisdictions, it is unlawful for Canadian audit partners to remove from the local jurisdiction working papers of their foreign counterparts, which may impact the level of review the Canadian audit partners are able to perform.”

She also points out that, as in the case of Sino-Forest, shareholders are not going to wait around for regulators to pronounce on the legitimacy of documentation. “Generally, markets will move faster than regulators.” Still, there’s a balance to be achieved between the benefits of tapping emerging markets and providing protection to Canadian investors.

“Achieving this balance takes time.  From an enforcement perspective, regulatory response can be hindered by foreign local law and the lack of jurisdiction of the Canadian regulators in those foreign markets.”

The important thing for Canadian companies doing business in China is to mitigate risk by ensuring that the board and management “are following reasonable procedures to understand the business operating environment of the issuer and related risks.”

With tensions rising between U.S. and Chinese regulators, and the recent example served by Sino-Forest, Gilbert says Canadian auditors must also be scrutinizing their policies closely:

“I have no doubt that Canadian auditors are also reviewing their internal procedures with respect to emerging market issuers with a view to reducing both litigation and reputational risk.”

-David Dias

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