Is The SEC Action Against Auditors Of Chinese Companies One Of Gunboat Diplomacy?

by: Jeffrey Friedland

The actions by the U.S. Securities and Exchange Commission (SEC), which has charged five China based affiliates of major auditing firms with violations of the U.S. securities laws, will likely have a definite impact on Chinese companies listed in the United States. But for now, it appears that many investors are taking a wait and see attitude. Wednesday, Baidu's (NASDAQ:BIDU) shares closed down 2.36%, at $88.12, and Sina's (NASDAQ:SINA) shares were down 1.43%, closing at $41.49. But not all Chinese shares listed in the U.S. closed down Wednesday. Ctrip (NASDAQ:CTRP) closed up .5% at $18.02, and smaller capitalization China Industrial Steel (OTCPK:CDNN) was up 3.45% closing at $1.20. Since I see the SEC action as one that is political, short-term there could be buying opportunities in many Chinese companies listed in the U.S., especially if a path to resolution becomes apparent.

One has to wonder, is gunboat diplomacy by the U.S. rearing its ugly head? Is the U.S. once again trying to show its teeth as the major global power?

It's clear that actions taken by the SEC to sanction five China based affiliates of major auditing firms, PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu, Ernst & Young and BDO are appropriate under U.S. regulations. Four of these, PwC, Deloitte, Ernst & Young and KMPG are considered the "Big Four" accounting firms.

I see the SEC action as the culmination of "China bashing" that has gone on for some time. Since the 2008 global economic crisis, China has been viewed as a scapegoat for many of America's problems, including the country's high unemployment, low economic growth, and decreasing manufacturing sector. This China bashing became a major issue during the recent U.S. presidential campaign. At times it seemed that both candidates tried to outdo each other, as to who would be tougher on China.

Under U.S. regulations there is no question that the SEC has the right to demand audit work papers from PCAOB (Public Company Accounting Oversight Board) regulated auditing firms, including these subsidiaries of major auditing firms in China. But the glitch is that Chinese law prevents the Chinese based affiliates of the accounting firms from complying with the SEC's requests.

Caught in what I see as a political firefight between the Chinese and the U.S. government are at least 115 of the more than 400 Chinese companies that trade in the U.S. who have been audited by the Chinese subsidiaries of the Big Four accounting firms.

The U.S. Position

The enforcement action brought by the SEC on Monday was a culmination as to what the SEC viewed as an impasse over Chinese auditing firms providing their audit work papers to U.S. regulators. This SEC action puts pressure on Chinese companies that are listed in the U.S. and who now find themselves as pawns in a political battle between China and the U.S. The likely next step will be the U.S. taking action to deregister companies who can't comply with U.S. audit requirements.

I see the action by the United States as one of attempted gunboat diplomacy towards China. China may not react quickly, but I continue to see signs of China's population becoming increasingly more nationalistic. I don't see China as simply giving in to U.S. demands, especially if China sees the U.S. action as one affecting its sovereignty. It's also important that any resolution allows the Chinese government to "save face."

While I'm not going to suggest that China will take as drastic an action as selling their holdings of U.S. Treasuries, I do think that China will retaliate, although it may take a while.

China's Position

China's laws prohibit the removal to outside of the country of audit papers. And, China won't allow foreign regulators to work within China. They consider this information to be "state secrets."

The PCAOB does not have any cooperative agreements with Chinese regulators, including the China Securities Regulatory Commission or China's Ministry of Finance, which share regulatory authority over Chinese accountants.

In September, the PCAOB announced that it had reached a preliminary agreement to begin observing Chinese regulators during reviews of Chinese auditing firms, and saw the step as a "trust building exercise." It's apparent that the negotiations between the U.S. and the Chinese authorities either broke down, or didn't proceed at a rapid enough pace for the SEC.

Tuesday, the PCAOB chairman, James Doty, was quoted by Bloomberg as saying that the talks and negotiations with the Chinese government were proceeding. He also was quoted as saying,

I continue to believe the Chinese regulatory authorities have every reason to resolve these issues of transparency and access to audit work papers.

If Doty's statements are in fact true, one has to wonder why the SEC would take such drastic action unless there was a political motive behind it. We'll have to see if President Obama, Treasury Secretary Geithner or other administration officials make any statement on this SEC action.

The Likely Outcome

Companies that are at risk for being deregistered by the SEC include Qihoo 360 Technology Co. Ltd (NYSE:QIHU), SouFun Holdings (NYSE:SFUN), Baidu, Sina and Ctrip. Many articles in the financial press over the past few days, including in the Wall Street Journal, Bloomberg and the New York Times, have focused on whether the companies audited by these five auditing firms will have to leave the U.S. markets if their auditors will not or legally cannot comply with the SEC's requests.

I agree with William McGovern, the Asia partner of the law firm of Kobre & Kim LLP, and a former SEC enforcement attorney. He was quoted by Bloomberg as saying,

Simply swinging the hammer of enforcement, while effective at garnering headlines, will likely not be enough to achieve the SEC's goal. As capital flows from the U.S. to China at an increasing rate, the pressure will grow on the SEC to find a way to forge compromise. The path to compromise may mean that the SEC has to recognize China's sovereign interest in protecting certain industries or companies.

It's interesting to see that McGovern's comments don't indicate that he sees China as giving in to the SEC's action.

Wednesday, Ravi Sarathy of Citi was quoted by Barron's as indicating that he expects talks between China and the U.S. will result in a compromise. But he doesn't see this occurring immediately. I agree that there won't be an immediate solution. It's my experience that governments don't move very quickly on anything, and I think that this will definitely be the case with this China-U.S. dispute.

I believe that Chinese companies listed in the U.S. will do some soul searching. Many will question whether complying with the U.S. regulatory environment is an appropriate price to pay to have a U.S. listing.

My conclusion is that many Chinese companies will want to maintain a U.S. listing for prestige, access to investors, share liquidity, and most importantly for access to capital. I believe that management of most of these companies will find a way to remain listed in the U.S. This may include their changing to smaller auditing firms based in the U.S. or even in Hong Kong, who are in good graces with the SEC and the PCAOB.


Investing in smaller-capitalization companies, as well as investing in companies in emerging markets (including China), is not suitable for all investors and can be risky. It's important that investors thoroughly perform their own due diligence and analyze the potential risks.
The companies mentioned above include a smaller capitalization company with operations based in China, China Industrial Steel.

Disclosure: I am long OTCPK:CDNN, BIDU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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