China has long argued that the Public Company Accounting Oversight Board (PCAOB) should rely on Chinese regulators to examine the work of Chinese accounting firms that are also subject to US inspection under Sarbanes-Oxley. This concept is known as regulatory equivalency, where a regulator is to consider the work of a foreign regulator as the equivalent of doing it itself.
The PCAOB has so far refused to accept the concept of regulatory equivalency, insisting instead on at least joint inspections of foreign accounting firms together with local regulators. That may change.
Shaswat Das, an attorney with Hunton & Williams, has noted an obscure reference in a recent European Union (EU) directive that indicates the EU wants to move away from joint inspections to the US accepting regulatory equivalency. Shas observes that
it now appears that the PCAOB (with the SEC's concurrence) has determined to proceed along a path of full, mutual reliance that may result in very few joint inspections conducted by the PCAOB in the EU during the coming years - raising questions about the continued efficacy of the PCAOB's international inspections program.
The EU already recognizes regulatory equivalency with China (but withdrew it for Hong Kong due to the pathetic lack of effective audit regulation in the territory) and China is certain to demand to be treated the same as the EU. While I think that Chinese regulators do a good job, I don't think they will effectively regulate the audits of companies not listed in China.
If the US moves to regulatory equivalency with the EU, it is certain to end any chance of inspections of Chinese accounting firms by the PCAOB, because Chinese regulators will hold out for regulatory equivalency. That is bad for investors.
Regulatory equivalency makes sense when local regulators have incentive to strictly enforce rules. For example, food safety regulators could be trusted to do an effective job when the products are also sold in home markets, since the local public will demand that regulators do their job. But audit regulation lacks such incentives.
It might work for the few Chinese companies that are dual listed in the US and China (those, however, are state controlled with other incentives), but otherwise I think we can expect that Chinese regulators will focus on protecting Chinese investors, not foreign investors. How could there be any expectation that Chinese regulators would devote the time and develop the expertise to look at Alibaba's (NYSE:BABA) complex financial situation when the stock is not traded in China?
Does anyone really believe that Chinese regulators will hold Chinese auditors to PCAOB standards with respect to overseas listed Chinese companies? Do they even have the expertise to do so if they wish to? I am unaware of any case where anyone has been brought to justice in China for accounting fraud or other crimes where the victims have been investors in overseas listed Chinese companies.
There have been many cases of Chinese executives looting companies, conspiring with bank officials to issue false confirmations, and even kidnapping auditors. Nevertheless, no one is ever charged with crimes (and these are crimes in China). A Chinese official once told me that criminal matters are decided by Public Security, and Public Security has exercised their prosecutorial discretion to ignore these crimes.
Nonetheless, going down the path of regulatory equivalency does provide a face saving way out of the current impasse over inspections in China. However, that way out is at the expense of investors who will likely be denied effective inspections.
Shaswat Das was the lead negotiator for the PCAOB with China for the past few years until negotiations broke down late last year over China's insistence that a pilot inspection program not look at any state owned enterprises or internet companies. Das then left the PCAOB.
Apparently negotiations were restarted. I have heard from multiple sources that the PCAOB will conduct two pilot inspections this year, of Alibaba and Baidu (NASDAQ:BIDU), two of the largest US listed Chinese companies (and two that were on China's list of companies that could not be inspected last year). Working papers will be moved to Hong Kong, apparently to assuage Chinese concerns about foreign regulators working on Chinese soil.
That is good news, but the benefit for investors may be short-lived if the PCAOB continues on the path to regulatory equivalency with Europe. China is unlikely to agree to a further expansion of the inspection program if the PCAOB has accepted regulatory equivalency with Europe. Shaswat Das wisely expresses this concern.