This is a guest entry from Jim Peterson, an American lawyer whose practice focuses on financial and accountancy related issues, and who is a 19-year veteran of Arthur Andersen’s in-house legal group. He launched his column, “Balance Sheet” in the business section of the International Herald Tribune in 2002 – evolving to his blog, “Re:Balance”. His two books on the accounting profession are “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald 2d ed. 2017) and “DOA: Can Big Audit Survive the UK Regulators” (Amazon 2019).
By Jim Peterson
When in need of street wisdom, legendary Chicago columnist Mike Royko called on his bar-stool pal Slats Grobnik.
Not even Slats could explain what has possessed the United States Senate – which on May 20 passed the Holding Foreign Companies Accountable Act – to vote to expel Chinese companies from the American capital markets because their auditors are shielded by the Chinese regulators from the oversight and inspection program of America’s audit regulator, the Public Company Accounting Oversight Board.
As the world’s greatest deliberative body – so goes the cliché – the fractious Senate can barely muster bi-partisan agreement on the time of day – so passage of the HFCA by unanimous resolution must elicit skepticism about whether there are adults minding the playroom.
The Act first plays to the chest-thumping China hawks – Trade Representative Robert Lighthizer and economic advisers Larry Kudlow and Peter Navarro. It would require a Chinese company seeking access to the American capital markets to certify that “it is not owned or controlled by a governmental entity….”
That provision -- so susceptible to gaming that Slats would guffaw over his beer -- pictures a trench-coated character out of John le Carré, peddling a fistful of “no control” certificates -- facially valid and untraceable in provenance.
For two reasons, though, Slats would truly slap his forehead over the Act’s second bit: a Chinese company would lose its US listing and its shares would be barred from US trading, if the PCAOB were unable for three years running to access its auditor and its working papers under the auditor inspection program put into place by the Sarbanes Oxley law of 2002 and activated by extension to ex-US auditors in 2005.
For starters, even though since first requested the Chinese have consistently forbidden PCAOB auditor inspection, the enforcement armory of the American securities regulators has long had the necessary weapons locked, loaded, and zeroed in to make it happen.
Launch of the inevitable Chinese/American diplomatic and trade apocalypse has – at least on paper -- needed no more to pull the trigger than the order of an authorized zealot – one of the noted hawks or, even and perhaps better in these over-heated times, theocratic and rapture-ready Secretary of State Mike Pompeo.
Here’s the short guided tour through the existing arsenal:
· Sarbanes Oxley § 102(a) and PCAOB Rule 2100 require auditors reporting on an issuer’s financial statements to be registered.
· Under Sarbanes Oxley § 104(a), auditor registration includes and requires a registered firm to submit to the PCAOB’s inspection process, including access to personnel and working papers.
· Sanctions for non-compliance include revocation of a registration, under Sarbanes Oxley § 105 (see the PCAOB’s orders relating to PKF (Hong Kong) (January 12, 2016), Crowe Horwath (HK) CPA Limited (July 25, 2017), and Anthony Kam & Associates Limited (November 28, 2017).
· Audit reports by a de-registered firm may not thereafter be included in an issuer’s SEC filings (see the SEC’s Financial Reporting Manual § 4115.1).
· The obligations of a principal auditor using or relying on the work of another audit firm – whether or not that firm is referred to (Manual § 4104.1-.5), or must itself be registered (under the “substantial role” threshold of Rule 1001(p)(ii)) – include the production of work papers and other documents related to that firm’s work (see PCAOB Staff Questions and Answers on Audits of Mainland China Issuers By Registered Firms Outside of Mainland China, December 30, 2016).
· Further, a non-US firm on which a principal auditor relies, whether or not registered, must under Sarbanes Oxley § 106(b)(2) produce its work papers on request and designate a US agent for service of PCAOB or SEC process.
· Finally, because the financial statements of an issuer in the US may only be reported upon by a registered auditor (Sarbanes Oxley § 102(a)) – the consequences are as summarized in a recent blog post from the Columbia Law School (emphasis added):
“Companies that fail to file within the allowed grace period are subject to a variety of costly penalties, including deregistration by the SEC, delisting by stock exchanges, the inability to raise capital through issuance of public securities, and potential debt covenant violations.”
With all that authority already in place to bar Chinese companies, and their audit firms, who won’t comply from US trading of their securities, the questions Slats Grobnik would press—caring no more about the grimy details of the law-making process than he would the ingredients in a classic Chicago hot dog – would be:
· What could they be thinking -- against the immediately predictable blowback from the Chinese securities regulator to a proposal “directly targeted at China…(that) … politicizes securities regulation”?
· Why now, having welcomed for fifteen years the listings of some of the world’s largest companies – the likes of Alibaba and PetroChina and China Life and China Telecom – while the inevitable emergence of a scandal on the order and scale of Luckin Coffee has been predictable the entire time?
· And has anyone the moxie to do it?
That last is not to be ignored -- the question who would do the dirty and disruptive work of de-registering auditors and stripping Chinese companies of their US listings.
The weapons exist and are at the ready -- not so the boots on the ground. This administration’s lack of confidence in the PCAOB was manifest in its clean sweep of all five board members and the gutting of its senior staff, and this March, a budget proposal to eliminate the PCAOB altogether and roll up into the SEC whatever remaining modest scope of its politically permissible activities might survive.
Nor does SEC chairman Jay Clayton have standing as the fire-breathing regulator needed and committed to wage the hawks’ holy war. In his background is the record-breaking $ 25 billion IPO of Alibaba in 2014, featured among the big deals of his pre-SEC life as a partner in the heavyweight firm of Sullivan & Cromwell – while in his current position, he offers only frustrated reminders to investors of the limits of his agency’s timorous reactions to the on-going Chinese rebuffs.
The search for coherent thinking behind the HFCA becomes even more muddled, in looking for consistency in the justification by Senator John Kennedy (R.-La.), the bill’s principal sponsor, in the Congressional Record: “We are excruciatingly transparent. We like investors throughout the world to know what they are buying.”
Slats again – Izzat so? Then what do investors know about the operations in China of, for two quick examples:
· Caterpillar, which shows seven manufacturing and distribution locations in China in its Form 10-K for 2019, is estimated to derive some 5% of its $ 53.8 billion in global revenue from that country.
· Apple, which for the first quarter of 2020 rang up revenue in China of $ 13.6 billion -- 14.8% of its total global revenue of $ 213 billion.
High-ranking American companies – audited respectively by the US firms of the PwC and EY networks. Neither auditor explicitly shows use or reliance on the work of their colleague firms in Hong Kong or China, although both would be subject to the legal and regulatory obligations noted above – to maintain and produce information – but only if “on request.”
How long would we hold our breath, waiting to know whether Chairman Clayton’s foot soldiers might “request” access to the audit work scrutinizing those billions of China-based revenue? Slats’s lament for his beleaguered Chicago Cubs – the perennial and off-putting “just wait till next year” – extended a fulsome five score and eight years.
A long political step too far, for Senator Kennedy to extend what consistency of logic there may be in his HFCA, to benefit the investors he claims to favor, by reaching for access to the China-based audit work supporting the American firms’ reporting on the financial statements of ex-Chinese companies that include their large operations there.
Nor, presumably, would it suit the China-bashers. Audits covering the operations in China of Cat or Apple are no less opaque to PCAOB inspection than those of Alibaba or PetroChina – but where would the sponsors of the HFCA see the pay-off in picking that fight?
The Senate’s headlong rush portends a reprise of the enactment of Sarbanes Oxley itself. As I wrote in the now-lamented International Herald Tribune on July 20, 2002, about that law’s equally lamentable passage, “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”
That assessment has been well vindicated, by two decades of small-bore and ineffective behavior by a body whose mission would have been at least as well executed under existing laws, regulations, and behavior modification by the sector itself. As Slats would say, “here we go again.”
It does not inspire confidence that a version of the Senate-passed HFCA was promptly introduced in the lower chamber. The warning from Will Rogers is stark:
“Ancient Rome declined because it had a Senate. Now what’s going to happen to us with both a House and a Senate?”
Might good sense intrude? Elected officials definitely have the authority to inflict the HFCA – otiose and pernicious as it would be. But a strategy of “ready – fire – aim” cannot repeal the impact of the still-valid Law of Unintended Consequences.
If you want more about the China companies/auditor conflict, see my previous newsletter edition here, “China Frauds, auditors and regulators’ obligation to protect investors,” or search “China” on my legacy blog re: The Auditors.