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Deloitte's explosive dilemma

May 14, 2012 | By |

Deloitte is stuck between a Chinese rock and a US hard place.

US securities watchdog has fired a loud salvo at the China unit of global accounting firm Deloitte Touche Tohmatsu last week for failing to cough up audit reports of a PRC client. The unidentified mainland company is under Securities and Exchange Commission’s probe for alleged accounting fraud.

SEC charged Shanghai-based Deloitte Touche Tohmatsu Certified Public Accountants Ltd. (DTTC) last Wednesday (May 9) for violating Section 106 of the Sarbanes-Oxley Act, and Section 929P(b) of the Dodd-Frank Act, which extends the antifraud provisions of the Securities Exchange Act of 1934 to transactions occurring outside the U.S. which involve only foreign parties.

The latest round of accusations from the SEC came after its futile chase of the auditing papers since 2010. It is also the US regulator’s second attack against Deloitte after it failed to respond to SEC’s subpoena last May to provide documents concerning another client, once NYSE-listed Longtop Financial Technologies Ltd, which it resigned as its auditor.

Here comes Deloitte’s dilemma:  providing its PRC client’s information to the US regulator would make it violate China’s “state secrets” law, and other regulations governing the conduct of accountants in China. 

Penalty of such crime could well mean an end to Deloitte’s China operation. And it comes in a testy moment when all the Big Four auditing firms’ China licenses will soon expire and the nation’s financial ministry is demanding them to go local and limit the number of foreign partners at the helm.

Deloitte was hoping the US regulator would relieve its obligation after it handed the client’s audit papers to Chinese Securities Regulatory Commission and hoped the Chinese watchdog would pass it along. The documents never got anywhere close to the US shore.

“Deloitte & Touche is caught between a rock and a hard place,” says Rosario J. Girasa, a professor of legal studies and taxation at Pace University's Lubin School of Business in New York. He believes this problem will need to be resolved by the Congress or diplomatically.

Many legal experts agree that only a nod at the top—between the US and Chinese governments— could bring a solution, as seen in the case of Swiss banks putting aside its bank secrecy law and releasing information of its US clients suspected of tax evasion to the US authorities. Deloitte is now effectively a pawn for diplomatic gain.

Calling SEC’s latest charges a “conflict between the laws of the US and those of China,” Deloitte said SEC’s action is a “profession-wide issue,” which will be “the first of a series of similar proceedings by the SEC affecting the wider audit profession in China.”

It is yet to be seen how Deloitte will respond to SEC’s latest charges and how other auditors with US-listed PRC clients find creative ways to please both regulators across the Pacific. But the incident has dealt another blow to Chinese enterprises floating at US bourses which have already been tainted by scandals of accounting fraud and governance misconducts since 2010.

Another blow to China Inc equities?

As Deloitte’s saga continues to unfold, US securities enforcement lawyer Joon H. Kim warns that US-listed PRC companies may be deemed as bad apples by US investors.

"When the SEC has this much trouble getting the documents it needs to regulate and investigate US-listed Chinese companies, the market will view investments in US-listed Chinese companies as comparatively riskier, as those companies are then not subject to the same oversight as other US-listed companies,” explains Kim, a New York-based partner of law firm Cleary Gottlieb Steen & Hamilton.

"During the past couple years, the slew of accounting fraud allegations involving US-listed Chinese companies already had made investors wary, but learning that the companies' accounting documents are not readily accessible to the SEC will inevitably have the effect of further undermining investor confidence in US-listed Chinese companies,” adds Kim.

Time to head home?

As the prestige of a US ticker fades and the PRC companies listed in the US are suffering from a valuation plunge, David Donald, a law professor of Chinese University of Hong Kong, believes heading home may be a better option for them.

He says “a real solution is for them to delist from the US and list in Hong Kong” as the Hong Kong bourse has grown much bigger and sophisticated than it was in the 1990s when many PRC companies flocked to the US to raise funds. Currently, mainland companies account for more than half of Hong Kong Stock Exchange’s market cap.

“I’m sure the Hong Kong Stock Exchange will welcome them,” says Donald. “The problem of cross border dealings will be adjusted by all the bilateral agreements [Hong Kong has] with China and Chinese accounting principles can be used at the HKEx and people here speak the same language, which can eliminate the cultural difference and suspicions.”

Although there’s still yet to be a test case of a successful relisting in Hong Kong or mainland, many US-listed PRC enterprises are quizzing their lawyers on how to go private, to follow the footsteps of  China’s online game giant Shanda Interactive and security technology provider China Security & Surveillance Technology, which underwent management buyouts last fall.

It may take a few years for these haigui stocks to gain a local status since they have to revamp their corporate structures and meet the regulatory and listing requirements in China or Hong Kong, but the tide is certainly about to change.
 

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