On January 22, SEC Administrative Law Judge Cameron Elliot ordered that the China units of the global “Big Four” accounting firms should be suspended from auditing US-listed companies for 6 months. The decision came in the aftermath of the disputes between the auditors and the SEC over submitting work papers on US-listed Chinese companies to US regulators for examination. The news has caused huge share price volatility in Chinese-listed companies in the US today, which we believe will continue for the near term.
Chinese stocks listed in the U.S. got hammered on January 22, and the bloodshed continued on January 23, led by the internet and solar stocks. The market is now concerned that this group of companies will miss filing 2013 annual reports to comply with the U.S. listing requirements. On January 24, the Chinese government struck back.
What is going on is effectively a conflict in the laws of two jurisdictions. Under U.S. securities laws, the SEC is empowered to investigate alleged fraud and require the production of audit work papers from non-U.S. accounting firms; under Chinese laws, such audit work papers are deemed state secrets and cannot be provided.
In theory, the SEC could see fit to delist all of the Chinese companies listed on American exchanges. The impact of a widespread delisting would be nuclear as it could dissolve the entire food chain that services these listed companies, including investment banking, accounting, auditing, and research coverage. Ultimately, it is the American investors and institutional managers who would take most of the financial losses.
Beyond China’s borders, the SEC’s hard-line policy may also have a devastating effect on multinationals such as YUM, Ford, GM, Coca-Cola, and P&G, all of which have sizable operations in China and will also no longer to be able to produce audit reports. It is clear that if the standoff between the SEC and the Chinese government persists, the whole auditing regulatory framework supporting the global operation of those firms and the capital raising function of U.S. capital market will suffer.
So what could the SEC do, instead of barring auditors from working on what needs to be audited?
As it stands, a primary function of U.S. securities laws is to ensure that all material information about an issuer, including all investment risks, is adequately disclosed to investors free of material misstatements or omissions. So long as investors are adequately informed about any omissions, they are responsible for the risks of their investments.
In other words, one solution would be for the SEC to require disclosure that the audit work papers of domestic Chinese auditors may not be made available to the SEC, so that investors can take this information into account in their investment decisions.
Rather than starting to regulate these foreign private issuers according to the same compliance standards as U.S. registered entities, the SEC should highlight to investors the risks involved in investing non-US registered foreign entities. This way, investors can assess on their own the risks associated with a foreign private issuer.
We believe that there are trading opportunities if the market continues its sell off. We recommend companies with long and established histories of operation, strong franchises and leadership in their industries, headquartered in major cities, with stable management and strong balance sheets.
Many thanks to Ana Swanson in Washington, D.C.