Mind the GAAP: Addressing Fraud Trends at Chinese Companies
Last month we noted a trend concerning fraud and accounting irregularities at NYSE- and Nasdaq-listed Chinese companies. The trend is not being ignored: on July 11 and 12, representatives from the SEC and the Public Company Accounting Oversight Board (“PCAOB”) met with representatives from the China Securities Regulatory Commission and China’s Finance Ministry. The SEC and the PCAOB (which oversees audit firms) are seeking cross-border oversight that would allow U.S. examiners to inspect audit firms in China, which Chinese officials have claimed violates China’s existing laws relating to state secrets. But whether China can afford to resist such access cannot be ignored: according to Bloomberg, “Chinese companies listed in the U.S. have had $4.1 billion wiped off their market value this year amid a wave of auditor resignations and fraud allegations by short-sellers . . . .”
Running a parallel path, in June the PCAOB rejected an application by a China-based audit firm to become a U.S.-registered auditor, the first rejection since a policy issued in October 2010 that permits the PCAOB to consider the ability to inspect foreign-based auditors in evaluating such applications. Further, shareholders are taking their claims of accounting and securities fraud to U.S. courts against China-based companies and their external audit firms. Reuters has reported that suits against external audit firms (such as the recently allowed shareholder suit against the audit firms of Chinese company China Expert Technology, Inc.) may find deeper pockets than the potentially non-responsive, underinsured and illiquid Chinese companies themselves.
OUR TAKE: Investors should continue to monitor trends with respect to corporate governance deficiencies and accounting fraud. This is still a developing area. The progress of talks regarding cross-border audit oversight, and whether shareholders are successful in efforts to obtain damages for the fraud, will likely have a significant impact on future investments in Chinese companies.