A new dispute over access to accounting information on U.S.-listed Chinese companies should give American investors pause.

Recently, investors in Chinese companies listed on U.S. stock exchanges that are suspected of fraud, as well as U.S. accounting firms that audit those companies, have been unable to obtain audits performed in China by Chinese accountants acting on behalf of the U.S. firms, perhaps because of a Chinese law forbidding disclosure of “state secrets.”

U.S. and Chinese regulators have so far been unable to agree on how review of those audits should be conducted, but this stalemate needs to be resolved. Sovereignty should not be used as a cover for inadequate financial transparency.

The dispute stems from the fact that American auditing companies cannot open their own auditing offices in China and must operate through Chinese affiliates. The Chinese government has long rejected American requests to investigate Chinese auditing companies on the grounds of protecting Chinese sovereignty. The American accounting firm Deloitte Touche Tohmatsu is “caught in the middle of conflicting demands by two government regulators,” according to a company spokesman. The U.S. Securities and Exchange Commission (SEC), investigating fraud by a Chinese company listed on the New York Stock Exchange, has demanded that Deloitte produce audits by Deloitte’s Shanghai affiliate. Deloitte has refused to comply with the SEC demand (now the subject of a subpoena from a Federal court) because it fears punishment under Chinese secrecy laws.

Deloitte’s China-based unit had been the auditors of Longtop Financial Technologies, Ltd, which listed on the New York Stock Exchange in 2007 for $17.50 a share. The SEC’s scrutiny of Longtop began after Deloitte expressed concern about whether the company’s cash balances had been correctly reported to Deloitte’s affiliate in China. Deloitte “smelled trouble” and resigned as Longtop’s auditor following threats and intervention by the company when Deloitte’s affiliate tried to confirm Longtop’s cash balances at local banks. The SEC subsequently delisted Longtop and subpoenaed papers from the accounting firm’s audit of Longtop.

In explaining its refusal to comply with the subpoena, Deloitte argued that “turning over [its Shanghai affiliate’s] work papers could violate Chinese law prohibiting the disclosure of ‘state secrets,’ which it says includes information about the ‘national economy and social development.’ ’’ The SEC, in a court filing seeking enforcement of its subpoena of the audit, reported that Deloitte had approached the China Securities Regulatory Commission (regulator of Deloitte’s China unit) as well as three other Chinese agencies seeking permission to transfer the documents, but none replied.

Negotiations between Chinese government regulators and the Public Company Accounting Oversight Board (PCAOB) based in Washington, D.C. began last year. The PCAOB is a non-profit corporation that was created by the 2002 Sarbanes-Oxley law to oversee the audits of public companies in order to protect investors in the wake of high-profile accounting scandals such as WorldCom and Enron.

In addition to the Deloitte-Longtop case, there are other problematic cross-border accounting cases that involve Chinese companies accused of fraud that were able to obtain U.S. listings without undergoing the due diligence that is performed by an underwriter of an IPO. Instead, Chinese companies have used a perfectly legal means known as a “reverse takeover” (RTO) or “reverse merger” which occurs when an unlisted company purchases a majority of shares in an inactive company that is already listed on a U.S. stock exchange.

The RTO route, as The Wall Street Journal noted, allowed companies to start trading without a formal underwriting process or SEC review of the prospectus, and many of those companies used tiny U.S. audit firms that appeared to do very little work. The consequences of this gap in U.S. securities regulation are by now apparent, with more than two dozen Chinese companies listed through reverse mergers having announced auditor resignations or other accounting problems as of July 2011.

Since the RTO problems surfaced, the SEC has approved more rigorous rules: Reverse merger companies cannot be listed unless they have filed audited financial statements covering a full fiscal year commencing after the filing of specified initial documentation.

But while the RTO rules have changed, troubling questions remain. How can American accounting firms adequately confirm the accuracy of their affiliates’ audits if they are denied access to accounting information on listed Chinese companies that may have engaged in fraudulent conduct? In November, 2011 a report appeared that Chinese officials had met with “representatives of the top worldwide accounting firms to warn them about releasing information to outside parties as a possible violation of Chinese secrecy laws.”

Are state secrets really involved? The SEC, in its request to a Federal court to force Deloitte to hand over audit papers, argued “it is entirely unclear what national interests of China are truly at stake.” Although Chinese law is vague, an amendment to the State Secrets Law promulgated in April 2010 provided that only commercial information from “central enterprises” — 120 state-owned companies under the jurisdiction of the State Assets Supervision and Administration (SASAC) — could be considered “state secrets.” Some transactions of audited companies with such “central enterprises” could be classified as “state secrets,” but so far there has been no hint of this in the cases mentioned here.

Another issue underlies these cases: The PCAOB evaluates the firms that audit the books of companies traded in the U.S., and for that reason has been trying for some time to gain access to the audits performed by some 50 auditing Chinese companies. The PCAOB has requested that it be permitted to conduct joint inspections with Chinese regulators but this has been rejected so far. A dialogue with Chinese regulators last summer ended without agreement. Another meeting was scheduled for the fall, but the Chinese canceled. The President of the PCAOB has recently announced that another meeting will be held soon.

These problems need quick resolution, and the U.S. should push forcefully for it. U.S. investors, who are sought by Chinese firms, need sufficient evidence of the soundness of those firms, while the Chinese government wants companies to be able to obtain foreign financing. It is reasonable for the U.S. to support requests for adequate information in order to protect American investors.

Chinese national sovereignty would not be violated if China permits American regulators within its boundaries solely in order to inspect the finances of U.S.-listed Chinese companies. A hard economic reality may underlie China’s resistance to foreign inspection of Chinese audits: Rather than uncovering any “state secrets” protected by Chinese law, thorough inquiries could disclose embarrassing flaws in Chinese financial and auditing practices. But continuing to shield companies from the consequences will only deepen investor mistrust even as China’s presence expands in global markets.

Stanley Lubman, a long-time specialist on Chinese law, is a Distinguished Lecturer in Residence at the University of California, Berkeley, School of Law and is the author of “Bird in a Cage: Legal Reform in China After Mao,” (Stanford University Press, 1999).

What do you do if a Chinese company invokes “state secrets” as a reason for not handing over documents to its auditors?

In the case of KPMG, it’s decided to issue a “qualified opinion of scope limitation” – essentially not being able to sign off on a company’s books – for its client, Hong Kong-listed China High Precision Automation Group Ltd.

China High Precision, which listed in Hong Kong in 2009, said in a statement to the exchange on Oct. 27 that despite making “continuous effort in cooperating with KPMG” to provide adequate information, it wasn’t able to provide them because its legal adviser said it could run afoul of the “Law of the People’s Republic of China on the Guarding State Secrets” in doing so. The stock has been suspended from trading since.

An excerpt from KPMG’s report says it had discovered accounting inconsistencies at the company, whereby management explained that its products are “related to aerospace and other fields which are classified as state secrets.”

KPMG declined to comment. China High Precision declined to comment beyond its statement to the stock exchange.

Auditors have been grappling with the headache of what exactly construes as a Chinese ‘state secret’ for the last few months. They’re under pressure from U.S. regulators to hand over documents related to U.S.-listed Chinese companies, but don’t want to inadvertently expose Chinese state secrets.

Deloitte Touche Tohmatsu’s China unit, who resigned from U.S.-listed Longtop Financial Technologies Ltd. this year, has been asked by the SEC to hand over documents related to its investigation into the company. So far Deloitte has declined to give anything to U.S. regulators, saying it’s “caught in the middle of conflicting demands by two government regulators.”

While state-owned firms can argue that they are in possession of sensitive state information, it’s harder to think what Longtop, a Xiamen-based private financial software provider, and China High Precision, a producer of precision machinery, could be privy to.

“It’s been long recognized that state secret laws in China are pliable and can be wielded by the state for a variety of ends,” Nathan Bush, a lawyer with O’Melveny & Myers in Beijing told the WSJ in September. “The definition of a state secret is sufficiently broad that information that passes into your hands through private parties could, in retrospect, turn out to be state secrets.”

Bloomberg

Muddy Waters’ Carson Block

The group that oversees U.S. auditors is contemplating shining a bit more light on the individuals behind the audits of U.S.-listed companies. Could this be enough to end the flood of accounting scandals among such companies based in China?

On Oct. 11 the U.S. Public Company Accounting Oversight Board issued a proposed rule change – after seeking comment on the broad concept since late July – that would require the disclosure in an audit report of the name of the person “responsible for the engagement and…performance” of an audit. Currently, only the name of the audit firm is required to sign off on an audit.

The PCAOB hopes the change would increase “transparency into and accountability for the preparation and issuance of audit reports,” according to the proposed rule, particularly where two or more firms may be involved in the audit of a particularly large company or a company based overseas. In submissions to the PCAOB, the major accounting firms have opposed the proposed rule change.

That’s been a major issue for a number of Chinese companies listed in the U.S., where U.S.-based accountants have largely outsourced their auditing responsibilities to Chinese firms. While the U.S. firm signs the audit, investors may judge the audit differently if they knew most of the work was conducted by a third party overseas.

But the changes may also help improve the quality – and credibility – of Chinese audits done by the major accounting firms. That’s the take of Carson Block, founder of Muddy Waters Research.

“We believe that there are particularly egregious situations in which some Big Four partners in China offices have actually conspired with their clients to defraud investors,” Mr. Block said in comment on the rule change posted on the PCAOB’s website. “Even the most reputable auditors in China seem to be in a race to the bottom.”

“I believe that identification of the audit engagement partner — particularly with his or her signature — will decrease investors’ future losses to fraud and gimmicky accounting by billions of dollars,” he wrote in the Oct. 7 note.

Mr. Block didn’t specify which Big Four partners he was making the allegation against, and he provided no evidence or specifics. The Big Four accounting firms – PricewaterhouseCoopers, Deloitte Touch Tohmatsu, KPMG and Ernst & Young – declined to comment on the letter. Mr. Block confirmed the letter – which isn’t posted on the Muddy Waters website – was written by him.

Starting from mid-last year Muddy Water’s has posted a series of reports online on overseas-listed Chinese companies, claiming the firms have grossly overstated revenue and profits – and that the auditors failed to recognize it, allegations that the firms have denied. The reports also warn that Mr. Block and his firm have likely sold stocks in those companies short in advance of issuing the reports.

It’s been a difficult time for the major audit firms in China. Big Four firms signed off on the audits of a number of Chinese companies that have since got caught up in accounting scandals.

Now they’re finding themselves trapped in a regulatory quandary between China and the U.S. In early September the U.S. Securities and Exchange Commission turned to a U.S. federal court to enforce a subpoena for Deloitte’s China operations to hand over working documents relating to the audit of Longtop Financial Holding, a Chinese company recently delisted from the New York Stock Exchange. Deloitte had declined to hand over the documents, saying Chinese secrecy laws prevented it from doing so.

And earlier this week Reuters reported that the Ministry of Finance and China Securities Regulatory Commission had asked that the foreign audit firms prepare a report outlining any audit information they may have handed over to a foreign regulator – seemingly a clear signal that China is not willing to roll over for the SEC.

The PCAOB’s rule change might pale in comparison with the bigger issues auditors are facing in China. Still, if Mr. Block is right it may mean sleepless nights for auditors in China signing their names.

–Dinny McMahon

Bloomberg

Muddy Waters’ Carson Block

The group that oversees U.S. auditors is contemplating shining a bit more light on the individuals behind the audits of U.S.-listed companies. Could this be enough to end the flood of accounting scandals among such companies based in China?

On Oct. 11 the U.S. Public Company Accounting Oversight Board issued a proposed rule change – after seeking comment on the broad concept since late July – that would require the disclosure in an audit report of the name of the person “responsible for the engagement and…performance” of an audit. Currently, only the name of the audit firm is required to sign off on an audit.

The PCAOB hopes the change would increase “transparency into and accountability for the preparation and issuance of audit reports,” according to the proposed rule, particularly where two or more firms may be involved in the audit of a particularly large company or a company based overseas. In submissions to the PCAOB, the major accounting firms have opposed the proposed rule change.

That’s been a major issue for a number of Chinese companies listed in the U.S., where U.S.-based accountants have largely outsourced their auditing responsibilities to Chinese firms. While the U.S. firm signs the audit, investors may judge the audit differently if they knew most of the work was conducted by a third party overseas.

But the changes may also help improve the quality – and credibility – of Chinese audits done by the major accounting firms. That’s the take of Carson Block, founder of Muddy Waters Research.

“We believe that there are particularly egregious situations in which some Big Four partners in China offices have actually conspired with their clients to defraud investors,” Mr. Block said in comment on the rule change posted on the PCAOB’s website. “Even the most reputable auditors in China seem to be in a race to the bottom.”

“I believe that identification of the audit engagement partner — particularly with his or her signature — will decrease investors’ future losses to fraud and gimmicky accounting by billions of dollars,” he wrote in the Oct. 7 note.

Mr. Block didn’t specify which Big Four partners he was making the allegation against, and he provided no evidence or specifics. The Big Four accounting firms – PricewaterhouseCoopers, Deloitte Touch Tohmatsu, KPMG and Ernst & Young – declined to comment on the letter. Mr. Block confirmed the letter – which isn’t posted on the Muddy Waters website – was written by him.

Starting from mid-last year Muddy Water’s has posted a series of reports online on overseas-listed Chinese companies, claiming the firms have grossly overstated revenue and profits – and that the auditors failed to recognize it, allegations that the firms have denied. The reports also warn that Mr. Block and his firm have likely sold stocks in those companies short in advance of issuing the reports.

It’s been a difficult time for the major audit firms in China. Big Four firms signed off on the audits of a number of Chinese companies that have since got caught up in accounting scandals.

Now they’re finding themselves trapped in a regulatory quandary between China and the U.S. In early September the U.S. Securities and Exchange Commission turned to a U.S. federal court to enforce a subpoena for Deloitte’s China operations to hand over working documents relating to the audit of Longtop Financial Holding, a Chinese company recently delisted from the New York Stock Exchange. Deloitte had declined to hand over the documents, saying Chinese secrecy laws prevented it from doing so.

And earlier this week Reuters reported that the Ministry of Finance and China Securities Regulatory Commission had asked that the foreign audit firms prepare a report outlining any audit information they may have handed over to a foreign regulator – seemingly a clear signal that China is not willing to roll over for the SEC.

The PCAOB’s rule change might pale in comparison with the bigger issues auditors are facing in China. Still, if Mr. Block is right it may mean sleepless nights for auditors in China signing their names.

–Dinny McMahon