Do you have the patience to wait until the mud settles, and the water is clear?
Tao Te Ching of Lao Tzu, Verse 15
What will be the impact on the rickety and shambolic audit model for large global companies, if the January 22, 2014, opinion of Administrative Law Judge Cameron Elliot of the US Securities and Exchange Commission becomes final and enforceable?
That opinion would impose a six-month suspension from US public company practice on the Chinese affiliates of the Big Four audit firms – putting China-based registrants at risk of trading suspensions and de-listings, strangling the pipeline of China company IPO’s into the US, and threatening the compliance of American and other public companies having significant business presence and reportable operations in China.
As found by the ALJ, the Big Four firms had “willfully” failed and refused to produce audit work papers relating to their China-based engagements, in response to SEC enforcement subpoenas, asserting that they would be in violation of Chinese legal and state secret restrictions – positions brushed aside by the ALJ as not “in good faith” and “not sincere at all” (page 105).
Reactions and perspectives differ dramatically. To sort them out, consider the fable of Asian origin, of the committee of blind men tasked to describe an elephant:
Each feels a different part of the animal – and they variously say that for its leg it is like a column, its trunk -- a snake, its side -- a wall, its ear -- a fan, its tail -- a rope.
Start with the Chinese themselves. Resolute optimists might see a new era of cross-border bonhomie in the China Securities Regulatory Commission’s turn-over to the SEC of documents it had received from Deloitte relating to its engagement by Longtop Financial Technologies Limited. As announced by the SEC on January 27, 2014, that supported discontinuance of the SEC’s enforcement action commended against Deloitte in 2011 – the first of the actions leading to the ALJ opinion.
Is it the start of a climb-down by the Chinese? Skepticism, caution and prudence would all advise against betting the ranch.
That’s because the behavior of the Chinese remains inconsistent, incomplete and inscrutable. Reacting to the ALJ’s decision, the CSRC issued the lofty warning that “the SEC should bear all responsibility to possible consequences arising from the decision.
And noting that the ALJ’s order is subject to appeals, first to the full SEC and then to the appellate court, Chinese analysts and corporate spokesmen took the casually sanguine view that all current reports and filings are proceeding as scheduled.
By which they failed to see two problems: First, delay through this reporting cycle is not a strategy, but only a temporary expedient; next year will arrive, all too soon and with all the same issues. Second, in any event, it should inhere in Chinese companies’ voluntary choice of American channels to the capital markets that US regulators had the right to set their rules.
As well they should, considering that effective Chinese assurance remains an elusive if needed goal. Witness the potential impact of the ALJ’s suspension order on Peoria-based Caterpillar, with fiscal 2013 revenue of $ 56 billion. Asia was its second-largest region, of which China contributed $ 3.5 billion. On this financial and geographic scale, big-firm audit support plainly is required.
Moreover, as shown by the company’s fourth-quarter write-off of $ 580 million, or some 87% of its July 2012 acquisition of Hong Kong-listed ERA Mining and Machinery Ltd for $ 653 million, the production of reliable financial information from China fell victim to “deliberate, multi-year, coordinated accounting misconduct.”
Assertions by Caterpillar of such issues as discrepancies between physical and book inventory, at an acquired company whose major product was hydraulic roof supports to prevent rock-falls in coal mines, raise the ominous prospect that both investors and coal miners in China alike should worry about their roofs falling in.
But there are only two equally unacceptable alternatives, if Caterpillar and other companies with significant Chinese operations are denied the services of Big Four firms there: either trading suspensions for otherwise all-American enterprises, or filing by their auditors of opinions with the deadly and impermissibly non-compliant “except for” language required by US auditing standards (see AU 508.22-26) for unresolved restrictions on the ability to perform audit work believed necessary.
In his China Accounting Blog, advantageously on the ground, academic Paul Gillis correctly observed the futility of attempts at replacement of the Big Four’s local firms: smaller firms in China would lack “the scale and skills to audit the Big Four’s clients,” and attempts to fly in non-Chinese audit personnel would fall afoul of local licensing and disclosure requirements.
But the suggestion by Gillis that the Big Four could serve their six months in the penalty box after May 1, and then return to do 2014 audits, would be seen by the SEC and the PCAOB to show a nose-thumbing and recidivist attitude, such as fatally poisoned relations between Arthur Andersen and the Justice Department back in 2002. Fresh subpoenas and de-registration proceedings could be expected instantly, with the US regulators’ full wrath over-hanging any such evasiveness.
Meanwhile the Big Four themselves promised both full-out appeals and non-stop work for their clients, falling back on hope for a political solution and claiming to be “heartened by the significant progress on information sharing between the Chinese and US regulators over the past year.”
To which the jaundiced reaction of the ALJ must carry weight. With the negligible movement and long-term delaying capacity of the Chinese since the 2002 passage of the Sarbanes-Oxley law – Longtop developments notwithstanding -- anyone so “heartened” would have been similarly charmed back in 1912, that the lifeboat count on the RMS Titanic, cynically reduced to 20 from the planned and sufficient 64, actually exceeded maritime safety regulations.
As for the American regulators, blogger Jonathan Weil suggested that the SEC might simply back-burner the order, lacking either a deadline for action or the will to take on an issue of such intense political dimensions – an approach consistent with such persistent can-kicking as the SEC’s never-ending postponements of action on convergence of American and international accounting standards, and the PCAOB’s multi-year waving at the unproven benefits of mandatory auditor rotation.
Except that, for its very credibility, the SEC can do no less than vigorously affirm ALJ Elliot’s order. Now in the chair after making her reputation as a hard-nosed prosecutor, Mary Jo White has in two recent speeches stoutly declared the primacy of her commitment to the agency’s enforcement efforts.
Thus doubly required to show that she clanks when she walks as the meanest badge in town, she would check both reputation and priorities at the door if seen to be less than robust in support for the ALJ – to say nothing of the devastating impact of retreat on the morale and commitment of her staff.
Still, the potential for international regulatory antagonism and the likelihood of a major cross-border conflict have been in full public view, ever since Sarbanes-Oxley launched the PCAOB with its over-reaching jurisdictional aspirations and the ambition to operate internationally despite lacking the tools to do so.
And therein lies the SEC’s need to protect itself on judicial appeal. No less than the firms themselves, who in their PCAOB registrations consistently put down markers of possible conflicts among competing national regulations – the regulators accepted those markers with a blind eye to the potential for the type of stand-off now presented, leaving the SEC chargeable with a form of “agency entrapment” for its own decade of irresolution.
Finally, as to ALJ Elliot himself – the public version of whose 112-page opinion consists of 47 pages of factual recitals followed by lengthy portions blacked out for its discussion of the Chinese laws and Chinese markets.
The ALJ plays to the five SEC commissioners who will be his initial reviewers on appeal – reciting that the audit firms’ “actions involved the flouting of the Commission’s regulatory authority” (page 102) and “failed to recognize the wrongful nature of their conduct” (page 103).
But, critically for the public assessment of his analysis, the ALJ refused to disclose much of his record, out of a seemingly punctilious concern that “some of my factual findings and legal discussion may interfere with any ongoing discussions” between the SEC and its Chinese counterpart (page 4).
If the theme has a ring of familiarity in its prim assertion – “trust me, but I won’t tell you why you should” – at least to the critics of the accounting profession – it would be in the similar opacity of the one-page standard audit report itself.
A jurist seeking credence owes a better standard of completeness, at least to the sighted if not to the blind, under the 1913 maxim of Justice Louis Brandeis, that “sunshine is said to be the best of disinfectants.”
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