Re:Balance -- Jim Peterson

Luckin Coffee – What’s Brewing In China?

With the echoes still ringing from China-based Luckin Coffee’s $ 300 million accounting scandal in 2019, the company is reportedly planning to relist its shares in the United States.

The American regulators –- the Securities and Exchange Commission and the Public Company Accounting Oversight Board –- might actually buy this remarkable assertion of restored corporate virtue. It will be a test of the policy and enforcement commitment of these erstwhile gate-keepers.

There’s ample room for doubt. My own views are well recorded: American policy toward Chinese companies has been incoherent and inconsistent for years, most recently with the Holding Foreign Companies Accountable Act of last year, with its can-kicking three year extension before Chinese companies with uninspected auditors might face de-listing.  

Looking back:

• The wave of reverse mergers by which Chinese companies gained access to US listings in this century’s first decade caught the SEC on the back foot.
• The agency was played like a chump in its 2015 smoke-and-mirrors “settlement” regarding enforcement subpoena responses by the large accounting firms.
• Meanwhile the PCAOB has been stymied since its launch in 2002 by the inability to inspect and access the working papers of auditors reporting on enterprises in China.

As for Luckin’s post-scandal history: 

• The company’s NASDAQ-traded American Depository Shares were de-listed in June 2020; its founder/controlling shareholder was forced out; and it filed for bankruptcy in February 2021.
• It was recapitalized with the injection of $ 250 million from two Chinese private equity groups, reportedly connected to the company’s earlier history, ahead of the availability of audited financial statements.
• Under an agreement announced by the SEC on December 16, 2020, the company agreed to pay $ 180 million to settle securities fraud charges based on $ 300 million of fabricated sales and $ 190 million of inflated expenses.
• In October 2021 it agreed to pay $ 175 million to settle shareholder class litigation –- with a court approval hearing scheduled for July 22, 2022.

On September 21, 2021, the company filed its annual report on SEC Form 20-F, covering the years 2019 (as re-stated) and 2020, supported by the clean audit opinion of Centurion ZD CPA & Co.  That firm, a one-office operation in Kong Kong, described on its website as formed by the April 2016 merger of Dominic K.F.Chan and AWC (CPA) Limited, succeeded Marcum Bernstein & Pinchuk, which had replaced EY post-scandal but resigned for its reported inability to audit and report on the company’s results for 2019 and 2020.

Which is where things should get interesting for the American regulators.

Centurion states that it “provides a comprehensive range of services on a global perspective,” across the range of “audit and accounting services, taxation, risk assessments services, corporate finance consultancy and business advisory services.”

To offer such a range, the demands on Centurion’s personnel and modest size are considerable. Its website names just six directors including Managing Partner Chan. Its report to the PCAOB for the year ended June 30, 2021 (Form 2), shows a total of 52 accountants of whom 18 are certified.

The Form AP filed with the PCAOB on October 26, 2021, for Luckin shows the engagement partner to be Managing Director Chan himself. Chan spreads himself widely: for the firm’s US registrant clients (see the SEC’s listing of companies for which inspection reports are not available), he and his colleague Wing Wai Lai are named as the engagement partners on 25 of the 35 Form AP reports filed with the PCAOB in the last twelve months.

As for Centurion’s capacity to handle the demands of auditing a company the size of Luckin, its resources must measure against the currently-reported size of the company: third-quarter 2021 revenue increased 106% to $ 370 million, derived from 5,671 stores, mostly on the Chinese mainland, and a market valuation above $ 2.5 billion. 

History provides ready examples that serious financial malfeasance can be facilitated by the over-reaching of small practitioners:

• The multi-year scheme by which Rita Crundwell embezzled $ 54 million from the city coffers of Dixon, Illinois –- where a regional firm issued compilation reports, while the principal of a two-person local accounting practice signed the audit opinions (and was eventually able to contribute a modest $ 1 million in litigation settlement).
• Bernie Madoff’s flamboyant Ponzi scheme, abetted by a sole practitioner practicing out of a suburban strip mall office, who in his plea of guilty to securities fraud acknowledged simply “rubber stamping” Madoff’s fictitious filings.

Providing color to the lurking questions of Centurion’s resource and expertise adequacy are indicators that its relationship with its regulators is generously described as uneasy at best:

• On October 27, 2011, the PCAOB’s inspection report on the predecessor Chan firm found actionable audit deficiencies at two of its then four SEC-registered clients, including failures to obtain sufficient audit evidence relating to the accounting for convertible debt and preferred stock and also compensation expense –- also noting that the Chan firm did not respond when offered the opportunity to comment on a draft.
• On May 19, 2016, one month after the Chan/AWC merger that formed Centurion, the PCAOB announced sanctions against AWC and related parties, including its principal, “Albert” Wong Chi Wai. Among other things, “AWC improperly relied on management representations in auditing cash and revenue and ignored numerous red flags indicating potential fraud and undisclosed related-party transactions.” AWC and Wong were censured, each was penalized $ 10,000, the firm’s PCAOB registration was revoked, and Wong was given a two-year practice bar.
  • According to the Centurion Form 3 filed with the PCAOB on November 29, 2017, the Hong Kong Institute of Certified Public Accountants reprimanded the Centurion firm and imposed a penalty of HK$ 25,000 and costs of HK$ 10,000, apparently related to the above PCAOB proceeding.
• On September 26, 2017, Centurion reported (PCAOB Form 3) that Chan and his predecessor firm were reprimanded by the HKICPA and jointly fined HK$ 30,000 and costs of HK$ 10,000, for breach of the standards relating to non-recognition for deferred tax liabilities in connection with a client acquisition.
• On June 24, 2019, the firm reported (Form 3) the HKICPA’s personal reprimand of Chan and a penalty of HK$ 80,000 and costs of HK$ 36,630, for a client on which Chan was the engagement partner, responsible for mistakes in calculating the company’s loss per share.
• In its press release dated January 15, 2001, the HKICPA announced action against Chan as sole proprietor of the Chan firm in connection with a review report for the period ended December 31, 2018 –- two years after the Chan/AWC merger –- relating to misclassifications and related deficiencies, reprimanding Chan and the firm and imposing a penalty of HK$ 50,000 and costs of HK$ 15,000.

 If Luckin does pursue its re-listing attempt, it will rest with the SEC and the PCAOB whether all or any of this should move the agencies into action.

They could, of course, choose the passive course, deferring under the HFCAA’s three-year non-inspection trigger, leaving investors in the meantime to pour their funds into a hole as black as Luckin’s darkest expresso.  

But should they? The agencies’ tools under the Sarbanes/Oxley regime are all at hand: With its 2021 annual report in plain sight, Luckin’s business plan remains criticized -- its ambitious growth plans fueled by customer discounts at levels that guarantee long-running losses, and little chance to convert to profitability by raising prices, with competition fierce and customer loyalty fickle. 

 While the PCAOB has not reported on an inspection of Centurion since that of its predecessor in 2011, the firm if asked today would presumably deny inspection and workpaper access. De-registration could promptly follow as a matter of course. No re-listing of Luckin would happen -- instead a potential new scandal averted.

 

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Chinese Companies in the US: The SEC Should Be Making American Foreign Policy?

Nearly a year into the Biden presidency, the breaks with his predecessor are stark and wide-ranging: the Paris climate accord, Iran, NATO, infrastructure –- and of course, the question whether success against COVID-19 should rely on the science of vaccinations or veterinary medicines for equine heartworms.

In that context, it bears wondering why America’s top securities regulator, Gary Gensler, chairman of the Securities and Exchange Commission, has with enthusiasm embraced one of the prior administration’s least coherent ideas.

By rules finalized on November 5 and December 2, Gensler committed his agency and the US audit regulator, the Public Company Accounting Oversight Board, to the Holding Foreign Companies Accountable Act, passed in May 2020, under which foreign companies would be punished for their auditors’ failure to allow oversight agency inspection and production of their working papers.

Aimed directly at the recalcitrant Chinese, who have refused, since passage of the Sarbanes/Oxley law in 2002, to submit to the enforcement processes of the PCAOB, the HFCAA perches Chairman Gensler on the pointed horns of a dilemma: What shall he do now? 

That’s because it is well enough, at the level of the cheer-leading rhetoric of Washington bureau-speak -- as Gensler’s latest press release put it, “the final rule furthers the mandate that Congress laid out and gets to the heart of the SEC’s mission to protect investors … to ensure that the auditors of foreign companies accessing U.S. capital markets play by our rules.”

Left un-addressed, however, are implications for international policy, well above the pay grade of a securities regulator. At the heart of the matter: is official Washington prepared either to de-register the uninspected Chinese member firms of the large international accounting networks, or to enact stock trading prohibitions and ultimate de-listing of non-compliant Chinese companies?

There are multiple issues:

• To start, application of the HFCAA could not please the bankers and other participants in the American-based portion of the world’s capital markets, putting at risk of exclusion an estimated 250 companies with market capitalization above $ 2.1 trillion and headed by such as Alibaba, Tencent and JD.com.

• The self-interest of the bankers would align with ex-China investors in preserving not only simple trading mechanics, but also the availability of information about Chinese companies, as required under the American regimes, incomplete as may be. There is no indication, for example, that an audit regulator in Hong Kong would be any more successful in achieving inspections and document production than its American counterpart.

• Consistency of approach should also drive attention to the unavailability of auditor information on the enormous China-based operations of the array of giant corporations based or listed in the US –- a simple example being Apple, which steadily generates about one-quarter of its revenue in China although the local Chinese firm of EY’s global network has never made available its personnel or its papers.

• China’s own policy intentions and desires are in play. It may indeed suit that country’s leadership to reel in the listings of its country favorites, bringing them home to the proximate bourses of Hong Kong or Shanghai. That step would be congruent with the evident arm-twisting wrought on the fallen darling, ride-share company Didi, which announced on December 3, in timing most likely coincidental, that it has repented of its US initial public offering and will take steps to de-list in favor of Hong Kong –- a move of scant comfort to the investors who saw Didi’s share price lift from its initial offering price of $ 14 to a high of $ 18.01, only to crash back last week to a range around $ 7.

Finally, the entire recent exercise –- passage of the HFCAA and the ponderous rule-creation process of the SEC and the PCAOB –- is redundant and duplicative of pre-existing authority and tools under Sarbanes/Oxley itself.

That is, as outlined here last May, since the time that law was passed in 2002, its framework has required that both domestic and foreign auditors of US-listed companies submit to the PCAOB; that sanctions for non-compliance would include a firm’s de-registration; that audit reports of a de-registered firm were not permissible for SEC filing; and that the consequences for a company would include trading prohibitions and de-listing.

That authority has gone unexercised for almost twenty years. Now, with the HFCAA lurching into place, its rules contemplate a three-year timetable before sanctions would fall on either a non-compliant company or its auditor. That is, commencement of meaningful enforcement consequences would not start before 2024.

Chairman Gensler having inherited a poisoned chalice of mutually conflicting policy goals and potential unintended consequences of uncertain geo-political scope, he stands before a wide-open opportunity window. There, a prediction may be made with confidence, that political exigencies will yet oblige him to hurl that chalice through the window and as far down the road as possible.  

 

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De-Listing Chinese Companies – American Policy is “Ready, Fire, Aim”

The American securities regulators have a problem with China, expressed in their hand-wringing laments (e.g., here and here): their counterparts forbid inspecting the work and accessing the work papers of the auditors of Chinese public companies whose securities trade on America’s capital markets.

“Why so?” is the mystery. The SEC and the PCAOB have the effective means by which to relieve their frustrations, which – whether lacking vision, will, or coherent policy -- they have been unwilling to deploy. Instead, a “President’s Working Group” led by Secretary of the Treasury Steven Mnuchin reported on July 24 a proposal that is muddled in concept, inefficient in structure, and destined to be ineffective even if eventually put into place.  

It’s an exercise in “Potemkin regulation” – to create a façade of legitimacy, like the faux villages supposedly built by Grigory Potemkin to impress Empress Catherine II on her visit to the Crimea in 1787. Here’s why:

Empowered by the Sarbanes-Oxley law of 2002, the SEC and the PCAOB have been packing, but have kept securely holstered, a double-barreled weapon:

• Auditors of public companies whose securities trade in the US can be de-registered (Sarbanes-Oxley § 105) for failure to submit to PCAOB inspection including the obligatory production of working papers (§ 104(a)).

• Companies reporting to the SEC that fail to file accounts bearing the opinion of a registered auditor (§ 102(a) and SEC Reporting Manual § 4115.1) are subject to exclusion from issuance or sale of their securities in the US.

Only if used, these would combine in a swift and efficient two-step: the PCAOB de-registers a non-compliant auditor, then the SEC bars a company failing to file compliant financial statements. QED.  

Not so simple, in the Potemkin village. For unknown reasons, rather than break out the available armaments, the PWG proposes:

Instead of a straight-forward trading ban imposed directly by the SEC, rule-making would invite the American securities exchanges to pursue their own de-listing process (PWG report, p. 9) – an awkward and unnecessarily complex “solution” that would, among other inefficiencies, not reach the possibility that companies would simply retreat to non-exchange trading in the over-the-counter market.

To supplant a Chinese audit firm beyond the reach of PCAOB inspection, a Chinese company would obtain its audit report from the Chinese auditor’s US affiliate, deemed a “co-audit firm” – a term unknown in the professional vocabulary and having no defined scope or meaning (PWG report, p. 8). Such a process would fail, for two separate reasons:

• First, risk managers in the American firms should be aghast. Their firms are not licensed to practice in China, nor do they have the language, local technical knowledge nor cultural and political awareness to perform there. The extent of a US firm's necessary reliance on the personnel, work and documentation of its Chinese brethren would render it a “letter-box,” by which it would offer up its name, reputation and financial resources to unknown and unmeasurable exposures.

• Second, the PWG blithely assumes that in fulfillment of the PCAOB’s inspection process, the American “co-audit firm” would obtain and produce the work papers evidencing the actual work performed in China – a notion both mis-placed and naïve, given the long-standing access refusal of the Chinese regulators who would view such a ruse as risibly transparent.

To the contrary, for two decades the consistent Chinese have swaddled the American regulators in blankets of woolly rhetoric, which in their credulous diplomatic ineptitude the Americans have believed to be real and dependable promises. There is no reason to expect a fundamental change in the Chinese position.    

Nor does the PWG’s construct address the key political issue, namely the collateral effects of threatening the US listings of a roster of Chinese companies estimated at a market capitalization of $ 1.7 trillion (PWG report, p. 7).

That is, while the Chinese themselves might welcome the opportunity to capture the exchange listings of such global giants as Alibaba, PetroChina and China Life, the panjandrums of the American capital markets and the managers of the investment funds holding those companies in their portfolios might feel otherwise – as would those who believe in the desirability of promoting rather than antagonizing the enormity of the Sino-American trading relationship.

Put briefly, there is no perspective from which the PWG[1] proposal can be wrestled into rationality. Not surprisingly, it has perplexed commentators literally around the globe, from Paul Gillis’s China Accounting Blog to the Financial Times in London.

It is not impossible, of course, that Secretary Mnuchin is cranking a fog-making machine as cover for the inconsistent and unpredictable POTUS –- or that the administration is simply vamping for time through the up-coming election.

Either way, the interests of effective operation of the capital markets deserve better.

 

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[1] As a side observation for the language geeks, this body’s label joins a short list of rare three-fold oxymorons. The classic has long been “Holy Roman Empire” – a polity deserving none of those descriptions. My own offering has been “Italian justice system,” as my work experience up and down that congeries of ancient trading states showed their jurisprudence to be neither just nor systematic. Here, there is no evidence of substantive presidential guidance, and the PWG as a “group” oddly does not include the chairman of the PCAOB, the agency most involved and affected; readers are left to conclude as to the fitness of its report under the rubric of “work. ” Submissions of other such triplets are invited.    

Crowe Horwath – On The Rocks in China

In the original version of “between a rock and a hard place” -- as Homer tells the story in Book 12 of the Odyssey -- when Odysseus sailed for home through the narrow straits between Scylla the six-headed monster and the deadly whirlpool Charybdis, he escaped the twin hazards at the cost of only six of his sailors’ lives.

 No such luck for Crowe Horwath (HK) CPA Limited, the Hong Kong member firm of the eighth largest of the global accounting networks, and auditor of 22 modest-sized companies based in China and filing financial statements in the US with the Securities and Exchange Commission.

By its order dated July 27, 2017, the Public Company Accounting Oversight Board censured the firm and revoked its registration, for its refusal to produce documents to the PCAOB to enable its “access to the information that is necessary to be able to inspect (Crowe’s) audit work as required by the (Sarbanes-Oxley) Act and PCAOB rules” (¶ 2).

The audit firm defended its position based on a direction from the Chinese Ministry of Finance under that country’s laws. Sympathy is in order for Crowe Horwath’s global CEO, who Tweeted (@jkevingmcgrath), “Our Hong Kong member firm (is) caught between compliance with laws & regulations of the Chinese govt and their desire to comply with the PCAOB.”

Thus is brought forward a hostage to fortune that was embedded in the prospect of cross-border clashes of sovereign powers, immediately with the post-Enron enactment of Sarbanes-Oxley in July 2002 -- legislation that created the PCAOB and its inspection and oversight authority over the auditors of US-registered public companies.

That is, the PCAOB has been failing since 2002 to fulfill its members’ wishful promises of solutions to its inability to conduct inspections of Chinese firms – history dating to the PCAOB’s willingness to register non-US audit firms despite their explicit declarations of foreign legal impediments to compliance with its inspection regime.

The PCAOB’s revocation order made clear (¶ 10) that Crowe Horwath was to get no regulatory surcease under the May 2013 Memorandum of Understanding with the Chinese Securities Regulatory Commission and the country’s Ministry of Finance – deprecating that document (¶ 11) as a “non-binding agreement between the signing parties.” So stated, the PCAOB effectively conceded the internal inconsistency between the MOU’s “intent with regard to mutual assistance and the exchange of information for the purpose of enforcing and securing compliance with the respective Laws and Regulations of (the parties’) jurisdictions” and the bail-out that “it is ‘not intended to create legally binding obligations or…supersede domestic laws’ of the parties” (ellipsis in the order).  

The PCAOB’s slap at Crowe Horwath might demonstrate effective agency muscle – or, as likely, could be foundational for dramatically unintended consequences. While the firm’s China-based US registrants will be forced to look elsewhere for audit services, there are broader reasons to be skeptical.

To start, Paul Gillis in his China Accounting Blog for July 26 calls out the agency to “pick on someone their own size” – with implications much deeper than a dig at the Big Four’s dominance of the large-company market in China.

Here is the context: at last count there were reportedly 92 Chinese companies with securities listed on the American exchanges. The upper end is totally dominated by the Big Four – of the ten largest companies in Standard & Poor’s index of the top 50 US-listed Chinese firms, PwC’s member firms audit six – Deloitte three – EY one.

Meanwhile, questions about accounting and reporting in China are fraught and persistent – the year-ago news of an SEC investigation into the accounting of Chinese giant Alibaba makes the point. An eruption of financial malfeasance in China is a simple inevitability, on a scale to have disruptive effect on the share prices of companies listed in America, to which the American regulators will be obliged to fashion a responsive strategy.

Those reactions will be intractably complicated. The SEC will be unable to secure documents and testimony, on the assumption that the Chinese securities regulator would exercise the veto granted in the largely illusory “settlement” of February 2015 – and the PCAOB will be prolonged in the paralysis of its fifteen-year inability to inspect.

Yet with its enforcement action taken against Crowe Horwath’s Hong Kong firm, the PCAOB has firmly nailed its policy colors to the mast – and (to thoroughly mix the metaphors of maritime hazard) will now, with its blind eye turned to the future, cruise merrily along until it too strikes the rocks.

That is because, to maintain any semblance of credibility as enforcer, it would seem obliged to maintain consistency with its sanction of Crowe Horwath, up the ladder of size to events involving Big Four clients. Yet – yanking the ticket of a Big Four firm in Hong Kong or China would have repercussions going to the heart of the global Big Audit model. Simply put, a regulatory deathblow against a Big Four firm in an economy the size of China would threaten the integrity and presage the collapse of a global Big Four network. And in turn, the limited range of auditor replacement choice renders impossible the functioning of a “Big Three” model – whether for the US-listed sector of large Chinese companies on its own or on the larger global stage.

Or put in Homeric terms – by pursuing Crowe Horwath between a rock and a hard place, the PCAOB may very well have sailed itself into those same troubled waters.

 

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And please also consider the comprehensive discussion of these issues in the new edition of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – just released by Emerald Books and available at Amazon.

The SEC Settlement with the Big Four Accounting Firms – The Chinese Puzzle Misses Some Key Pieces

On February 6, the Securities and Exchange Commission in Washington announced its order, ostensibly resolving its long-running impasse with the Chinese affiliates of the Big Four accounting networks, over working papers of the Chinese auditors demanded but not produced in response to the American agency’s investigation requests.

Is this “settlement” anything but another exercise in governmental hocus-pocus, by which the bureaucrats act as if they have delivered something real, and observers must pretend to believe them?

Reviews from the commentariat are mixed. The Corporate Counsel blog exuberantly exclaimed that the “Tug-of-War Over Audit Files Finally Ends!” By contrast, writing from over in China, Paul Gillis viewed it as the SEC’s “near complete capitulation to the Chinese.”

Let’s take a look.

First, the deal includes not a breath of reference to the perpetually frustrated aspirations of the Public Company Accounting Oversight Board to inspect the operations of China-based auditors. This hostage to fortune goes back to the launch of the PCAOB itself under the Sarbanes/Oxley law of 2002, when the PCAOB agreed to register non-US audit firms despite their explicit declarations of foreign legal impediments to compliance with its inspection regimes.

To the diminishment of the PCAOB’s modest stock of credibility, its much-vaunted “progress” against the entrenched resistance of the Chinese regulators to fall into line with its cross-border ambitions, as touted over the years by chairman James Doty and his colleagues, has proved continuingly elusive, with no real progress realistically in view.

As for the SEC itself, the devil lurking in the details of its deal with the Big Four is clutching his Satanic ribs with derisive and scarcely-suppressed hilarity. And well he might.

Under the agreement:

• The Big Four are to put up the trivial sum of $ 500,000 each – minor fractions and lost in the rounding errors of their fees and expenses to accomplish this four-year armistice.

• The firms concede, as they must, their refusal to comply directly with the SEC’s requests – under the arguable justification of the inhibitions of their local Chinese laws.

• But they are permitted not to admit – yes, also not to deny -- the SEC’s charges that they were law-breakers.

• Most important, they are unrestricted in any aspect of their on-going services to their Chinese clients, including those with presence in the American capital markets.

The SEC’s press release also plumps the “additional remedial measures” it might invoke in the event of future Big Four non-compliance with its further requests. But reference to the actual text of the Order (pages 21 et seq.) confirms these to be no more than the small-bore weapons the SEC has already deployed to such little effect.

The SEC may, that is, either commence new enforcement proceedings, a tool always at the ready in any event, or re-start the existing proceeding -- the final legitimacy of which is left untested by the Big Four’s pursuit of review or appeals, their rights to which are explicitly preserved (page 20).

Against which, having reached a local accommodation by giving their documents directly to the China Securities Regulatory Commission instead of to the SEC, the Big Four affiliates have inserted their home agency as a protective shield against future exposure in America.

That is, the Big Four undertake that for future SEC requests, either they will make actual production to the SEC – an unlikely prospect until and unless the recalcitrant CSRC changes its attitude -- or they will produce to the CSRC, while sending along separate logs of documents subject to claims of privilege or the constraints of Chinese rules regarding state secrets or information deemed sensitive for political or any other reasons.

The house-keeping burden of preparation and submission of these elaborate document listings, in fulfillment of the letter of the Big Four’s obligations – a cost-heavy hassle that will work primarily to the enrichment of the inevitable teams of lawyers involved – will plainly be done in Big Four dialog with the CSRC and in compliance with its views on the permissibility of onward production to the American agency.

As to the spirit, the CSRC retains unfettered authority over the ultimate release of the documents, not being a party to the Big Four’s agreement. So the SEC is left not one step further down the road to real cooperation and enforcement compliance than it was before this illusory “resolution.”

The claim by its staff in the SEC release that “the settlement is an important milestone in the SEC’s ability to obtain documents from China” would no doubt be agreed by both the Big Four and the Chinese regulators.

But they would each have their separate, distinct and antagonistic reasons, as this “milestone” sits on the berm of a pot-holed path to nowhere.

 

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Alibaba: Jack Ma Cried Out “Open Sesame” – And They All Opened Their Wallets

The modern story of Alibaba Group Holding Limited (NYSE: BABA) may be just as “fabulous” as the ancient Persian version in the 1001 Nights (for which, see Burton’s colorful if quaint 1886 translation).

In what ways?

It makes for quite a tale: launched by a school teacher with $ 4000 – explosive growth – reported yearly revenue now $ 5.55 billion – potential as limitless as that of the combined Chinese consumer and business economies on which it feeds.

As a regular part of my graduate-level course in Risk Management, we examine how language can be manipulative or revealing – how names and labels can mis-lead or inform.

Why is it clichéd nonsense, for example, that “Even a broken clock is right twice a day”? How reliable is the maxim, “Buy on the dips”? What is the best reaction to “This time it’s different”?

So the public reaction is interesting to Alibaba’s initial public offering – Jack Ma’s globe-spanning sales tour, the company’s early closure of its order book, the offering price raised to $ 68, and the first-day price pop to $ 92.70 on September 18. With the underwriters’ exercise of their “green shoe” option to sell extra shares, Alibaba raised $ 25 billion and became the largest IPO in history.

All in the face of such darker elements of the “fable” as:

• A governance structure that captures and traps investor equity by lodging control in a circle of insiders.
• An opaque business model based in the Cayman Islands, operating through a network of separate businesses in the hands of Mr. Ma and his coterie.
• A home country distinguished by its resistance to corporate or regulatory visibility – see both the decade-long auditor inspection impotence of the PCAOB and the teeth-gnashing enforcement attempts at work-paper access by the securities regulators of both the US and Hong Kong – and a history of exporting financial chicanery into the world’s capital markets – see the major Canadian regulatory and civil litigation settlements related to Sino-Forest Corp., and the rash of dubious reverse mergers of Chinese companies into partners listed in other markets. 

History provides casebook examples of revealing terminology that might have alerted the sharp-eyed, but missed in the credulous buy-in of investors and gate-keepers to the stories of the flim-flam artists:

• At Parmalat, the recording of bogus transactions in an account called the “buco nero” might have been suggestive – the Italian equivalent of “black hole” not being immediately obvious for its legitimacy.

• A high-tech company in Silicon Valley engaged in that industry’s all-too-familiar practice of recording revenue on transactions not completed at year-end, keeping a separate ledger called the “oven list” – jargon for “half-baked” but booked early nevertheless.

• With a thesaurus full of kinder and gentler terms available, Enron’s use of special purpose vehicles denominated the “Raptors” might, for the curious, have suggested their predatory nature and raised the question, “Just who is the prey?”

As for Alibaba – which in its first trading week failed on any day to close above its opening price – there is more to compare with the old story than the image of an open-faced and humble wood-cutter, who by alert if simple eaves-dropping heard the magic phrase that opened the cave of the forty thieves.

As that version played out, AliBaba first concealed and disguised the thieves’ murder of his avaricious brother. And after the dead man’s cold-blooded slave girl had boiled in oil the thieves who came for revenge, and then knifed their chieftain while he sat as AliBaba’s guest at dinner, this superficially callow and guileless peasant looted their treasure trove for the life-time enrichment of himself and his family circle.

Not exactly a model for hospitality, openness or transparency.

So – for the huge herd of investors who rushed to buy Alibaba’s sizzle – in heedless disregard of the quality or even the existence of the steak – the future will soon tell whether, in their collective enthusiasm, they blinked and missed the unsubtle message in Jack Ma’s audacious branding choice.

 

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A Chinese Puzzle: What If Its Auditors Really Are Barred from Practice in America?

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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Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

 

Confidence in the American securities and accountancy regulators was not raised, when a press release on December 3 announced -- under the headline “SEC Charges China Affiliates of Big Four Accounting Firms …In Refusing to Produce Documents” – a proceeding against the five largest global networks.

For the first time in its eleven-year history, this column calls upon a graphic to illustrate the folly of a gang that couldn’t count straight:

 

   The PCAOB has been stymied for a decade in its futile attempts to enforce in China its asserted mandate under Sarbanes/Oxley to inspect and obtain working papers from auditors, including those in foreign countries, which audit more than twenty percent of a registrant’s assets or revenue (here). And the SEC itself has been piddling along with company-specific subpoena enforcement and administrative proceedings against Deloitte and its Shanghai affiliate.

So now they have called in the heavy artillery, in the person of Robert Khuzami, director of the SEC’s Division of Enforcement, who says that non-complying firms “face serious sanctions.”

Khuzami cannot be faulted for zealotry. He arrived on the scene of an agency whose Cox-era somnolence had missed not only Bernie Madoff’s predations on the domestic front but the internationally destructive tsunami of “reverse mergers” by which Chinese companies gained access to the world’s capital markets. That scorecard, a decade late and billions short, now includes more than 50 de-listings by the SEC and 40 fraud actions – and, elsewhere, a flurry of civil litigations, and most recently an agreement by Ernst & Young to settle civil litigation (but not a disciplinary proceeding) relating to Sino-Forest, by agreeing to pay C$ 117 million, the largest auditor settlement in Canadian history.  

(As an aside, those disposed to see darkly conspiratorial revolving doors in the place of Chinese fire drills will note that this is the same Khuzami whose predecessor at SEC Enforcement from 1998 to 2001, Richard Walker, thereafter went in-house at Deutsche Bank, where he hired Khuzami in 2002. So the latter, before becoming the top American securities cop in 2009, was on-scene at DB when the bank – as now reported – according to three whistle-blowers concealed losses of up to $ 12 billion for failure to “mark-to-market” the exposure gap on a notional $ 130 billion of exotic derivatives known as “leveraged super-seniors.”)  

Calling in Khuzami’s troops may look like the last act of desperate regulators – but it will actually play as the next act in “The Comedy of Errors.”

That’s not because it’s so little so late. Or because frustration of the PCAOB’s aspirations to access Chinese auditors and work papers would attract retaliation against their own ambitious plans to re-structure the global audit market by building and unleashing global-scale Chinese audit firms – an ambition otherwise unachievable both for want of competence in personnel and standards but also because, in reciprocal hostility, other countries will be no less protective of their local prerogatives.

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies.

There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

Consider just two examples: Caterpillar, whose annual filing with the SEC does not set forth results by geography but discloses total 2011 sales of over $ 60 billion and elsewhere reports its China sales to be 3% of its total. Or HSBC, which does report by region including $ 3.6 billion in profits from China in 2011 and whose mainland Chinese operations include 133 outlets including 27 branches, even after the announced sale of its interest in giant insurer Ping An.

A barrier to the use of Chinese audit firms would make it impossible for those companies to include audited results from their Chinese operations in their global accounts. The result would be top-level consolidated financial statements with a huge unaudited portion, and auditors forced in their opinions to confront the professional standards for limitations on their audit scope.

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself.

Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

Restoration of adult-level expectations and the pursuit of a non-litigated resolution process is essential, although a fading hope – since calling in the police as a last resort means an escalation of hostilities due to the one-dimensional DNA of their approach to problem-solving.

For good reason, then – under the latest blows from SEC Enforcement – the large accounting firms must feel like a bunch of nails in a hammer-testing factory.  

 

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Re-Posting: Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

Confidence in the American securities and accountancy regulators was not raised, when a press release on December 3 announced -- under the headline “SEC Charges China Affiliates of Big Four Accounting Firms …In Refusing to Produce Documents” – a proceeding against the five largest global networks.

For the first time in its eleven-year history, this column calls upon a graphic to illustrate the folly of a gang that couldn’t count straight -- here.

The PCAOB has been stymied for a decade in its futile attempts to enforce in China its asserted mandate under Sarbanes/Oxley to inspect and obtain working papers from auditors, including those in foreign countries, which audit more than twenty percent of a registrant’s assets or revenue (here and here). And the SEC itself has been piddling along with company-specific subpoena enforcement and administrative proceedings against Deloitte and its Shanghai affiliate.

So now they have called in the heavy artillery, in the person of Robert Khuzami, director of the SEC’s Division of Enforcement, who says that non-complying firms “face serious sanctions.”

Khuzami cannot be faulted for zealotry. He arrived on the scene of an agency whose Cox-era somnolence had missed not only Bernie Madoff’s predations on the domestic front but the internationally destructive tsunami of “reverse mergers” by which Chinese companies gained access to the world’s capital markets. That scorecard, a decade late and billions short, now includes more than 50 de-listings by the SEC and 40 fraud actions – and, elsewhere, a flurry of civil litigations, and most recently an agreement by Ernst & Young to settle civil litigation (but not a disciplinary proceeding) relating to Sino-Forest, by agreeing to pay C$ 117 million, the largest auditor settlement in Canadian history.

(As an aside, those disposed to see darkly conspiratorial revolving doors in the place of Chinese fire drills will note that this is the same Khuzami whose predecessor at SEC Enforcement from 1998 to 2001, Richard Walker, thereafter went in-house at Deutsche Bank, where he hired Khuzami in 2002. So the latter, before becoming the top American securities cop in 2009, was on-scene at DB when the bank – as now reported – according to three whistle-blowers concealed losses of up to $ 12 billion for failure to “mark-to-market” the exposure gap on a notional $ 130 billion of exotic derivatives known as “leveraged super-seniors.”)

Calling in Khuzami’s troops may look like the last act of desperate regulators – but it will actually play as the next act in “The Comedy of Errors.”

That’s not because it’s so little so late. Or because frustration of the PCAOB’s aspirations to access Chinese auditors and work papers would attract retaliation against their own ambitious plans to re-structure the global audit market by building and unleashing global-scale Chinese audit firms – an ambition otherwise unachievable both for want of competence in personnel and standards but also because, in reciprocal hostility, other countries will be no less protective of their local prerogatives.

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies. There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

Consider just two examples: Caterpillar, whose annual filing with the SEC does not set forth results by geography but discloses total 2011 sales of over $ 60 billion and elsewhere reports its China sales to be 3% of its total. Or HSBC, which does report by region including $ 3.6 billion in profits from China in 2011 and whose mainland Chinese operations include 133 outlets including 27 branches, even after the announced sale of its interest in giant insurer Ping An.

A barrier to the use of Chinese audit firms would make it impossible for those companies to include audited results from their Chinese operations in their global accounts. The result would be top-level consolidated financial statements with a huge unaudited portion, and auditors forced in their opinions to confront the professional standards for limitations on their audit scope.

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself. Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

Restoration of adult-level expectations and the pursuit of a non-litigated resolution process is essential, although a fading hope – since calling in the police as a last resort means an escalation of hostilities due to the one-dimensional DNA of their approach to problem-solving.

For good reason, then – under the latest blows from SEC Enforcement – the large accounting firms must feel like a bunch of nails in a hammer-testing factory.

 

My apologies for the re-posting, especially to subscription readers to whom the intended video clip did not feed -- a lesson learned in attempting to reach beyond competence with technology.

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Mandatory Auditor Rotation -- The PCAOB Sails Off the Charts

“Otter: We could do it with conventional weapons, but that could take years and cost millions of lives. No, I think …that this situation absolutely requires a really futile and stupid gesture be done on somebody's part!

“Bluto: We're just the guys to do it.”

            “Animal House,” 1978

The Public Company Accounting Oversight Board's August 16 release and statements pose this central question on auditor independence and the prospect of attempted mandatory rotation:

“Will term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets?”

With all the ambiguity, nonsense and denial right there, focus on mandatory rotation. Time enough to come back to independence, when readers of stout constitution have stocked up enough antacid to alleviate their heartburn in digesting the Concept Release itself.

Consensus unhappiness with the current audit model and the historical “pass/fail” auditor’s report (alluded to by PCAOB member Jay Hanson and as I have discussed here) has, unsurprisingly, not strengthened the tissue-thin case for mandatory auditor rotation. Proof of weakness is, in this case, reciprocal with weakness of proof.

Each of the PCAOB members’ statements nods to the decades-old and too-familiar positions on rotation – Chairman Doty himself managing to mix up a metaphor that only a land-locked Texan could love:

“The learning curve, and cost-based issues involved in changing audit firms, cannot be fairly described as uncharted waters.” 

I have charted these waters, near and far (e.g., here and here) – so, not to repeat, this report from the distant end of Chairman Doty’s learning curve:

The world outside the United States is still terra incognita to the PCAOB, whose parochial approach has ignored the barriers to implementation of rotation on the large-company scale – the only sector where the issue should matter at all.

Between now and the public roundtable scheduled for March 2012, two matters of compelling impracticality should be on the table.

First is the PCAOB’s limited ex-US authority. Although the agency proclaims robust worldwide impact (e.g., the Chairman’s speech, here), its record is otherwise, and suspect.

Instead, the PCAOB has shown itself all too lacking in ability to operate effectively outside the US at all – witness the empty-handed return of its mission last month to China – a market from which the agency has been completely excluded although China has emerged in the last year as a major exporter to America of corporate malfeasance and shenanigans (tracked by Kevin LaCroix’s D&O Diary and even on the screen of researchers at the PCAOB itself).

Were the PCAOB to attempt mandated auditor rotation outside the United States, the consequences – fully foreseeable, and obnoxious -- would range from securities trading prohibitions on the American exchanges, to considerably irritated securities and accountancy regulators in countries understandably miffed at the infringements on their sovereignty.

Picture, for example, the situations of Deutsche Bank, audited in Germany by KPMG, or Sociéte Générale, audited jointly in France by Ernst & Young and Deloitte.

Even if replacement auditors were available, whether in the US or elsewhere – which is far from a certainty (see below) – it defies both logic and imagination to think that audit quality could be improved by obliging a German or French--based parent to engage an additional new audit firm to achieve a single opinion on its consolidated worldwide financial statements.  

As for auditor displacement at the parent level, there should be no reason to think that regulators of the securities markets and the accounting profession in those countries would tolerate, much less welcome, such an uninvited intrusion.

So the PCAOB’s ability to impose its will on major foreign regulators is comparable to the idea that audit quality requires each audit opinion to be personally signed by a Tyrannosaurus Rex – simplistic to mandate, although ill-advised, and impossible to achieve.

As for the second issue -- resource availability -- there is more than the PCAOB recognizes to the Big Four’s nearly total dominance at the global level of large-company audit – besides the awareness that mandatory rotation would only increase the tetrapoly’s hold. 

Namely – in many major economies one firm has clear leadership in large-company audits – e.g., PwC in the UK, KPMG in Germany, E&Y in France, and Deloitte in Spain.

A result is significantly lop-sided distribution of technical and industry expertise and personnel even among the Big Four, constraining rotation choices because such talent shortfalls are not readily or quickly solvable.

That is, what incentive would there be for a firm with a resource deficit to invest the time and cost to build or import the competence needed to rotate onto a complex, world-scale audit engagement – with the known prospect that its prospective new client and its stream of fees would be rotating away at the end of the cycle?

And if not, symmetrically, how does a large company rotate its auditors, if there is no place to turn?

Seekers for answers might recall the legend written on the old flat-earth maps – that beyond the horizons of ignorance, “there be dragons.”

 

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