The Security and Exchange Commission (SEC) on Dec. 3 charged the Chinese affiliates of the “big four” accounting firms with violating U.S. securities laws.
According to the SEC, the firms—KPMG, Ernst & Young, PwC, and Deloitte—refused to hand over documents needed to investigate accounting fraud at Chinese companies listed on U.S. stock exchanges.
“Only with access to work papers of foreign public accounting firms can the SEC test the quality of the underlying audits and protect investors from the dangers of accounting fraud,” said Robert Khuzami, director of the SEC’s Division of Enforcement in a press release.
The SEC is stepping up its efforts to obtain essential information in its investigation of wholesale accounting fraud at Chinese companies utilizing reverse mergers to list on U.S. exchanges.
A reverse merger is a process where a private company buys a public company already listed on an exchange. More than 90 Chinese companies have used this route over the last few years to gain access to a listing on U.S. stock exchanges.
Such companies domiciled in China simply bought any publicly traded company in the United States for little money, mostly in shares, and changed the name. This way, scrutiny by regulators and exchanges was largely avoided.
The SEC only requires disclosure of audited financial statements and some legal documents. It was the duty of the China affiliates of the “big four” to provide these statements and assure their quality.
Accounting Frauds Prompt Investigation
Since the end of 2010, however, seven of these reverse merger companies have delisted and declared bankruptcy because of accounting irregularities.
The most well-known example was Sino Forest Corp., a Chinese-based firm that claimed to have large forestry assets in China. Last year, Muddy Waters, a research and investment firm dedicated to discovering accounting fraud and profiting through short sales, uncovered that the company did not actually own most of these assets. Sino Forest was forced to delist and filed for bankruptcy in March 2012.
Among the most prominent victims was hedge fund manager John Paulson. He is estimated to have lost $105 million after buying into the company, according to the Wall Street Journal. Paulson is the founder of New York-based fund Paulson & Co.
The SEC ramped up its investigations of theses companies and their auditors due to the rampant accounting fraud. The Chinese affiliates of the big four accounting firms, however, refused to cooperate, which is why they have now been charged, along with the China partnership of BDO.
SEC Investigation Unlikely To Return Results
The Epoch Times spoke to an insider who had previously worked at one of the big four accounting firms. “The SEC is looking for a scapegoat,” he said on request of anonymity, because his current role bars him from commenting on public affairs.
The person explained that the SEC has no jurisdiction to prosecute the Chinese affiliates. Since the accounting firms are essentially networks of individual, locally owned partnerships, the U.S. firms—and the headquarters—do not own the affiliate partnerships in China nor have jurisdiction over them. As such, the SEC has little recourse in prosecuting them. Accounting firms, like law firms, are set up as partnerships in individual jurisdictions, and different regions are structured and operate according to local rules and regulations.
The membership firms share the brand name and some overhead, such as IT and marketing. If the Chinese affiliates of the big four had broken Chinese securities laws, the Chinese regulators would have to prosecute them.
“This basically means that little will come out of it, except that ultimately, the SEC could bar these firms from being the accountants of future U.S. equity listings from Chinese companies,” said the source. This will effectively bar future listings of most Chinese firms since the “big four” have an overwhelmingly large market share in the audits of large companies.
But it seems that official barring might not be necessary after all. Given that Chinese reverse merger companies are already under fire from short sellers such as Muddy Waters and have disappointed investors globally, the possibility of a large number of listings in the foreseeable future seems remote.