In the last several years, many small- to medium-sized Chinese companies found a way to trade on the New York Stock Exchange and NASDAQ through an obscure transaction called a reverse merger. Through these transactions, both U.S. and foreign companies can gain access to U.S. capital markets by merging with a U.S.-listed “shell” company without going through a more involved initial public offering (IPO).

However, according to U.S. regulators, shareholders’ attorneys and others, the financial statements of many Chinese reverse-merger firms weren’t altogether legitimate. James Doty, chairman of the U.S. Public Company Accounting Oversight Board (PCAOB), oversees auditors of U.S.-listed companies and has been actively negotiating with Chinese regulators to enable U.S. inspections of China-based auditors of U.S.-listed companies. These auditors claim they can’t turn over their papers because they are considered state secrets. Knowledge at Wharton Today spoke with Doty about why he believes it is critical for the U.S. to inspect foreign-based auditors of companies trading on U.S. exchanges.  

Knowledge at Wharton Today: The U.S. Securities & Exchange Commission has charged the China-based affiliates of the Big Four accounting firms of violating U.S. law by refusing to share their audit documents. The PCAOB has made clear that it will take action if it cannot reach an agreement with the Chinese authorities over inspections of PCAOB-registered auditors in China. What is the status of your negotiations with the Chinese?

James Doty: First, let me say that the views I express here are my own and should not be attributed to the PCAOB as a whole or any other board member or staff.

The PCAOB made progress in 2012. The U.S.-China Strategic and Economic Dialogue meetings in Beijing in the spring of 2012 gave me an opportunity to meet with [China Securities Regulatory Commission (CSRC) chairman] Mr. Guo Shuqing and officials of the Ministry of Finance to state our views on the importance of conducting joint inspections and having access to audit work papers in China.

At that meeting, [Former] U.S. Treasury Secretary [Timothy] Geithner, and U.S. Federal Reserve chairman Ben Bernanke were supportive of our efforts to make progress on cross-border oversight with China. And former Chinese Vice Premier Wang acknowledged our concerns. That visit was followed by our observational visit of a quality review by Chinese audit regulators in October.

Next, we met with our Chinese counterparts in Washington in November and provided a Memorandum of Understanding (MOU) that is now under discussion. The PCAOB is working with the Chinese on the legal and technical language and details of the MOU and hope to be able to reach an agreement soon.

We are encouraged by recent important, positive remarks in the press by Dr. Tong Daochi [the CSRC’s head of international affairs]. He talked about the importance of access to audit papers to maintaining market integrity and the desire of the CSRC to cooperate with the U.S.

Knowledge at Wharton Today: If your Chinese counterparts don’t respond soon, will the PCAOB respond by deregistering China-based auditors of U.S.-listed companies?

Doty:  The PCAOB has to consider what the statute requires us to do if the Chinese break off these discussions, or if the discussions don’t bear fruit. The Board is charged with implementing and enforcing a law that says: First, the auditor of any company that participates in U.S. markets and has SEC reporting obligations must be registered with the PCAOB; and, second, that that auditor must cooperate with PCAOB inspections. If we don’t resolve the inspection obstacles soon, we will have to re-evaluate the registration status of those auditors.

Knowledge at Wharton Today: What would U.S. inspections of Chinese-based auditors of U.S.-listed firms accomplish?

Doty: First, it is required by U.S. law if you want to audit a company that trades in the U.S. So it would bring these firms into compliance with U.S. law.

We would then know if these audits were conducted in a manner that provides a meaningful basis for confidence in the financial statements and would be able to start driving improvements in those audits and in those auditors’ practices, where necessary. You can’t do that if the State (China) says we can’t let you look at audit work papers. That’s not going to work for long in a global free market.

Knowledge at Wharton Today: What’s your response to the claim that Chinese audit papers are state secrets?

Doty: Chinese companies have come to U.S. markets because the integrity of these markets confers a premium. The PCAOB inspection regime is established to provide assurance that investors’ interest in quality audits is being protected. The audit is [critical] to the integrity of our capital markets.

What exists in auditors’ files are not state secrets. They are audits of financial statements of public issuers that investors rely upon. They’re either well conducted audits, or they’re not.

Knowledge at Wharton Today: Have Chinese regulators taken action on their own to clean up this situation?

Doty: We have believed for a long time that our counterparts are trying to achieve a solution and are proceeding in good faith on these negotiations. Chairman Guo of the CSRC speaks in terms of a regulatory regime with zero tolerance for fraud. They want market integrity and reputable securities enforcement.

Knowledge at Wharton Today: With the continuing integration of the world’s financial markets, what lessons about cross-border regulation can be learned from this episode with China?

Doty: Over the last five to 10 years, cross-border regulation has been one of greatest success stories. The PCAOB has an increasing number of international agreements — we have 16 agreements and conduct inspections in more than 40 jurisdictions.

The PCAOB now is closely working with regulators around the world. Part of this resulted from solving issues of data protection in European countries, including Switzerland, Germany and the Netherlands. We also have MOUs with Singapore, Korea, Japan and, just recently, with France and Finland.

Much of the world is coming around to the need to have effective cross-border oversight of audits. The more the Chinese take a view that they are the exception, the more their companies and audits will be viewed with suspicion.