By Pam Martens: January 27, 2014

Most Americans would be stunned to learn that companies based in China, a country associated with accounting secrecy, have gained a foothold to the tune of over a trillion dollars on U.S. stock exchanges. According to Thomson Reuters, the market value of Chinese companies currently listed on the New York Stock Exchange and Nasdaq Stock Market is more than $1.4 trillion.

Last week, U.S. investors learned the hard way that when China sneezes, the U.S. may catch pneumonia. Growth in China is slowing and there are growing fears that its massive overinvestment in real estate and manufacturing plants in recent years has led to unsustainable levels of Chinese business and bank debt. Stock markets in countries which have been major beneficiaries of the China growth story plunged at the end of last week, including a two-day drop of almost 500 points in the U.S.

Questions about Chinese growth and debt levels could not come at a worse time in U.S.-China relations. Despite diplomatic efforts by James Doty, Chairman of the Public Company Accounting Oversight Board (PCAOB) and Treasury Secretary Jack Lew in the spring and summer of last year to forge an agreement, a behind the scenes war is raging over China’s decade of stonewalling U.S. regulators over access to documents prepared by auditors of publicly traded companies that are based in China but listed on U.S. stock exchanges. China takes the position that these audit work papers hold state secrets and it prohibits audit firms from releasing the documents directly to U.S. regulators.

The growing concern is that the so-called “state secrets” these documents purportedly hold may actually be a paper trail showing accounting or securities fraud that might, indeed, embarrass China but do far more damage to the life savings of American investors and the reputation of U.S. stock exchanges.

Since 2010, the Securities and Exchange Commission (SEC) has brought dozens of fraud cases against China-based firms and more than four dozen of those firms have been deregistered from U.S. exchanges. Unfortunately, tens of billions of dollars of U.S. investors’ life savings have been lost in the process and significantly more may still be at risk.

The dispute came into full view last week when news media widely reported that the SEC had won a ruling from an administrative law judge, Cameron Elliot, barring the Chinese affiliates of the Big Four accounting firms from leading audits for companies listed on U.S. exchanges for six months as a result of their refusal to turn over their audit work papers on companies under investigation by the SEC. The accounting firms said they had to refuse to avoid violating state secrecy laws in China. That’s a bigger deal than it may sound at first blush, since many of the publicly traded companies affected may have to file audited reports with the SEC in the interim. That could force hundreds of companies, including large multinationals doing business in China, to find new lead auditors or hope that an appeal of the matter succeeds.

The firms receiving censures and six-month bans are Deloitte Touche Tohmatsu CPA Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian CPAs Ltd. One accounting firm, BDO China Dahua Co., Ltd., received only a censure since it had already withdrawn as a registrant in the U.S. market.

Judge Elliot’s 112-page decision was scathing at times, noting that “to the extent Respondents found themselves between a rock and a hard place, it is because they wanted to be there. A good faith effort to obey the law means a good faith effort to obey all law, not just the law that one wishes to follow.” The Judge was referring to the fact that the affiliates of the Big Four knew that once they registered with the PCAOB, they would be required under U.S. law to turn over their audit work papers conducted in China if U.S. regulators made that request in an investigation, regardless of secrecy laws imposed by China.

Judge Elliot wrote further: “Respondents’ actions involved the flouting of the [Securities and Exchange] Commission’s regulatory authority, which may not be as egregious as, say, accounting fraud, but is still egregious enough that it weighs against leniency…Respondents have failed to recognize the wrongful nature of their conduct, and because they are all registered with the [Public Company Accounting Oversight] Board as public accounting firms, their occupation obviously presents opportunities for future violations.”

On February 8 of last year, Doty, the Chair of the PCAOB, sent a signal to China in a public speech before the Annual Conference on Securities Regulation and Business Law in Austin, Texas. Doty said: “My preference is to work out cooperative arrangements to facilitate inspections and, when necessary, investigations. But if authorities in China and other countries continue to put up obstacles to legally required inspections of firms that have chosen to register in the United States, the PCAOB will have to re-evaluate the status of those firms in our system. Any action we take will be a result of thorough and thoughtful deliberation. But ultimately our charge is to implement and enforce policy decisions embedded in U.S. law to protect the interests of investors in quality audits.”

By spring 2013, it looked like détente had arrived. The PCAOB announced on May 24, 2013 that a Memorandum of Understanding on enforcement cooperation with the China Securities Regulatory Commission (CSRC) and the Ministry of Finance in China had been reached. The agreement was said to establish “a cooperative framework between the parties for the production and exchange of audit documents relevant to investigations in both countries’ respective jurisdictions.  More specifically, it provides a mechanism for the parties to request and receive from each other assistance in obtaining documents and information in furtherance of their investigative duties.”

Two months later, newly installed U.S. Treasury Secretary Jack Lew announced on July 11, 2013 that China’s securities regulator, the CSRC, “will begin providing certain requested audit work papers to our market regulators, an important step towards resolving a long-standing impasse on enforcement cooperation related to companies that are listed in the United States.”

But according to documents and testimony submitted by the SEC to Judge Elliot prior to his recent ruling, the CSRC has been stonewalling it for years and has failed to provide any material assistance in more than 23 cases where assistance was sought.

Dozens of the Chinese stock frauds grew out of reverse mergers. That process permits private companies, including those located outside the U.S., to access U.S. stock markets by merging with an existing public shell company. Some of the frauds, however, involved Chinese companies that went through a regular Initial Public Offering (IPO) process and used large Wall Street firms as underwriters. These Wall Street firms should have done thorough due diligence on the new listings prior to a public offering or stock exchange listing. What failed so spectacularly in that process is yet to be fully explained.

On April 26, 2011, a small company, Citron Research, headed by Arthur Left, posted a stunning assessment of a China-based company that was trading on the New York Stock Exchange and had been underwritten by Goldman Sachs and Deutsche Bank just four years prior. The company was Longtop Financial Technologies Ltd. and Citron Research, which concedes that its principals may take positions in stocks it covers, ostensibly shorting stocks at times, had this to say about the company:

“The most obvious risk factor in the China space, and the factor that has linked so many of these collapsed stocks, is obviously “the story too good to be true.” Which brings us to the curious case of Longtop Financial (NYSE:LFT), a company that produces software for the banking sector. In this report, Citron outlines several concerns which should be considered by the auditors as they prepare the company’s annual audit.  It is the opinion of Citron that every financial statement from its IPO to this date is fraudulent … read on to understand.”

Citron went on to point out factors that should have been obvious to its auditors: the company’s profit margins were far in excess of their competitors; the bulk of its work force was said to be employed by a third party but that third party had employees of Longtop signing the so-called third party’s official documents. That fact alone raised a glaring red flag on the authenticity of the company’s reported costs, and, therefore, earnings.

A spectacular flameout of Longtop began on May 17, 2011 when the New York Stock Exchange halted trading in the shares of the company. At the time of the trading halt, the company had 57 million shares outstanding and a market cap (total value) of $1.08 billion.

Six days later, Longtop filed a notice with the SEC advising that its CFO had resigned as well as its auditor, D&T Shanghai, on the basis that it had found signs of financial fraud. D&T Shanghai noted further that prior year audit reports could not be relied upon. D&T Shanghai was not some tiny accounting outfit like the one used by Bernie Madoff – it is a member firm of Deloitte Touche Tohmatsu Ltd. and it proceeded to ignore subpoenas from the SEC for the audit work papers on Longtop.

On November 14, 2013, Judge Shira Scheindlin in U.S. Federal District Court in New York City entered a ruling in favor of Longtop shareholders who had lost all their money with a damage award of $882.3 million against Longtop and its former CEO, Wai Chau Lin. The ability to collect that sum from the company and Lin, both based in China, may present insurmountable hurdles given China’s history of stonewalling U.S. regulators.

All of which raises the obvious question that U.S. regulators do not seem to be asking each other, at least in public: if Chinese-based auditors will not honor U.S. laws for cooperating with securities fraud investigations and turning over audit documents, why do we still have $1.4 trillion of Chinese shares trading on U.S. exchanges?