SEC Not Backing Down in Fight Against Chinese Auditors

The Securities and Exchange Commission turned up the pressure on auditors in China when it recently initiated enforcement proceedings against the Chinese affiliates of the Big Four accounting firms and BDO. On December 3, 2012, the Commission filed an administrative action alleging that each firm—Deloitte Touche Tohmatsu CPA Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen, PricewaterhouseCoopers Zhong Tian CPAs Ltd., and BDO China Dahua Co. Ltd.—violated Sarbanes-Oxley and the Securities Exchange Act by failing to provide the Commission copies of audit workpapers.

The case is the latest step in an ongoing dispute between U.S. regulators and the auditors of Chinese companies trading on U.S. markets.

While Sarbanes-Oxley requires foreign accounting firms to provide audit workpapers to the SEC and the Public Company Accounting Oversight Board (PCAOB) on demand, this requirement has not been generally followed in China, where a number of civil and criminal laws restrict the transmission of information that could harm the national or “economic” interests of the country. The current SEC dispute—which could lead to five of the largest audit firms in China being barred from providing public accounting for companies listed on U.S. exchanges—could have a significant impact on corporations with large operations in China.

An Uneasy Relationship Between Regulators

Beginning in 1994, the SEC entered into a series of agreements with the China Securities Regulatory Commission (CSRC) in anticipation of China joining the global financial community. These agreements sought to create an “enhanced relationship” between the regulators with the stated goal of “building and maintaining open, fair, efficient, and sound securities markets.” None of these agreements creates a direct obligation for the regulators to produce documents to each other, however, and each provides that assistance may be denied if a request would violate domestic law.

In September 2011, the public was given a window into the difficulties the SEC has faced in obtaining documents in China when the Commission filed a subpoena enforcement action against Deloitte Touche Tohmatsu CPA Ltd. (DTTC). The SEC sought the workpapers for the audit of Longtop Financial Technologies Limited, a Chinese company whose securities were then traded on the NYSE.

In opposing the SEC’s application, DTTC argued, inter alia, that if it produced Longtop’s workpapers directly to the SEC, “China regulators would be authorized to dissolve the firm entirely and to seek prison sentences up to life in prison for any DTTC partners and employees who participated in the violation.” To support its position, DTTC provided the court with a letter from the CSRC directing the auditing firm to comply with the States Secrets and Archives laws in China and stating that the SEC should work with the CSRC “to find a solution.”

The case was stayed this past summer to allow the SEC to seek a larger diplomatic resolution with Chinese authorities regarding the exchange of documents. Following months of diplomatic meetings, the regulators reached an impasse due in part to the CSRC’s insistence that, if documents were produced, the SEC would be precluded from using them in any legal action without the CSRC’s advance written authorization. The SEC moved to lift the stay, and DTTC argued in court filings the stay should be maintained until the conclusion of the related administrative proceeding against the auditing firms. The court heard argument on this issue on January 21, 2013. No decision has been made.

At the heart of the dispute between the SEC and auditors in China are a number of Chinese laws that provide potentially serious penalties for transmitting protected information overseas. Understanding these laws, and the sanctions for violating them, is important to understanding the challenges Chinese accounting firms face when trying to comply with U.S. regulatory requirements.

State Secrets Law