Between Mortar and Pestle: SEC Pressure Grinds Auditors Against PRC State Interests

by Sheppard Mullin Richter & Hampton LLP
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Comity among US and Chinese regulators may top this New Year’s wish list for United States-listed companies in China. After a failed six-month pursuit of a diplomatic solution, the SEC revived its federal court petition to force the PRC accounting member firm of Deloitte Touche Tohmatsu CPA, Ltd (“DTTC”) to produce audit working papers supporting its China-based audit of Longtop Financial Technologies.

If unresolved, the continued conflict between the mortar of Chinese privacy laws and the pestle of US regulatory pressure raises the possibility of fewer accounting firms that are willing or able to perform public company audits in China.

Concerns of United States Regulators

The spat stems from a wave of fraud claims involving accounting discrepancies in reverse-merger IPOs by China-based companies. Questionable financial structures and reporting have stimulated the SEC’s push for greater transparency. DTTC’s struggle with the SEC arose from the regulator’s prosecution of fraud allegations against Longtop Financial Technologies case. The SEC subpoenaed DTTC to produce its audit working papers to further its investigation. DTTC refused to comply, claiming that under Chinese regulations, it is prohibited from submitting working papers created in China directly to the SEC.

DTTC has claimed that, as a PRC entity, Chinese State Secrecy laws and accounting regulation prohibit submission of working papers to foreign regulators such as the SEC. Potential penalties include imprisonment of DTTC employees and dissolution of the firm. DTTC claims that PRC regulators require the SEC to work through the China Securities Regulatory Commission to obtain access to DTTC’s working papers for audit conducted in China. The SEC recognizes that while there is a conflict of laws between DTTC’s obligation to comply with U.S. and China’s laws, DTTC is still subject to U.S. laws and must comply with its subpoena.

The Longtop case, however, is one among a number of disputes set to test the regulators of the world’s two largest economies. The SEC has already initiated over forty fraud-related investigations. Estimated losses on similar fraud allegations were estimated to top $34 billion prior to the SEC’s December 3, administrative proceedings against each of the Big Four accounting firms. The objective of these proceeding, rather than subpoena enforcement, is to prevent firms that do not submit PRC-based working papers from performing audits on US-listed companies. The SEC affirmed that its action against the accounting firms last month is “intended to address concerns arising from foreign mergers and issuers”.

From the US perspective, if the information supporting audit working papers is unreachable, other critical information underlying SEC filings may also be unsupportable. Given the United States disclosure-based regime, undermining confidence in the audits and, therefore, the quality of the fillings, is precisely what the SEC is attempting to avoid. Moreover, the Public Company Accounting Oversight Board (“PCOAB”) cannot perform its duty to patrol the integrity of public company auditors without access to their work product.

US Regulatory Authority

United States courts and regulators have ample authority to punish firms that refuse to submit foreign audit working papers. Clause 106 of the Sarbanes-Oxley Act deems accounting firms to have consented to the production of its work papers. Should voluntary production fail, US courts in SEC actions and class action suits have affirmed that documents located in China are discoverable. Judges have reasoned that the US state interest in preventing fraud by enforcing disclosure trumps the PRC state interest in secrecy. The initial SEC subpoena of Deloitte’s working papers supporting its audit of Longtop Financial Technologies was no exception, despite being a Chinese entity.

Independent from the SEC and outside of the courts, the PCOAB has the authority to deregister any public accounting firm that refuse to provide working papers. Public company audits must be submitted by registered firms for regulatory compliance. If the Chinese affiliates of the Big Four firms are deregistered, it is difficult to see a path regulatory compliance for US-listed companies with major Chinese operations.

Should deregistration occur, any given firm could still support the audit of a registered firm, as long as it does not take as substantial role—more than 20% of the engagement. Even now firms are becoming more selective about their clientele—Deloitte is already implementing more rigorous client screen procedures.

China State Secrecy

The Chinese national government, as the opposing side of auditor’s dilemma, claims a strong public policy interest in protecting state secrets—including financial records. The government has repeatedly and explicitly prohibited Chinese accounting firms from directly releasing audit working papers to foreign regulators, including the China Securities Regulatory Commission (“CSRC”) joint statement with the State Secrecy and Archive Bureaus prohibiting the practice.

China is not unique in requiring regulators to approve cross-border transmission of financial records. (e.g., England, Germany, Canada). US courts, however, generally require specific state interests threatened by the specific material to relieve subpoena requirements on the basis of comity. China tends to be more reticent to share the documents and, more importantly, it rarely provides a clear rationale for protecting them in specific cases.

Part of difficulty in assessing China’s state interest in audit papers is the blurry line between government and private business. In China, the term state owned enterprises may indicate anything from a completely state-governed entity such as a policy bank to the equity stake in a local company owned by a municipality. In the Longtop case, its dealings with state policy banks and their potential complicity strengthened China’s state secrecy interest. DTTC, for its part, has not sought to justify the PRC’s state interest in its audit working papers, but has argued that it is unquestionably enforced by the PRC government.

Consequences and Resolution

The SEC is not likely to flinch on demanding objective support for its filings. The PRC Ministry of Finance and CSRC have submitted potential solutions to the dispute for the State Council’s consideration, but China is unlikely to compromise on state privacy. Therefore, without an intergovernmental resolution, auditors would be forced stop issuing audits or taking a substantial role in audits for China-based companies. Experts, however, eschew that possibility because it would effectively force multinational companies to choose between US capital markets and Chinese operations.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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