At issue is the SEC’s ability to investigate potential fraudulent activities at China-based companies registered with the SEC. Under U.S. law, the SEC is empowered to conduct fraud examinations of companies issuing securities on U.S. exchanges. An important focus of those investigations typically involves the review of the documentary evidence used to prepare and conduct audits – known as workpapers – and other files of the auditors retained to sign off on the financial statements. Chinese auditors have refused to make those documents available, claiming they are deemed state secrets under Chinese law.
More on the history of the dispute can be found in an article by Berman DeValerio associates Anthony Phillips and Bing Zhang Ryan, “SEC Takes China-Based Auditors to Task For Refusal to Produce Work Papers“, which was published last year.
The resulting clash has led to a series of confrontations between the SEC, the China-based affiliates of international auditing firms, and Chinese regulators, details of which appear in Administrative Law Judge Cameron Elliot’s decision. The auditors claim they want to comply with the SEC’s requests, but can’t because they are bound by Chinese law.
In a detailed and strongly worded 112-page decision, Judge Elliot found little credence in the auditor’s arguments: “[T]o the extent [the Auditors] 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.” Judge Elliot made his frustration clear:
I have little sympathy for Respondents on this issue. Respondents operated large accounting businesses for years, knowing that if called upon to cooperate in a Commission investigation into their business, they must necessarily fail to fully cooperate and might thereby violate the law. Then, when actually called upon to fully cooperate, Respondents complained that they should be relieved from the duty because, among other things, they invested money and effort in building up their accounting businesses. Such behavior does not demonstrate good faith, indeed, quite the opposite – it demonstrates gall.
Judge Elliot recommended a six month suspensions, which the auditors have vowed to appeal. As such, the initial decision will not yet take effect.
The response to the suspension order was swift. Chinese-based stocks fell dramatically on January 22 and 23. And on January 24, the Chinese regulators struck back, criticizing the ruling for “disregard[ing] China’s efforts and progress made in providing auditing documents and pushing China-U.S. cross-border law-enforcement cooperation ahead.”
The answer to “what’s next” may come not from any appeal of the administrative law judge’s decision, but rather from a recent court filing in a related matter.
The SEC has been battling to enforce a subpoena directed at the Chinese affiliate of Deloitte Touche Tohmatsu to obtain audit work papers and other documents concerning Deloitte’s audit of Longtop Financial Technology. (This battle was also discussed in our prior article.) Less than one week after the Judge Elliot’s decision, the SEC and Deloitte filed a joint motion to dismiss the action to enforcement the Longtop subpoena. According to the motion, the SEC held discussions with the China Securities Regulatory Commission (“CSRC”) concerning cross-border enforcement of the subpoena. As a result of those discussions, Deloitte had provided a “substantial volume” documents and information to the CSRC which, in turn, were produced to the SEC. Moreover, Deloitte agreed to continue its cooperation with the investigation. As a result, the SEC dismissed its enforcement action.
What are the lessons to be learned from these two related developments? It is clear that the SEC is flexing its muscle under the Sarbanes-Oxley Act and achieving some success in obtaining underlying work papers. Those efforts, however, have come only after protracted, multi-party negotiations with auditors and Chinese regulators. Given the delays and hurdles outlined in the administrative law judge’s decision, time will tell whether the dealings between the SEC and the CSRC will be constructive cross-border discussions that allow U.S. regulators greater (and timely) access to the audit work papers for Chinese-based companies that access U.S. markets.
In the meantime, investors should keep these concerns in mind when considering investments in Chinese-based companies. And, the SEC should not lose sight of its overarching mission of transparency and fairness. If you access the U.S. capital markets, you must play by U.S. rules. And if you elect to audit a company subject to U.S. rules, you must follow suit.
*In August 2017, our firm name changed to Berman Tabacco. Case references and content published before that date may refer to the firm under our prior name, Berman DeValerio.