A US Securities and Exchange Commission (SEC) administrative law judge’s finding that the Chinese affiliates of five international accounting firms breached section 106 of the US Sarbanes-Oxley Act 2002, in failing to comply with SEC requests for audit documents relating to Chinese companies listed in the US, came as no great surprise. Neither is it the end of the matter. The accounting firms have announced their intention to appeal. In the meantime, the judge’s decision to suspend four of the Chinese affiliates from issuing audit reports with respect to US listed companies for six months does not take effect until the appeal process has concluded.


In order to raise capital overseas many Chinese companies have listed in the US. Some have done so by way of so-called “reverse mergers”; namely, buying a US listed shell company as a short cut. For a number  of years concerns have been raised about the financial viability of some Chinese companies listed in the US.

The SEC’s administrative action comes on the back of its repeated attempts to get the Chinese affiliates of the five international accounting firms (the accounting firms) to hand over their audit papers in respect of 10 Chinese companies listed in the US (the 10 SEC registrants).

While the accounting firms have co-operated in handing over some documents to the SEC, these have not included their audit papers. The accounting firms have cited Chinese national security laws as preventing them from handing over audit papers to a foreign regulator.

The SEC commenced administrative proceedings against one of the accounting firms in May 2012 and against all of them in December 2012; these two sets of proceedings were then consolidated.

The proceedings allege that the accounting firms wilfully refused to hand over to the SEC their audit papers in connection with the audits of the 10 SEC registrants that were or are the subject of fraud investigations by the SEC’s Enforcement Division.

The administrative proceedings were commenced pursuant to SEC Rule of Practice 102(e)(1)(iii) and allege that the accounting firms breached section 106 of the Sarbanes- Oxley Act (section 106). Section 106(e) (an amendment as a result of the so-called “Dodd-Frank Act” 2010) provides that:

“A willful refusal to comply, in whole or in part, with any request by the Commission or the Board (the PCAOB) under this section, shall be deemed a violation of this Act”.

In May 2013, the US Public Company Accounting Oversight Board (PCAOB), the China Securities Regulatory Commission (CSRC) and the Ministry of Finance in China entered into a Memorandum of Understanding on Enforcement Cooperation (MOUEC), providing for mutual assistance and the exchange of information in order to secure compliance with their respective securities laws.

The MOUEC is not legally binding and permits the withholding of information if (among other things) disclosure would contravene local laws. The information that can be requested under the MOUEC includes (Article IV(b)(ii)): “audit working papers or other documents held by audit firms, provided that the documents relate to audit work that is subject to the regulatory jurisdictions of the PCAOB and/or the CSRC and the MoF”.

The SEC is not a party to the MOUEC, although the PCAOB may share non-public information obtained through cooperation under the MOUEC with the SEC.

Against that background, the SEC court proceedings are clearly a significant escalation in its attempts to obtain the audit papers of the accounting firms.


The administrative law judge’s decision (the Decision) was handed down on 22 January 2014 and is well over a hundred pages. The publicly released version is heavily redacted in many parts; in particular, passages dealing with certain confidential information and the parties’ expert testimony. The judge states in the introduction to the Decision that:

“Accordingly, although the expert testimony regarding Chinese law, and the testimony pertaining to interactions between the Commission and the CSRC, were entirely in open court, I find that the potential cost of disclosing some of my factual findings and legal discussion on these issues outweighs the benefits of disclosure, so much so that they should be issued under seal”.

The Decision finds that the accounting firms wilfully breached section 106 in refusing to comply with the SEC’s requests for their audit papers. The Decision censures the accounting firms and suspends the Chinese affiliates of the so-called “Big Four” from practicing before the SEC for six months; in effect, preventing them auditing US listed companies for six months.

It is important to stress that the Decision is not yet final and does not take immediate effect. It is an “Initial Decision”, albeit an important one. The Decision does not become final until the SEC enters an order of finality. This is unlikely to happen anytime soon because the four accounting firms whose Chinese affiliates were suspended have already released a joint statement confirming they intend to appeal.

The accounting firms can first initiate a review of the Decision by petitioning a panel of SEC Commissioners within 21 days, which will then review the Decision anew.

Even if the SEC issues a Final Decision, the accounting firms can appeal it to a US court of appeals and, ultimately, seek to appeal to the US Supreme Court. In the meantime, the accounting firms may request the SEC to stay any decision that is made final or ask an appeal court to do so. As such, an appeal process could take years.


The main issue for determination by the judge, in deciding whether the accounting firms had breached section 106, was whether they had wilfully refused to provide the

SEC with their audit papers relating to the 10 SEC registrants.

The accounting firms argued (among other things) that their failure to comply with the SEC requests was not “wilful” because it was not done in bad faith and, in any event, even if the refusal was wilful the accounting firms had not intended to breach section 106 itself.

While recognising that the wording of section 106 was not straight forward, the judge was unwilling to import a concept of bad faith or to find that good faith afforded a defence. This was primarily because the statutory provision was not a criminal offence but rather an administrative provision (albeit with potentially serious consequences).

The judge considered that it was a breach of section 106 if the person served with a request for information from the SEC chose not to comply; the motive for failure to comply was not relevant. Therefore, the accounting firms could not argue in their defence that Chinese national security laws prohibited them from handing over their audit papers.

In the judge’s opinion compliance with foreign law was not relevant to whether section 106 had been breached, although it was relevant to the appropriate administrative sanctions.

Those sanctions depended on what was in the public interest and fell to be determined according to factors such as: the reasons for default, the degree of default, the likelihood of future breaches and the like. In imposing the suspensions and censure (and censure only in the case of one of the accounting firms) the judge had in mind “a strong general deterrent” as regards other China based accounting firms.

A way forward

There is no doubt that the Decision makes for uncomfortable reading for auditors of Chinese companies listed in the US. In particular, perhaps rather unsympathetically, the Decision states that to the extent the accounting firms found themselves between “a rock and a hard place, it is because they wanted to be there” and that they chose not to comply with the SEC requests pursuant to section 106.

In several passages the Decision records that the accounting firms did not set out with the intention of flouting section 106 albeit, in the judge’s opinion, they made a choice based  on (for example) business interests and in the hope that US and Chinese regulators would come to an agreement.

Clearly, an extra-judicial resolution would be preferable to years of litigation and the uncertainty that comes with it. The accounting firms have a legitimate concern that if they hand over their audit papers to the SEC without prior authorisation from the Chinese regulators this could result in serious sanctions under Chinese laws. It will be interesting to see how this “conflict of laws” plays out in any appeal but, in these situations, political solutions are often more expedient.

Interestingly, after the court hearing closed the accounting firms sought to add supplementary evidence that the judge accepted could be “potentially exculpatory”. The judge was unwilling to evaluate that evidence given argument and testimony before him had closed.

However, such supplementary evidence is likely to be relevant if the accounting firms petition the SEC Commissioners to review the Decision. While it is unclear what probative value the supplementary evidence will have it is likely to relate to further substantial cooperation between the SEC and CSRC against the background of the MOUEC.

There are already signs that common sense may prevail. In the week after the Decision press reports confirmed that the SEC had agreed to withdraw a subpoena against Deloitte in connection with its audit work relating to Longtop Financial Technologies Ltd; a Chinese business software company listed in the US and incorporated in the Cayman Islands. In passing, it is worth noting that Deloitte resigned before signing-off on any audit of Longtop. The CSRC has apparently agreed to the production of a substantial number of documents (including, audit papers) relating to Deloitte’s audit work in China.

Hopefully, such cooperation is indicative of a way forward, particularly given the potentially drastic consequences and uncertainty for Chinese companies listed in the US should the suspensions of the Chinese affiliates of the  Big Four accounting firms take effect.

If the suspensions do take effect the ability of Chinese companies to tap the US capital markets and of US investors to access one of the most important markets in the world could be severely prejudiced. While the judge appears to have heard much testimony on

such matters from the parties’ respective expert witnesses, particularly in the context of appropriate sanctions, the truth is that uncertainty reigns; that is not good in the current financial environment.

For now, in common with other commentators, our understanding is that the Decision does not affect the accounting firms’ audits for the current financial year.

To a large extent the SEC’s decision to seek resolution of its section 106 requests in the courts reflects its frustration with the degree of cooperation from the Chinese regulators in allowing access to the accounting firms’ audit papers. Hence, the SEC has sought to “up the ante”.

However, the CSRC has expressed “profound regret” following the Decision. It appears to us that if common sense does not prevail the scope for cultural misunderstanding is worryingly high. A compromise has to be found against the framework of the MOUEC and, in our view, this is likely.