In recent years the Securities and Exchange Commission (“SEC” or the “Commission”), seeking to fulfill its role as the regulator designated to protect the integrity of companies listed on U.S. stock exchanges, has taken an increasingly active role in investigating potential fraud - even when the alleged conduct has occurred outside of the territory of the United States. However, reaching over the regulatory fence into foreign jurisdictions creates the potential for conflict between the United States and other countries’ financial regulations, and, unfortunately, exposes companies to multiple and sometimes conflicting regulatory regimes. A recent judicial determination that the refusal of the Chinese affiliates of five global accounting firms to provide audit-related work papers constitutes a willful violation of U.S. law brings such tensions into stark relief and appears to have forced the accounting firms into settlement negotiations.
The decision, issued by Administrative Law Judge (“ALJ”) Cameron Elliot on January 22, 2014 (the “Initial Decision”), censured all five firms for willfully violating Section 106 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) and suspended all but one from practicing before the SEC for six months. The appeal-which was to be heard this month-has been delayed to allow settlement talks to continue between the firms and the SEC. On June 2, 2014, the SEC granted the accounting firms a 90-day extension to file appellate briefs. The stated goal of this extension was to facilitate “continued settlement efforts.” Unless a settlement is reached soon, the accounting firms’ refusal to provide documents in response to SEC requests could lead to significant penalties, including a “role” bar prohibiting the auditors from playing any significant role in the preparation of audit reports filed with the SEC for a period of six months.
Even if the settlement negotiations are successful, the Initial Decision could have a significant impact not only on the sanctioned auditors, but also on the companies that hire them and China-based corporations contemplating public listings in the United States. Companies must recognize that the Chinese auditors of U.S. issuers are likely to cooperate with future U.S. enforcement investigations, even if doing so means risking the wrath of Chinese regulators.
I. Increased SEC Scrutiny of U.S.-Listed Companies Leads to SEC Action
Between 2008 and 2011, the number of Chinese companies listing on U.S. stock markets increased dramatically, with more than 60 Chinese companies joining U.S. exchanges. Many of these companies listed via a “reverse merger” - a process by which a private firm arranges to be acquired by a publicly-traded shell company with little or no operations. Such an arrangement gives the private firm a U.S. listing with less expense and regulatory disclosure than is required for an initial public offering.In 2011, however, such listings came under intense regulatory scrutiny, with the SEC warning investors to remain skeptical of financial documents and audit reports put forth by such companies. By early 2013, the SEC had charged 64 Chinese individuals and companies with fraud and revoked the registration of 50 entities. The SEC has attempted to delist or de-register additional companies, but that process appears to have been slowed by accounting firms’ failure to turn over audit work papers, which are “documentation of auditing or review procedures applied, evidence obtained, and conclusions reached by the accountant in the audit or review engagement.”In declining to share their work papers, many accounting firms have cited the barriers posed by a veritable maze of Chinese data privacy and state secrecy laws. Chinese State Secrets Law, broadly drafted to include everything from information related to national defense to “economic and social development,” can render the collection and transmission of Chinese corporate data a criminal act. The boundaries of this definition are dangerously murky, as seen in the 2010 Rio Tinto case, in which an Australian employee of the international mining giant received a ten-year prison sentence after being charged with industrial espionage. In addition to the State Secrets Law, the Chinese Archives Law requires that those in possession of information “whose preservation is of value to the state and society” maintain its confidentiality and prohibit its sale or transmission abroad. Further complicating the situation is China’s extensive patchwork of data privacy regulations that govern the collection and transmission of personal information. The broad scope and lack of publicly available precedents interpreting these laws mean that it is often difficult, if not impossible, to draw bright-line distinctions between what is, and is not, legally restricted. Accordingly, when seeking to comply with U.S. regulations regarding disclosure of financial data, companies operating in China and their auditors can find themselves in uncertain territory, erring on the side of nondisclosure. It is that nondisclosure, however, that caught the attention of the SEC.
A. The SEC Takes Action
In 2011, numerous allegations regarding inaccuracies in the public filings of companies operating in China listed in the United States began to emerge. On September 8, 2011, the SEC filed a subpoena enforcement action in U.S. District Court for the District of Columbia against a China-based subsidiary of Deloitte (“Deloitte”) for failing to produce work papers in connection with a related SEC investigation. Deloitte claimed that compliance with the SEC’s request would run afoul of Chinese State Secrets Law. Following multiple attempts to secure its work papers, on May 9, 2012, the SEC issued an Order Instituting Administrative Proceedings (the “Deloitte OIP”) against Deloitte, alleging that Deloitte’s refusal constituted a willful violation of U.S. regulations. Several months later, on December 3, 2012, the SEC filed a second order (the “Omnibus OIP”) that extended its action to four additional firms: BDO China Dahua CPA Co., Ltd. (“BDO”), Ernst & Young Hua Ming LLP (“E&Y”), KPMG Huazhen (“KPMG”), and PricewaterhouseCoopers Zhong Tian (“PwC”) (together with Deloitte, the “Respondents”). Like the Deloitte OIP, the Omnibus OIP alleged that the accounting firms - each of which performed audit work for different China-based issuers whose securities were registered with and had become the target of fraud investigations by the SEC - had willfully refused to furnish their audit work papers and related documents to the SEC. Through the requests for these work papers, the regulators sought to obtain key information on the clients’ businesses and internal controls and to identify relevant witnesses, customers, and third parties knowledgeable about the transactions. Respondents, who are foreign public accounting firms within the meaning of Sarbanes-Oxley § 106(g) and regulated by the Chinese Ministry of Finance and the China Securities Regulatory Commission (“CSRC”), refused to comply with the Division’s requests on the grounds that Chinese law prevented them from providing work papers directly to the Commission. Proceedings pursuant to the Deloitte OIP and the Omnibus OIP were consolidated on December 20, 2012 and arguments were heard in July 2013.The apparent widespread nature of the problem led to extensive negotiations between U.S. and Chinese regulators. In May 2013, the Public Company Accounting Oversight Board of the United States (“PCAOB”) and the CSRC signed a “Memorandum of Understanding on Enforcement Cooperation” setting forth the two countries’ mutual objectives of enhancing cooperation and improving the accuracy and reliability of audit reports. Such diplomatic efforts, while significant, were insufficient to stop the SEC’s enforcement action from going forward.
II. Chinese Affiliates of Accounting Firms Sanctioned and Prohibited From Practicing Before the SEC
The ensuing Initial Decision concluded that Respondents willfully violated Sarbanes-Oxley Section 106 by refusing to provide their audit work papers and chastised Respondents for their “flouting of the Commission’s regulatory authority.” All five firms were censured and all but BDO - which no longer provides services to Chinese companies with U.S.-listed securities - were barred from practicing before the Commission for six months. Such a prohibition could be devastating for these particular firms. While the ongoing settlement negotiations may resolve the particular jeopardy for those already in the SEC’s legal cross-hairs, U.S.-listed companies must understand the legal landscape surrounding the administrative decision or they too may find themselves caught in dangerous legal territory.
A. “Willful Refusal” to Comply with an SEC Request
Sarbanes-Oxley § 106(e), which provides that a “willful refusal to comply . . . with any request by the Commission . . . shall be deemed a violation of this Act,”24] was central to the decision to sanction the accounting firms. According to the SEC’s Division of Enforcement (the “Division”), a “knowing failure to produce documents” requested pursuant to Sarbanes-Oxley § 106 constitutes a “willful refusal to comply.” In contrast, the accounting firms argued that a showing of bad faith or bad intent was required. Because Sarbanes-Oxley does not define “willful” or “willful refusal,” the Initial Decision noted that the statutory language is not plain. In addition, because the legislative history was of little help, the Initial Decision relied instead on a number of non-binding authorities interpreting other statutes to support the proposed definition. In the context of Sarbanes-Oxley § 106(e), the Initial Decision concluded that “‘willfully’ means ‘choosing to act or not to act after receiving notice that action was requested,’ ‘refusal to comply’ means ‘failure to comply,’ with no particular state of mind requirement, and ‘willful refusal to comply’ means ‘choosing not to act after receiving notice that action was requested.’”
Based on this interpretation, the Initial Decision determined that the accounting firms’ motive was irrelevant, provided that they were aware of the Division’s request and decided not to comply with it. As a consequence, bad faith need not be demonstrated and the accounting firms’ willful refusal to provide the relevant documents to the SEC was sanctionable. For reasons not detailed in the publically available version of the Initial Decision, ALJ Elliot upheld the Division’s refusal to permit Respondents to produce their audit work papers “through an alternate means, such as through foreign counterparts of the Commission or the Board,” as provided for by Sarbanes-Oxley § 106(f). However, it has been publicly reported that the SEC has been communicating with the CSRC regarding a proposal that would allow the transfer of documents directly between US and Chinese regulators.
B. Penalties Imposed to “Serve the Public Interest”
In deciding whether to impose penalties on the firms, the Initial Decision considered whether sanctions would “serve the public interest” according to the six factors set out in the seminal case on SEC sanctions, Steadman v. SEC.The Steadman factors include:
- the egregiousness of the alleged violations;
- the frequency of the violations;
- the extent to which the firms were aware of their wrongdoing;
- whether the firms made assurances against future violations;
- the degree to which the firms acknowledged their wrongful conduct; and
- the likelihood that the violations would occur in the future.
ALJ Elliot found that the accounting firms’ conduct satisfied multiple Steadman factors, including the failure of all but BDO to recognize the wrongfulness of their conduct, the frequent opportunities for future violations and insufficient assurances therefrom, supporting a substantial sanction. However, a permanent practice bar before the SEC would not serve the public interest.
C. No “Intent to Defraud,” but not "Sincere"
In addition to the Steadman factors, ALJ Elliot also considered whether the accounting firms acted in good faith, namely, whether the accounting firms “attempted all which a reasonable man would have undertaken in the circumstances to comply with the Sarbanes-Oxley § 106 requests.” Respondents emphasized that they “were ready, willing, and able to produce documents, but were unable to do so because Chinese law prevented it.” Although his analysis was redacted, the Initial Decision appeared to consider that the Chinese regulators prohibited Respondents from producing audit work papers to the Division.
The Initial Decision made clear that “to the extent [the accounting firms] found themselves between a rock and a hard place, it [wa]s because they wanted to be there.”  The Initial Decision emphasized that the Respondents had registered with the PCAOB with the knowledge that they could be required to provide work papers and noted that the regulator thereafter notified the accounting firms that, even though they operated in China, they were subject to all applicable U.S. laws. Also significant was the accounting firms’ awareness that Dodd-Frank imposed additional requirements and the designation of a U.S. agent for service of Sarbanes-Oxley § 106 requests. Consequently, the Initial Decision examined the rarity of sanction proceedings and concluded that the accounting firms’ actions and their claimed inability to cooperate with Division proceedings were a “calculated risk.” Thus, although the accounting firms were not acting with “scienter” or “an intent to defraud” because “their state of mind at the time of their respective violations was driven by their concerns over potentially draconian Chinese law,” they were not acting “sincerely.”
III. Reading the Tea Leaves: Implications of the Initial Decision
Throughout this litigation, the SEC has made its position clear: auditors must gather enough information to determine whether companies subject to its regulation are acting fraudulently - anywhere in the world. Given the recent success of the Initial Decision and the ongoing settlement negotiations, there are no signs that the SEC will back down from future disputes over the extent of its authority. According to the SEC Enforcement Division’s Chief Litigation Counsel, Matthew Solomon, audit-related “records are critical to [the SEC’s] ability to investigate potential securities law violations and protect investors.” The SEC clearly hopes this action will prompt other Chinese auditors to cooperate with SEC investigations, as many had previously done.
The SEC may get its wish. According to its January 27, 2014 Litigation Release, the Division received a substantial volume of documents called for by its subpoena to Deloitte. In light of such cooperation, the SEC and Deloitte filed a joint motion to dismiss without prejudice the September 2011 subpoena enforcement action, which the court promptly granted. Deloitte’s cooperation will make it extremely difficult for the remaining holdouts. In addition, the Initial Decision appears to have forced the other accounting firms to the bargaining table, where they are being required to weigh the immediacy of penalties in the United States against the potential enforcement actions of Chinese regulations.
Because the ruling does not go into immediate effect, it is not expected to impact U.S.-listed companies relying on the accounting firms to audit their 2013 returns. However, in the future, U.S. issuers with China operations could be forced to identify alternative providers of accounting services or face the possibility of delisting. In addition, unless the Initial Decision is struck down, over 200 Chinese companies traded in the U.S. could be forced to find new auditors.
Any hopes of evading regulatory scrutiny by listing in other markets may be short-lived. In a case involving different factual circumstances, but nevertheless demonstrating the weakness of the Chinese state secrets argument, a recent Hong Kong High Court decision sanctioned Ernst & Young Hong Kong for its failure to produce audit papers requested by Hong Kong’s Securities and Futures Commission (“SFC”). The court rejected Ernst & Young’s argument that it was forbidden to do so by Chinese law, as it had failed to establish whether the audit papers actually contained such protected information.
This much is certain: as the pathways to public capital become increasingly international, listed companies operating in markets with different standards for accounting, anti-corruption compliance, and other financial controls will continue to encounter new challenges, as will their auditors. Companies must be aware of the conflicting regulatory regimes and work closely with experts who can guide them through an increasingly complex legal environment.