On January 22, 2014, an SEC Administrative Law Judge issued an initial decision suspending the Chinese affiliates of the Big Four accounting firms from practicing before the SEC for a period of six months. If and when this suspension takes effect, it will prevent these firms from issuing audit reports on U.S.-listed Chinese companies and from participating in the audits of U.S. companies with operations in China.
The case arises from requests that the SEC enforcement staff made to the firms to provide the staff with work papers related to audits of certain Chinese companies that are under SEC investigation. Section 106 of the Sarbanes-Oxley Act requires foreign accounting firms that issue audit reports filed with the SEC, or that perform work on which a U.S. accounting firm relies, to provide their work papers to the SEC when requested to do so. The Chinese Big Four affiliates declined to comply with the SEC’s Section 106 requests for their work papers on the ground that doing so would violate Chinese law. The Commission then commenced administrative actions against the firms alleging violations of Section 106. The ALJ held that the firms’ conduct constituted a willful violation of the Act, notwithstanding Chinese work paper disclosure limitations, because the firms chose to perform audit work for U.S. issuers “knowing that a failure to directly produce documents pursuant to Sarbanes-Oxley 106 might be a violation of Sarbanes-Oxley.” In the judge’s view, “to the extent [the Chinese Big Four firms] found themselves between a rock and a hard place, it is because they wanted to be there.”
Depending on its timing, the suspension could disrupt the audits of U.S.-listed Chinese companies that employ a Big Four auditor. In addition, this decision could have a significant impact on some multi-national U.S. companies. The Big Four – D&T, E&Y, KPMG, and PWC – audit the vast majority of the largest U.S. public companies. Many of these companies have operations in China, and those operations are frequently of sufficient magnitude that audit procedures must be performed in China as part of the parent company’s audit. The principal auditor normally relies on its Chinese affiliate to perform such procedures. Therefore, if the six-month suspension period coincided with a company’s audit, its U.S. auditor might be unable to issue an unqualified audit opinion.
The Chinese accounting firms have announced that they intend to appeal the ALJ’s decision to the five SEC Commissioners. If the Commission decides against the firms, they would then have the right to appeal to the U.S. court of appeals (and to seek U.S. Supreme Court review of any adverse court of appeals decision). This appeals process could last for several years, and the practice suspension will not take effect until the appeals are exhausted.
It is possible that the Commission will affirm the decision, but modify the terms of the suspension in a way that permits the firms to continue to perform work in cases where the Chinese firm’s role is limited to participating in an audit, but it is not the principal auditor. The ALJ considered, but rejected, such a suspension. Further, it is likely that, during the appeals, the SEC and the Chinese securities authorities will reach some sort of agreement on work paper access. Negotiations to that end are underway, and it appears that progress is being made. In fact, within a week of the ALJ’s initial decision, the Commission agreed to dismiss a similar case against D&T because the work papers requested in that case were, in fact, being produced — although transmitted to the SEC via the Chinese Securities Regulatory Commission, not directly from D&T.
Comment: Audit committees of companies with Chinese operations that are within the scope of the company’s audit should of course stay up to date on further developments in this litigation. They should also ask their auditor what its contingency plan is in the event that its Chinese affiliate is precluded from practicing before the SEC for a period of time. Companies with operations in China that are not audited by one of the Big Four firms should also be alert to these issues, since the same legal conundrum could arise for other Chinese firms and affect their participation in audits of companies that trade in the U.S.