Chinese Affiliates of Big Four Accounting Firms Ordered Barred from Practicing Before the SEC for Six Months; Suspension Stayed Pending Appeal

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1 Chinese Affiliates of Big Four Accounting Firms Ordered Barred from Practicing Before the SEC for Six Months; Suspension Stayed Pending Appeal Administrative Law Judge Finds that the Firms Willfully Refused to Comply with SEC Requests for Audit Work Papers for Issuers Under Investigation for Accounting Fraud SUMMARY On January 22, 2014, a Securities and Exchange Commission ( SEC ) administrative law judge issued a decision that is of substantial importance to China-based issuers of securities that are registered in the United States, to multinational corporations with significant operations in China and, more generally, to any party seeking to navigate conflicts between U.S. enforcement actions and local data-privacy and bank-secrecy laws. In a 112-page initial decision, Judge Cameron Elliot held that the Chinese affiliates of Ernst & Young, KPMG, Deloitte Touche Tohmatsu and PricewaterhouseCoopers 1 had willfully refused to comply with SEC requests for the production of audit work papers of certain China-based companies that the SEC was investigating for possible accounting fraud. As a sanction for this violation of Section 106 of the Sarbanes-Oxley Act, Judge Elliot censured the accounting firms 2 and further barred them from practicing before the SEC for six months. 3 The administrative law judge s ruling, which the accounting firms have indicated that they intend to appeal, does not take immediate effect. As a result, the decision is not expected to be immediately disruptive to U.S.-listed China-based companies relying on these firms to audit their 2013 financial statements. If, however, the accounting firms are ultimately unsuccessful in their appeal, then companies may need to find different auditors during the six-month suspension period or else be unable to file New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 financial statements, which could have a variety of serious consequences. Due to the significant number of issuers in China that use these auditors, the decision has the potential to cause serious disruption to many companies and their investors, particularly in light of uncertainty over what substitute auditing arrangements are feasible. The decision also focuses attention on a long-running dispute over access to information between the SEC and its Chinese counterpart, which, in this case, forbade the accounting firms from providing audit work papers directly to the SEC. BACKGROUND According to the SEC, on at least ten occasions in recent years, its investigations into possible fraud at certain China-based issuers whose securities were registered with the SEC were hindered by the accounting firms failure to turn over audit work papers for the companies under investigation. In connection with those investigations, the SEC had served mandatory requests on the accounting firms pursuant to Section 106 of Sarbanes-Oxley. In addition to allowing for such requests, Section 106 further provides that [a] willful refusal to comply... with any request... under this section [ ] shall be deemed a violation of that provision. In refusing to comply with the SEC s requests, the accounting firms argued that they were willing, but precluded by Chinese law in particular, the law surrounding the disclosure of state secrets from producing the requested documents. The accounting firms further explained that they had received explicit instructions not to produce their audit work papers from the SEC s Chinese counterpart, the China Securities Regulatory Commission (the CSRC ), and the Chinese Ministry of Finance, both of which repeatedly had made clear that cooperation with the SEC s document requests without the approval of the Chinese regulators would violate Chinese law. In late 2012, after extended and unsuccessful negotiations with Chinese regulators, the SEC instituted administrative proceedings against the accounting firms. The SEC, alleging that the accounting firms refusal to comply with the mandatory requests was willful, brought an action seeking (i) their censure, (ii) their permanent ban from issuing audit reports filed with the SEC, and (iii) their permanent ban from performing 50% or more of the work for such audit reports. Following 12 days of hearings before Judge Elliot in July 2013, which included expert testimony, the parties submitted post-hearing briefs before the record closed in September DISCUSSION 4 In determining whether respondents had violated Sarbanes-Oxley 106, Administrative Law Judge Elliot 5 focused on the meaning of the statutory term willful refusal to comply. Having consulted analogous statutory provisions, as well as precedents of the SEC and the PCAOB, Judge Elliot interpreted the phrase to mean choosing not to act after receiving notice that action was requested, without regard to -2-

3 good faith. In reaching this conclusion, Judge Elliot rejected the accounting firms argument that willful refusal requires proof of bad faith or bad intent. Finding instead that willfulness merely differentiates between deliberate and unwitting conduct, Judge Elliot stated that, to the extent [the accounting firms] 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. Having found that respondents had wilfully violated the law and were subject to sanction, Judge Elliot focused on what he identified as the calculated risk that respondents had run in assessing what sanction was appropriate. Analyzing that question through a rubric established in precedent and including, among other factors, the level of scienter involved in a violation, Judge Elliot expressed little sympathy for respondents dilemma between U.S. and Chinese law, explaining: Respondents operated large accounting businesses for years, knowing that if called upon to cooperate in a[n SEC] 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, [r]espondents complained that they should be relieved from that 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. Despite these harsh words, Judge Elliot emphasized that respondents had not acted with scienter, finding that their concerns over potentially draconian Chinese law drove their violation of U.S. law. Assigning great weight to this factor among other factors that were contradictory, Judge Elliot found that the public interest weighed in favor of censure with a complete bar to practicing before the SEC for six months. IMPLICATIONS The implications of this decision are significant and far reaching, but in large part are on hold until the review and appeals process which could take several years runs its course. As an initial step, the accounting firms are entitled to de novo review of the administrative law judge s initial decision by the Commissioners of the SEC, who can affirm, reverse, or modify the initial decision. In addition, the accounting firms are entitled to appeal any SEC order to the U.S. Court of Appeals for the District of Columbia Circuit. If, however, the decision as issued does become final, the suspension of E&Y, KPMG, DTT, and PwC will create an immediate challenge for issuers in China that use their services. By the count of one of the SEC s own testifying experts in the case, 161 such issuers would have been affected by the practice bar if it had been in place between 2010 and Further, the question of whether a viable alternative to the Big Four exists in China on a sufficiently large scale for any six-month suspension is unclear and was an issue that the SEC and respondents disputed, with respondents raising the specter of a massive delisting of China-based issuers from U.S. securities exchanges and the destruction of shareholder value -3-

4 as a result of the inability of those issuers to file financial statements without substitute auditors. Though Judge Elliot dismissed the accounting firms concerns in this regard as not credible, they may give other interested parties greater pause. In the meantime, the enduring uncertainty presents a risk factor for IPOs and other U.S. securities offerings from issuers in China during the coming year. Separately, the interpretation of what constitutes willful refusal under Sarbanes-Oxley 106 also has implications for issuers outside of China, whose auditors may face equally difficult choices between fulfilling SEC requests for audit work papers and meeting local data-privacy laws, for example, among other interests in tension with the SEC s investigative mandate. Finally, this dispute ultimately may only be settled at the highest diplomatic levels between the U.S. and Chinese governments. As Judge Elliot seemingly acknowledged, his decision cannot bridge the gap between what the SEC wants in the United States and the CSRC is prepared to allow in China. In a sign that a diplomatic resolution may be possible here, on January 27, 2014, the SEC moved to dismiss a related case in which it had sought to enforce an administrative subpoena against DTT seeking audit work papers for a U.S.-listed China-based company. See Joint Mot. to Dismiss Without Prejudice, SEC v. Deloitte Touche Tohmatsu CPA Ltd., 11 Misc. 512 (GK) (D.D.C. Jan. 27, 2014). After protracted discussions on cross-border enforcement cooperation, the CSRC produced to the SEC s apparent satisfaction a substantial volume of documents that the SEC had requested from both DTT and the CSRC. As a result, the SEC stated in court filings that at present, [it] does not believe that there is a need for judicial relief with respect to the [s]ubpoena. * * * Copyright Sullivan & Cromwell LLP

5 ENDNOTES The China-based entities are Ernst & Young Hua Ming LLP ( E&Y ), KPMG Huazhen (Special General Partnership) ( KPMG ), Deloitte Touche Tohmatsu Certified Public Accountants Ltd. ( DTT ), and PricewaterhouseCoopers Zhong Tian CPAs Ltd. ( PwC ). These four entities were non-u.s. public accounting firms registered with the Public Company Accounting Oversight Board (the PCAOB ). The formal rebuke of a censure is imposed, like a practice bar, under SEC Rule of Practice 102(e)(1)(iii). In addition, Judge Elliot censured BDO China Dahua CPA Co., Ltd. ( Dahua ), a former member firm of BDO, but did not bar it from practicing before the SEC. Judge Elliot redacted certain passages in the initial decision because they discuss the [SEC], the CSRC, and their interaction more candidly than is customary in diplomatic circles, and he did not wish to interfere with any ongoing discussions between the [SEC] and the CSRC. This publication is based on review of the public version of the initial decision. Judge Elliot, as an administrative law judge, is responsible for making findings of fact and law in public administrative proceedings that are instituted by order of the SEC. His initial decision is appealable to the Commissioners of the SEC itself, from which further appeal is available to the U.S. Court of Appeals for the District of Columbia Circuit. -5-

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