Cooperation between the Chinese and U.S. Regulators being put to the Test
On January 22, 2014, the U.S. Securities and Exchange Commission (“SEC”) Administrative Law Judge Cameron Elliot levied sanctions pursuant to SEC Rule of Practice 102(e) against the Chinese affiliates of the “Big Four” accounting firms for violating Section 106(e) of the Sarbanes-Oxley Act of 2002 by withholding audit documents the SEC requested in the course of enforcement investigations. Judge Elliot censured and suspended the Firms from serving as auditors to companies whose securities are traded in the U.S. for a period of six months.
In case you are not familiar with the facts, the SEC filed an administrative action against the auditors in 2012 after struggling for years to obtain information for dozens of accounting fraud probes at China-based companies. Once a petition for review is filed by the four auditors that received the bar -- Deloitte Touche Tohmatsu CPA Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian CPAs Ltd. -- the judge’s ruling is held from going into force until the SEC makes a decision.
The bar, if enforced, would force more than 200 Chinese companies traded in the U.S. to find new auditors, while multinationals with significant operations in China would also have to bring in new firms to check those units. If the SEC upholds the judge’s decision, the firms could ask the U.S. Court of Appeals in Washington to overturn the bar.
The Firms contend that Chinese law prohibits them from producing audit work papers and other related documents to the SEC or other foreign regulators. Notwithstanding any such prohibition, Judge Elliot determined that “willful refusal to comply” under Section 106 means “choosing not to act after receiving notice that action was requested” and that under such a definition, “the motive for the choice is irrelevant.” Because each of the Firms had not complied with at least one properly served Section 106 request, Judge Elliot determined that each had violated Section 106.
Judge Elliot also considered and rejected four arguments advanced by the Firms as affirmative defenses: (1) international comity prevents enforcement of the Section 106 requests; (2) the Firms did not act “willfully” under Section 106 because their legal obligations were “objectively unclear”; (3) the SEC lacks authority to request documents created prior the enactment of Dodd-Frank; and (4) the proceeding before Judge Elliot violated due process and equal protection and constituted selective prosecution.
Judge Elliot did not consider the first two arguments to be affirmative defenses. Ruling that judicial enforcement of the Section 106 requests was not a prerequisite to the administrative proceeding, Judge Elliot dispensed with the first argument on the ground that it was therefore irrelevant whether the Section 106 requests were enforceable. Based on his construction of Section 106, Judge Elliot next found “nothing objectively unclear” about Section 106 or the SEC’s requests. Referencing his construction of the meaning of “willfully” under Section 106, he stated that the Firms “knew exactly what was expected of them.”
Judge Elliot considered the third and fourth arguments as affirmative defenses but rejected both. Being “aware of no authority barring the use of a Sarbanes-Oxley 106 request to obtain documents created prior to Dodd-Frank’s effective date,” he found no merit to the third argument. Judge Elliot questioned his authority to consider the due process or equal protection claims but found that due process is satisfied where a party understands the issues and is afforded a full opportunity to meet the charges during the course of the proceeding. Finding no evidence of violations of due process or equal protection or of selective prosecution claims, Judge Elliot rejected the Firms’ fourth argument as well.
The judge’s decision has sent shockwaves through the auditing community. Chinese affiliates of the four largest accounting firms plan to file an appeal to U.S. regulators to reverse the judge’s decision to bar them for six months after they blocked investigations of possible accounting fraud.
The SEC will have to weigh the punishment just as U.S. and Chinese regulators make strides in overcoming some of the legal conflicts that the auditors say prevented them from cooperating with probes of China-based companies listed on U.S. exchanges.
The SEC has been continuously frustrated by the Firms’ reluctance to turn over audit documents so that the Commission can determine whether fraud has been committed by Chinese companies. The Public Company Accounting Oversight Board (PCAOB) has been similarly frustrated by efforts of the firms to keep confidential work-papers the PCAOB needs to carry its obligations under the quality review process established by Sarbanes-Oxley.
The overlooked point in the debate whether the Firms should turn over requested documents is the cultural differences between the U.S. and China. In the U.S., we hold individuals and organizations accountable for misconduct including fraud. The Chinese have a more group-oriented mentality on these issues. They are secretive and take offense to allegations of misconduct by anyone in the group as it reflects badly on the group as a whole. The Chinese believe trust is the issue at stake here and U.S. regulators should trust that Chinese authorities, such as the Chinese Securities Regulatory Commission, will handle the matter internally.
The China-based auditors have argued they are caught between U.S. law, which requires them to turn over all documents requested by regulators, and Chinese law, which prohibits transferring data that might contain state secrets to foreign parties. A compromise could be struck by giving the PCAOB access to work papers or allowing it to meet with auditors outside China, according to Chairman James Doty.
An agreement in May between the two countries allowed some cooperation, and U.S. regulators have received documents on at least four companies, the China Securities Regulatory Commission said last month. That agreement didn’t allow for the PCAOB to inspect audit firms in China.
This is an important issue for the future relationship between Chinese companies and U.S. regulators. The fact is U.S. authorities do have access to affiliates of U.S. companies in other countries. There is no valid reason for the regulators to make an exception in the case of Chinese companies simply because they may operate according to a different set of values. Ethics is best on norms of behavior and cooperation is one such norm as it pertains to business. The SEC should stand firm on this matter as it will signal to other countries whether we are serious in applying the law equally.
Blog posted by Steven Mintz, aka Ethics Sage, on March 13, 2014