On 22 January 2014, U.S. Securities and Exchange Commission ("SEC") administrative law judge, Cameron Elliot, issued an initial decision to suspend the Chinese affiliates of the Big Four accounting firms (Ernst & Young, KPMG, PricewaterhouseCoopers and Deloitte Touche Tohmatsu) from practicing before the SEC for six months. The suspension does not take immediate effect, and may be subject to a lengthy appeal process that could take months or even years to complete. The judge found that the Chinese affiliates of the Big Four had willfully refused to comply with SEC requests for the production of audit work papers of certain China-based, U.S.-listed companies in violation of the Sarbanes-Oxley Act. In refusing to comply with the SEC's requests, the Big Four argued that the accounting firms were prohibited by China's state secrets laws from producing the documents without the approval of Chinese regulators, which in this case was the China Securities Regulatory Commission ("CSRC").

The CSRC responded strongly on 24 January 2014, criticizing the ruling for "disregarding China's efforts and progress made in providing auditing documents and pushing forward China-U.S. cross-border law enforcement cooperation". The CSRC further warned: "The SEC should bear all responsibility for possible consequences arising from the ruling."

In fact, the SEC decision and this recent exchange between the two regulators was ostensibly unexpected. In May 2013, the U.S. Public Company Accounting Oversight Board ("PCAOB"), China's Finance Ministry and the CSRC signed a memorandum of understanding ("MOU") that established a framework between the parties for the production and exchange of audit documents relevant to the investigations in each respective jurisdiction. And after the signing of the MOU, Deloitte reportedly submitted to the SEC, via the CSRC and with its approval, a substantial volume of documents that the SEC had requested during the fraud investigation of a China-based company, to the SEC's apparent satisfaction. In this case, the receipt of documents through the cooperation of Deloitte and the CSRC led to the SEC withdrawing a subpoena enforcement action against Deloitte on 27 January 2014, a few days after Judge Elliot delivered his ruling.

Despite these positive developments, Judge Elliot's ruling seems to indicate that, in the SEC's view, the current non-binding MOU and the efforts of Chinese regulators may have been of limited helpfulness, and the current level of regulatory cooperation is far from satisfactory in allowing SEC greater and timely access to the audit work papers for China-based companies that access U.S. markets.

If Judge Elliot's decision goes into effect, even a temporary ban on the Chinese affiliates of the Big Four may have significant repercussions: it may deny Chinese issuers access to U.S. capital markets and erode shareholder value in those companies that are already listed. U.S.-listed multinational companies with significant China operations may also be affected. As they are typically serviced by the Big Four and their affiliates, they would face the challenge of engaging quality alternative accounting firms and may be unable to present accurate and timely financial information to U.S. investors.

This issue will ultimately need to be resolved between the SEC and the CSRC in a solution that addresses both CSRC's state secret concerns, and the SEC's goal of obtaining greater and timelier access to documents essential to investigating and prosecuting financial fraud. Despite the CSRC's stern response to Judge Elliot's decision, it is rumored that in private conversations, CSRC officials have emphasized that its policy of strengthening cross-border cooperation with the SEC and PCAOB remains unchanged, and it will continue to utilize and improve the framework created by the MOU to foster such cooperation. With greater efforts and compromises on both sides, we believe an appropriate resolution can be reached to prevent the impact of the SEC ruling.

In the meantime, Chinese companies should pay close attention to all sides of this issue, whether they are seeking a U.S. listing or balancing their responses to SEC/PCAOB probes and compliance with PRC law. They should also consider the following measures in managing the regulatory risk:

  • Understand the Law, Thoroughly.  PRC laws governing state secrets or accounting archives are extensive and complex. Yet they will need to be understood to formulate responses to regulators. Seeking clarification from legal counsel and government officials is strongly advised.
  • Beef Up Disclosure.  Regulators and investors will doubtless be paying close attention to the interplay and conflicts between PRC laws and U.S. securities laws. It is highly recommended that discussion of PRC law on state secrets and accounting archives be included in offering documents. And a risk factor addressing the enduring uncertainty caused by Judge Elliot's decision should become standard.
  • Good Faith Compliance.  Merely citing state secrets laws as a reason for non-disclosure without accompanying analysis will likely not be viewed as a "good faith" effort in the eyes of the regulators. Companies must make a concerted effort to provide arguments supported by sensible PRC legal analysis that fully anticipate and address regulatory concerns, without being perceived as evasive.

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