United States: Historic U.S., China Agreement on Auditor Access Announced: Is This a Crack in the Wall Separating The Cross-Border Enforcement Cooperation Impasse?

On May 15, 2013, the U.S. Securities and Exchange Commission charged CEO Dejun Zou and board chair Amy Qiu, husband-and-wife executives at China-based RINO International Corporation, alleging that they engaged in a scheme to overstate the company's revenues and divert $3.5 million in proceeds from a securities offering for their personal use. This would be a routine case – except it involves a China-based company, a jurisdiction that the SEC has found difficult to regulate. For some time now, the SEC has been hamstrung in gaining access to information from China. Today's historic announcement by the Public Company Accounting Oversight Board ("PCAOB") may be the first major step in alleviating such difficulties.

The PCAOB announced today that it had entered into an Agreement, referred to as a "Memorandum of Understanding on Enforcement Cooperation with the China Securities Regulatory Commission (CSRC) and the Ministry of Finance (MOF)." (See http://pcaobus.org/International/Documents/MOU_China.pdf) The historical Agreement formally creates a mechanism wherein both sides will allow "production and exchange of audit documents relevant to investigations in both countries' respective jurisdictions." The PCAOB Chairman James R. Doty said, "This agreement with China is an important step toward cross-border enforcement cooperation..."

Perhaps the most interesting aspect of the Agreement is that the SEC is not a party. What does that mean for the future of securities enforcement? In order to understand the full picture, we need to look back a few months.

As you may recall, on December 3, 2012, the SEC commenced administrative proceedings against the China affiliates of several accounting firms for their audit work papers related to nine China-based companies, the securities of which are traded publicly on U.S. exchanges. The SEC action was based on the audit firms' refusal to cooperate in the investigations. According to news sources, the basis for failure to turn over records may relate to Chinese law. That is, according to the Wall Street Journal, "(The audit firms) say Chinese law treats audit documents about Chinese companies as akin to state secrets, and that their employers could be jailed if they act without Chinese government blessing." Thus, the accounting firms have been effectively caught as a pawn in the complexities of U.S.-China relations.

Why is access important to the SEC's enforcement agenda? Let's go back to the RINO case. Based on the SEC's press release, "RINO's periodic filings contained false and misleading statements and omissions about the company's revenue and operations from 2008 to 2010. RINO maintained two conflicting sets of financial records — one set of books for filings in China and another set of books for filings in the U.S. The Chinese books reflected sales of approximately $31 million from the first quarter of 2008 through the first three quarters of 2010. But the U.S. books that formed the basis for RINO's SEC filings contained false contracts and portrayed sales revenues of approximately $491 million during that same time period — more than 15 times greater than the revenues recorded in the Chinese books." The issue is that the SEC has not been able to gain access to the second set of books in China.

While the PCAOB announcement suggests that we are heading toward a level of accessibility that would aid the SEC in some way, the Agreement is far from perfect. The good news is that in theory it will allow the PCAOB to obtain audit records and other financial documents from Chinese audit firms with the assistance of China's Securities Regulator and Ministry of Finance. Indeed, the PCAOB Chairman said, "The agreement allows the PCAOB to share the documents it obtains with the SEC as long as it gives the Chinese advance notice of the sharing." However, the bad news is that the Agreement "won't allow the SEC to use the PCAOB as a workaround to get documents that it couldn't otherwise," said Doty. How that is monitored remains unknown and no doubt will be an area of concern to defense lawyers.

However, that leaves the SEC without a solution. It is likely that by this October the SEC administrative law judge will rule on whether the China-based accounting firms are required to turn over the audit records, if no diplomatic solution emerges. The downside for Chinese accounting firms is that if the court rules against them they may be prohibited from auditing U.S.-traded companies: a severe price to pay indeed. It appears to this author and a number of others that diplomacy may prevail in the end and the SEC will likely get some of what it wants: access to records. It would not be fair to the accounting industry to force a non-diplomatic solution.

The broader lesson for China-based companies is to be aware of these ongoing events and be mindful of potential regulatory obligations and risks under U.S. law. Additionally, those looking to acquire Chinese companies should take heed of developments as they unfold. The sands are once again shifting, and understanding that the U.S. may soon have access to your Chinese books, records and audit papers is a potential area of risk. Looking to address this risk soon is the best way to avoid lengthy and costly issues with U.S. regulators, company shareholders and others.


This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. The Duane Morris Institute provides training workshops for HR professionals, in-house counsel, benefits administrators and senior managers.

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