United States: Big 4 Ban Raises Challenging Conflict-Of-Law Issues

Last Updated: February 7 2014
Article by Bradley J. Bondi and Chris Jones

Most Read Contributor in United States, July 2018

The alleged failure to comply with U.S. Securities and Exchange Commission requests under Section 106 of Sarbanes-Oxley has led to an unprecedented six-month ban for the China affiliates of the Big Four — Ernst & Young, KPMG, Deloitte & Touche and PricewaterhouseCoopers — and a censure for a China affiliate of a fifth firm, BDO International. The ban, which went beyond the relief requested by the SEC, likely will lead to further tensions between China and the United States.1

The SEC's press for sanctions and the resulting order from the administrative law judge came after years of efforts by the SEC to obtain work papers from the accounting firms. The SEC staff, faced with the difficult challenge of conducting investigations involving parties overseas, decided to issue SOX 106 requests to compel production of the relevant foreign audit work papers.

The SEC made its first SOX 106 request in March 2011, and made many more requests through April 2012. The SEC asserted that these audit work papers were necessary for the Enforcement Division's investigations into 10 China-based clients of the five accounting firms.

The judge's order illustrates the complex and difficult relationships between U.S. regulators, Chinese regulators, and accounting firms. In letters and meetings, Chinese regulators reportedly told the firms that they would face criminal and civil penalties for providing audit work papers to overseas regulators.

In October 2011, the firms met collectively with both the China Securities Regulatory Commission and the China Ministry of Finance to discuss the impasse. According to the firms, Chinese authorities consistently told them that compliance with the SEC requests could lead to jail time and other sanctions for the companies and individual employees. Based on this information, the firms declined to cooperate with SOX 106 requests, instead telling SEC lawyers to contact the CSRC.

The SEC engaged in extensive efforts to negotiate with both the firms and the CSRC in order to obtain the work papers.

But as the SEC stated in a similar matter, "the CSRC has been unable and/or unwilling to provide tangible help in the face of specific requests for assistance from the SEC."2 Accordingly, the SEC issued SOX 106 requests as a last resort after extensive, behind-the-scenes efforts to push the accounting firms and Chinese regulators to provide the work papers. The order also came after protracted negotiations between U.S. and Chinese regulators to foster greater cooperation in its oversight of public companies. In May 2013, thePublic Company Accounting Oversight Board signed a nonbinding memorandum of understanding with the CSRC in order to "ensure compliance with, and enforcement of, their respective laws and regulations in matters related to the oversight of the auditors subject to their regulatory jurisdictions."3

The SEC administrative law judge who issued the order ruled the companies willfully refused to comply with SEC requests for work papers and other documents from audits the accounting firms performed for the 10 China-based companies that were under investigation by the SEC Division of Enforcement. In other words, these accounting firms were potential witnesses or defendants in the SEC's investigation into these companies.

The accounting firms announced they will appeal the unusually harsh ruling, which is not effective until the commission makes a decision on appeal. But the order as it currently stands likely would cause U.S.-listed companies in China that use one of the large firms to scramble to find replacement auditors for the period of the ban.

This is no easy task with few choices of accounting firms left with capacities to conduct large audits. Some companies eyeing an initial public offering have already shifted their sights from the U.S. to Hong Kong in order to avoid the uncertainty created by the order.4

A crux of the issue in the SEC hearing — whether the firms should comply with SOX 106 requests if doing so could subject them to potential criminal sanctions — was largely sidestepped by the administrative law judge in his ruling. Each firm argued that it faced a Hobson's choice — complying with the SEC requests would have meant violating Chinese law for revealing what could be deemed state secrets under Chinese law and could have led to imprisonment and significant fines.

The firms all argued that compliance with SOX 106 requests would have resulted in criminal convictions in China. PricewaterhouseCoopers also added that it was aware that the criminal penalties could be enforced against individual employees of the firms.

The decision may be vulnerable on appeal. A federal court applying a conflicts-of-law analysis may hold that the more stringent Chinese law, which would subject these firms to criminal exposure for complying with the SEC's requests, trumps the U.S. government's interests in obtaining this information. But first, the firms must appeal the decision to the commission, which may affirm, modify or reverse the ruling, or the commission simply may delay a decision long enough to allow diplomatic efforts to solve the situation.

Conflict-of-Law Analysis

In order to reach an appropriate decision in a dispute where the laws of two countries conflict, a court would first need to determine whether complying with the SOX 106 requests would have violated Chinese law.5 Or, as the Second Circuit stated, whether "adjudication of [the] case by a United States court would offend 'amicable working relationships'" with a foreign country.6 The firms would bear the burden to demonstrate that Chinese law prohibited compliance with the SEC requests. In testimony before the administrative law judge, each firm presented evidence that Chinese law prohibited compliance. For example, Ernst & Young cited to a pronouncement from the CSRC that prohibited work papers from leaving China without approval of the regulatory authorities. Likewise, Deloitte & Touche explained that the firm understood from its discussions with Chinese regulators that it could not produce work papers directly to the SEC, but instead needed to work through the CSRC.

A. Factors to Consider

Because compliance with the SOX 106 requests would expose the firms to criminal liability in China, a court should apply a conflict-of-law analysis in order to "seek a reasonable accommodation that reconciles the central concerns of both sets of laws."7 This would include consideration of the relative interests of the two states as well as "the mutual interests of all nations in a smoothly functioning international legal regime."8 The Restatement (Third) of Foreign Relations Law has provided guidance on how to seek a reasonable accommodation through a list of nonexclusive factors.9 Those factors are:

1) the link of the activity to the territory of the regulating state, i.e., the extent to which the activity takes place within the territory, or has substantial, direct and foreseeable effect upon or in the territory;

2) the connections, such as nationality, residence or economic activity, between the regulating state and the person principally responsible for the activity to be regulated, or between that state and those whom the regulation is designed to protect;

3) the character of the activity to be regulated, the importance of regulation to the regulating state, the extent to which other states regulate such activities, and the degree to which the desirability of such regulation is generally accepted;

4) the existence of justified expectations that might be protected or hurt by the regulation;

5) the importance of the regulation to the international political, legal or economic system;

6) the extent to which the regulation is consistent with the traditions of the international system;

7) the extent to which another state may have an interest in regulating the activity; and

8) the likelihood of conflict with regulation by another state.

B. Swiss Banking Secrecy Conflict

This same analysis recently was relevant to another conflict-of-laws situation. Since 2008, the U.S. government has invested significant time, energy and resources in pursuing tax evaders. These enforcement efforts have created tension with Switzerland, a country with a long tradition of banking secrecy.10

Switzerland passed the Swiss Federal Banking Act in 1934, which ensured Swiss banks and personnel would preserve the privacy of their clients or face criminal and civil liability.11 A breach of these obligations also could lead to a loss of professional licenses.12

Swiss banks faced a similar Hobson's choice as that now faced by the accounting firms. The United States sought client information from Swiss banks to facilitate investigations into tax evasion, but compliance with the U.S. laws would have meant violating Swiss laws and facing exposure to harsh penalties in Switzerland. Principles of international comity would have restrained enforcement of the summons against the banks to provide that information.

Prior to the 2008 conflict, the Federal District Court for the Southern District of New York recognized the substantial Swiss interest in bank secrecy when it declined to enforce a subpoena that would have violated Swiss law.13 Ultimately, however, this decision did not resolve the impasse between the two countries. Instead, the United States, Switzerland, and the Swiss banks reached an agreement to resolve the issue without ever litigating the dispute. These circumstances, nonetheless, illustrate the difficulty in dealing with conflicting legal obligations and the importance of the principles of comity as described in the Restatement.

C. Applying a Conflict-of-Law Analysis to the China Auditors Case

Diplomacy is one avenue to resolve these issues, but U.S. courts also are empowered to deal with thorny conflict-of-law disputes. For principles of comity to apply, there must be an actual conflict between the foreign and domestic laws.14 Applying principles of international comity in a conflict-of-laws analysis requires a court to balance "the competing interests" of the two states.15

1. Factors Weighing in Favor of the SEC

Two factors may weigh in favor of the SEC and a decision to censure and ban the accounting firms for failure to comply with the SOX 106 requests for audit paper work.

The first is the "link of the activity to the territory of the regulating state."16 The SEC attempted to obtain work papers and other documents with information relating to the activities of companies under investigation.

The companies were all listed on U.S. exchanges, exposing U.S. investors to financial risk. These fraud investigations are important to the SEC's mission of protecting investors, particularly in a market that has been considered risky after several high-profile delistings, bankruptcies and fraud investigations.

A second factor that might weigh in favor of the SEC is the "connections, such as nationality, residence or economic activity, between the regulating state and the person principally responsible for the activity to be regulated ...."17 Each of the firms has a substantial presence in the United States. In addition, the firms were auditors for companies listed on U.S. exchanges.

All of the firms and the China-based companies had significant connections to economic activity in the United States. Nevertheless, the China subsidiaries are foreign entities operating at least in part under foreign laws, the information sought is not located in the United States, and the accounting firms are conducting audits for companies based in China.

2. Factors Weighing in Favor of the Accounting Firms

Most of the Restatement factors weigh heavily in favor of the accounting firms, foremost among them is the "likelihood of conflict with regulation of another state."18 This would consider both the competing interests of the United States and China, and the hardship of compliance on the accounting firms.19

Each firm had a clear understanding that compliance with the SOX 106 requests would have exposed them to liability under Chinese law. This could have included criminal penalties, including prison time, civil sanctions, and the loss of professional licenses.

The CSRC wrote a letter that stipulated that China-based accounting firms were prohibited from providing audit work papers and other documents to overseas regulators. All of the firms indicated that they could not comply with the SOX 106 requests due to the potential liability imposed by China if they provided the SEC with the documents. This makes clear that the firms were not able to comply with both Chinese and U.S. regulators.

The potential consequences for noncompliance with Chinese law were greater than the potential consequences for noncompliance with U.S. regulation. As the U.S. Supreme Court wrote in a case involving a conflict with Swiss law, "It is hardly debatable that fear of criminal prosecution constitutes a weighty excuse for nonproduction, and this excuse is not weakened because the laws preventing compliance are those of a foreign sovereign."20

Given the possibility of a criminal sanction against the firms if they complied with the SEC, the situation created a true conflict in need of reasonable accommodation.

In connection with this factor, the Restatement also looks at the "extent to which the regulation is consistent with the traditions of the international system."21 As former SEC Commissioner Paul Atkins stated in his expert testimony in this case, the SEC has a long and successful history of collaboration with foreign regulators to resolve conflict-of-law issues.22

In addition, the PCAOB has instituted a rule that "allows non-U.S. firms to withhold certain information on their Form 1 if they could demonstrate that providing the information would conflict with non-U.S. law."23 According to Atkins, this rule reflects the SEC's support for the PCAOB's efforts to achieve the goals of Sarbanes-Oxley without creating conflicts with foreign regulators.24 This approach should extend to a firm's inability to comply with an SOX 106 request for audit work papers.

This leads to yet another factor in favor of the firms — the "existence of justified expectations that might be protected or hurt by the regulation."25 Given the SEC's and PCAOB's historic willingness to work with foreign regulators and to seek reasonable approaches to conflicts, the accounting firms may have had a justified expectation that they would not be forced to act in such a way as to expose themselves to liability either in China or the United States.

Finally, the regulatory interests of China matter under the Restatement, which considers the importance of regulation to the regulating state.26 Here, China has a substantial interest in protecting state secrets and maintaining independence from overseas regulators.

Chinese authorities made clear to the accounting firms that divulging audit work papers to foreign regulators was prohibited. And China is not alone in curtailing access to such information. The PCAOB indicates that several countries, including Sweden, Denmark, Belgium and Italy deny the PCAOB access to conduct inspections.27

Certainly the United States has an interest in the enforcement of its regulations. But a court might find that the interests of the United States are outweighed by the interests of China in maintaining its sovereignty and protecting state secrets.

Moreover, Sarbanes-Oxley Section 106 already allows for alternative means of satisfying production obligations, including production through "foreign counterparts of the commission or the [PCAOB]."28 The firms sought to work through the CSRC, and in some cases provided the CSRC with the requested information. This underscores the importance of finding a diplomatic solution without resorting to a harsh ban on the accounting firms, which also harms innocent companies that utilize those firms.

Tough Choices Ahead for the Commission

Before this matter goes to the U.S. Court of Appeals for the D.C. Circuit, the firms must appeal to the commission. As mentioned above, the commission is faced with four options — affirm, modify or reverse the ruling, or delay a decision long enough to allow diplomatic channels to run their course.

Affirming the decision may create even more tension for U.S. relations with China and may be a sign for further tensions ahead with other nations as the SEC seeks to extend its international reach in the global marketplace. The United States and China have been negotiating issues surrounding the SEC's ongoing demands for China-based audit work papers but have not yet reached any resolution.29

A representative for the CSRC said, "We hope the SEC will take into consideration the big picture of China-U.S. regulatory cooperation, make the right judgment to resolve the situation properly. The SEC should bear all responsibility for the possible consequences arising from the decision."30

The commission may decide to delay a ruling to allow the U.S. government to reach a diplomatic solution to obtaining the audit work papers in much the same way the U.S. government reached a diplomatic solution with Switzerland in the tax cases.

However, one commentator has argued that such a delay could send a signal that auditing firms in China can continue their course of conduct and ignore SOX 106 requests in violation of U.S. law, and that this type of nonaction from U.S. regulators may not quell concerns some U.S. investors have expressed about the viability of the Chinese marketplace.31

Conclusion

The accounting firms announced they will appeal the decision — a process that begins with the SEC and ultimately can lead to the D.C. Circuit. The firms will be able to continue to work in China during its appeal to the commission, but the decision has created insecurity for both U.S. and China-based companies operating in China.

It exposes these companies to unnecessary risk because, without the major accounting firms, there may not be auditing and accounting firms with enough expertise or capacity to conduct necessary audits in a timely, efficient and accurate manner. This, in turn, could lead to companies being delisted from U.S. exchanges and losing significant revenue. One expert witness estimated that a delisting of all the clients of the firms could result in a $209 billion decline for those companies.32

This potential impact is critical, especially in the global age. As the U.S. Supreme Court observed, "[W]e cannot have trade and commerce in world markets ... exclusively on our terms, governed by our laws and resolved by our courts."[33] China has a strong state interest in maintaining state secrets, and these interests conflict with the SEC's requests seeking audit work papers.

Ultimate resolution of this conflict may come through diplomatic channels, but there is an equally appropriate means for resolution in the courts as well — a conflict-of-law analysis suggests that the accounting firms may have acted appropriately under the circumstances and thus should be able to continue to serve this important sector of the market without facing punishment from the SEC.

Footnotes

1 The SEC dropped a separate subpoena enforcement action against Deloitte & Touche over the firm's audit of Longtop Financial Technologies Limited, a China-based company listed on U.S. markets, because of the cooperation by both Deloitte and Chinese regulators with the SEC. U.S. SEC v. Deloitte Touche Tohmatsu CPA Ltd., No. 1:11-mc-00512-GK, 2014 (D.C.C. Jan. 27, 2014) (Pacer); see also Joint Motion to Dismiss Without Prejudice at 4, SEC v. Deloitte Touche Tohmatsu CPA Ltd., No. 1:11-mc-00512-GK, 2014 (D.C.C. Jan. 27, 2014) (Pacer).
2 See, e.g., SEC Reply Memorandum in Support of its Application for Order Requiring Compliance with Subpoena at 13, SEC v. Deloitte Touche Tohmatsu CPA Ltd., No. 1:11-mc-00512-GK-DAR, 2012 (D.C.C. Dec. 3, 2012) (Pacer).
3 Memorandum of Understanding on Enforcement Cooperation Between the Public Company Accounting Oversight Board of the United States and the China Securities Regulatory Commission and the Ministry of Finance of China, May 10, 2013, available at http://pcaobus.org/International/Documents/MOU_China.pdf .
4 Jonathan Browning et al., Hong Kong Lures New York IPOs After China Auditors Ban, Bloomberg (Jan. 26, 2014), available at http://www.bloomberg.com/news/2014-01-26/ban-means-hong-kong-luring-new-york-ipos-china-overnight.html .
5 In re Grand Jury Proceedings (Shams), 873 F.2d 238, 239–40 (9th Cir. 1989) ("A party relying on foreign law has the burden of showing that such law bars compliance with a court order.") (citing U.S. v. Vetco Inc., 691 F.2d 1281, 1289 (9th Cir. 1981).
6 Bigio v. Coca-Cola Co., 448 F.3d 176, 178 (2d Cir. 2006)
7 See, e.g. Hilton v. Guyot, 159 U.S. 113, 164 (1895); Société Nationale Industrielle Aérospatiale v. U.S. District Court, 482 U.S. 522, 555 (1987) (Blackmun, J., concurring in part and dissenting in part).
8 Id.
9 Restatment (Third) Of Foreign Relations Law Of The United States § 403(2) (1987).
10 See Bradley J. Bondi, Don't Tread On Me: Has the United States Government's Quest for Customer Records from UBS Sounded the Death Knell for Swiss Bank Secrecy Laws?, 30 NW. J. INT'L L. & BUS. 1 (2010).
11 Id. at 4.
Aérospatiale v. U.S. District Court, 482 U.S. 522, 555 (1987).
15 In re Grand Jury Proceedings (Marsoner), 40 F.3d 959, 965 (9th Cir. 1994).
16 Restatment (Third) Of Foreign Relations Law Of The United 12 Id.
13 Minpeco v. Conticommodity Servs, Inc., 116 F.R.D. 517, 524 (S.D.N.Y. 1987).
14 Hartford Fire Ins. Co. v. California, 509 U.S. 764, 798 (1993) (citing Société Nationale Industrielle States § 403(2)(a) (1987).
17 Restatment (Third) Of Foreign Relations Law Of The United States § 403(2)(b) (1987).
18 Restatment (Third) Of Foreign Relations Law Of The United States § 403(2)(h) (1987).
19 Minpeco, S.A. v. Conticommodity Servs., Inc., 116 F.R.D. 517, 523 (S.D.N.Y. 1987).
20 Société Internationale pour Participations Industrielles et Commerciales, S.A. v. Rogers, 357 U.S. 197, 211 (1958).
21 Restatment (Third) Of Foreign Relations Law Of The United States § 403(2)(f) (1987).
22 In re BDO China Dahua CPA Co., File Nos. 3-14872, 3-15116, at 69 (Jan. 22, 2013), available at http://www.sec.gov/alj/aljdec/2014/id553ce.pdf .
23 Id.
24 Id.
25 Restatment (Third) Of Foreign Relations Law Of The United States § 403(2)(d) (1987).
26 Restatment (Third) Of Foreign Relations Law Of The United States § 403(2)(c) (1987).
27 PCAOB, List of Issuer Audit Clients of Non-U.S. Registered Firms in Jurisdictions where the PCAOB is Denied Access to Conduct Inspections by Jurisdiction and Firm, http://pcaobus.org/international/inspections/pages/issuerclientswithoutaccesslistgrouped.aspx (last visited Jan. 28, 2014).
28 Sarbanes-Oxley Act of 2002 § 106(f), 15 U.S.C. § 7216(f) (2012).
29 Jonathan Weil, China Auditors Still Free to Keep Missing Frauds, Bloomberg (Jan. 24, 2014), available at http://www.bloomberg.com/news/2014-01-24/china-auditors-still-free-to-keep-missing-frauds.html .
30 Id.
31 Id.
32 In re BDO China Dahua CPA Co., File Nos. 3-14872, 3-15116, at 82 (Jan. 22, 2013), available at http://www.sec.gov/alj/aljdec/2014/id553ce.pdf 33 M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 9 (1972).

Originally published by Law360, New York (February 03, 2014)

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