Tension is escalating in the regulatory standoff between the United States and China over U.S. access to work papers prepared by audit firms in China. The dispute could put companies with China subsidiaries that rely on audits by Big 4 affiliates there and Chinese companies listed on U.S. exchanges in a tight spot.
The SEC and the China Securities Regulatory Commission (CSRC) are still sparring how much access the SEC should have to information on China-based companies that are listed on U.S. exchanges. U.S. Administrative Law Judge Cameron Elliot suspended China-based affiliates of all the Big 4 firms from practicing before the Commission for six months because they have refused to hand over documents requested by the SEC as it investigates accounting irregularities at a number of China-based, U.S.-listed companies.
The ban, which must be approved by the five-member Commission and then must survive a promised appeal by the audit firms, would mean if enacted clients of Ernst & Young Hua Ming, KPMG Huazhen, Deloitte Touche Tohmatsu, and PricewaterhouseCooper Zhong Tian would need a new auditor before they can file their next periodic reports. The SEC also censured Dahua CPA Co., formerly affiliated with BDO International. The firms say they are prohibited by home-country law from producing the audit work papers the SEC has demanded.
China-based public companies listed on U.S. exchanges that rely on a Big 4 affiliate to audit their financial statements would be wise to begin forming relationships with other audit firms, says Tom Vaughn, a member attorney with law firm Dykema. “A lot of us are pretty surprised it has gotten to this level,” he says. “A few years ago, I don't think anyone thought the two governments wouldn't solve the problem.” U.S.-based multinationals with businesses in China should also pay close attention as well, he says, although he believes the risk to China affiliates of U.S. companies of losing their audit firm is probably much less.
Some Progress, Too
There have been some positive developments in the standoff too. Soon after Elliot issued his opinion, the SEC said it is standing down in a separate proceeding against Deloitte's China affiliate because the CSRC handed over audit work papers the SEC has sought since 2011 in its investigation of Longtop Financial Technologies. The SEC declined further comment beyond its written statements on the two developments.
The Public Company Accounting Oversight Board, meanwhile, says it expects to gain the access it has demanded to perform routine audit inspections of China-based audit firms that are registered to audit U.S.-listed companies or entities affiliated with U.S.-listed companies. “The PCAOB continues to expect to reach a resolution with the Chinese authorities in 2014 that will allow us to conduct inspections of registered firms based in China,” said PCAOB spokesman Colleen Brennan.
“It looks like there's some movement. It would seem the dispute will be solved somehow before the administrative law judge's decision would take effect.”
—Dan Goelzer,
Partner,
Baker & McKenzie
Despite the potential SEC ban on Big 4 China affiliates, recent developments suggest progress in ending the stalemate, says Dan Goelzer, a former member of the PCAOB and now a partner at law firm Baker & McKenzie, although it's far from finished. “It looks like there's some movement,” he says. “It would seem the dispute will be solved somehow before the administrative law judge's decision would take effect.” Given the assured appeals process that must play out, it will be many months or years before any suspension would occur, he says. The Longtop breakthrough indicates perhaps the regulators are working out a way to share documents at the regulatory level. “There are incentives on both sides to reach a compromise,” he says.
Goelzer agrees companies with operations in China relying on audit firms that are caught in the regulatory standoff would be smart to begin paying closer attention to the situation, although he doesn't believe any level of alarm is in order. “They need to be aware of the problem, but I don't think it will affect them in the short term and likely not in the long term either,” he says.
According to Goelzer and Vaughn, the ALJ decision shows that the SEC enforcement staff intended for the threat of suspension to affect only China-based entities and not U.S.-listed companies with entities in China. The ALJ decision says the enforcement staff asked for the ban to apply only to audits where the firm plays a 50-percent or greater role in the audit. That would effectively carve out all or virtually all entities held by U.S.-based companies, they say, because less than 50 percent of their total assets or revenues are generated in China. “The SEC appreciates the fact that this decision could eventually affect multinational corporations and not just the China-based entities,” says Vaughn. “They're very concerned about the extra pressure that would put on them and the marketplace.”
‘ROLE' BAR REJECTED
Below is an excerpt from the ALJ case decision in which the court explains its reasoning behind rejecting the SEC Division of Enforcement's “role” bar request.
The Division's requested “role” bar is rejected for two reasons. First, it is not clear that I have authority to impose such a bar. Unlike the Exchange Act, which explicitly permits the placement of “limitations” on the activities of a registrant or associated person, Rule 102(e) explicitly permits only a censure and a practice bar. 17 C.F.R. § 201.102(e); 15 U.S.C. § 78o(b)(4), (6)(A). The Division has not pointed to any precedent authorizing a role bar under Rule 102(), nor am I aware of any such authority. Second, if Respondents onl7y take on, say, a forty percent role, the Division will still be unable to obtain direct production of about forty percent of audit work papers in any future investigation. The proposed role bar would therefore by insufficient to remedy the potential harm caused by any future violation.
Source: SEC.
Ultimately, the administrative law judge recommended the six-month suspension apply to all audits, but the SEC can still take heed of its enforcement staff's recommendation if it chooses to do so, says Goelzer. “The administrative law judge decision was, basically, I don't have the authority to limit the suspension in that way,” he says. “It has to be all or nothing. So it will be up to the Commission on whether it can limit the suspension in that fashion.”
The judge's decision reflects clear frustration on the part of the SEC that the situation has escalated to its current level, says Drew Bernstein, a partner with audit firm Marcum Bernstein & Pinchuk, which has some audit business in China. “They are kinda fed up, and they're using the legal process to raise the bar and put pressure on the whole system,” he says.
Bernstein agrees the likelihood of a suspension occurring anytime soon is not significant given the long appeal process and the high stakes for both U.S. and Chinese economies. Still, the action is escalating and companies are starting to mobilize, he says. “We're getting calls from companies,” he says. “We consider them inquiries. They're saying we're not looking to hire you as our auditor, but given the situation would you be available and could you do this?”
Jacob Frenkel, a partner at law firm Shulman, Rogers, Gandal, Pordy & Ecker, says he has no doubt companies are working on contingency plans. If they were to lose their audit firm to an SEC suspension, they might consider hiring a Hong Kong-based Big 4 affiliate that is perhaps licensed in China. It's also possible the Big 4 networks are looking at options to affiliate with other firms in China that would not be subject to the suspension and therefore could pick up stranded audit clients. “The sanction was imposed on the firms, not on any individual auditors,” he says. “If the warm bodies move, that may enable even the same auditors to provide the audit support. There are a number of logical workarounds that suggest there would be little to no disruption.”
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