The Securities and Exchange Commission has given up hope of reaching a diplomatic solution to the standoff with authorities in China over access to audit work paper and is turning the screws on audit firms instead.

In addition to its administrative orders last week against affiliates of five global audit firms to seek audit work papers, the SEC also filed a brief in U.S. District Court asking the judge to proceed with enforcing an earlier subpoena order against Deloitte Touche Tohmatsu in connection with its audit of Longtop Financial Technologies. The order makes it clear that the SEC is finished negotiating and is turning its attention back to the audit firm as a means to secure documents instead.

The SEC initially sought the subpoena in 2011, but requested a 6-month stay on the court order in August while it tried to work out a solution with the China Securities Regulatory Commission. “Those negotiations have now ended unsuccessfully,” the SEC wrote in its brief. “Indeed, there is no valid reason not to force DTTC to comply with the subpoena.”

Deloitte has argued it can't hand over its Longtop audit work papers because it would violate China law, where audit work papers are not allowed to be shared with regulators outside the country. Deloitte has told the court that the documents are beyond the SEC's jurisdictional reach, and the interests of China outweigh the interests of the SEC in the dispute.

The SEC argues that Deloitte knew when it took the Longtop audit job that the SEC could ask for audit work papers, yet it accepted audit fees and helped the company raise hundreds of millions of dollars from U.S. investors, so the firm knew and accepted the risks. “The party that should bear the consequences of that decision is the audit firm, not the SEC and not U.S. investors who may have fallen victim to a fraud conducted by a U.S. listed company that DTTC audited,” the SEC wrote in its brief. The U.S. court should focus on U.S. interests, not Chinese interests, in reaching its decision, the SEC says.

The brief provides a first-ever view of the detailed efforts the SEC has undertaken to gain access to audit work papers through a statement by Alberto Arevalo, an assistant director in the SEC's Office of International Affairs. Since 2009, Arevalo wrote, the SEC has sent 21 requests for assistance in connection with 16 separate investigations, including three requests for audit work papers. “The SEC has not received any of the requested audit work papers, nor has it received meaningful assistance from the CSRC in any of the other investigations,” he wrote.

Arevalo describes CSRC responses in some cases where the China authorities offered to provide limited documents, such as those CSRC deemed relevant to the SEC's investigation, or demands that the SEC agree it would not use any documents in any legal action. The SEC was not willing to accept the conditions CSRC sought to set, according to the statement.

He writes that SEC Chairman Mary Schapiro met this summer in China with CSRC Chairman Guo Shuqing, after which the CSRC proposed a kind of cooperation that led to some optimism at the SEC, which prompted the August request for a six-month stay in the subpoena order against Deloitte. After various fits and starts, however, those talk broke down and the SEC has concluded the CSRC does not plan to produce the documents it requests. “None of the recent events, including the CSRC's recent communications and production of documents, have changed the SEC staff's view that the CSRC is not now a viable gateway for the production of audit work papers, and there is no reason to expect it will become one in the foreseeable future,” Arevalo wrote.

Jason Flemmons, senior managing director at FTI Consulting and a former deputy chief accountant in enforcement at the SEC, says the brief serves as a turning point in the SEC's pursuit of evidence to investigate accounting problems with China-based companies. “Up to this point, the SEC has not divulged where it was with the negotiations,” he says. “Now the brief goes into some detail and it has pretty powerful language to say effectively that the CSRC is not going to be a gateway or conduit for obtaining work papers out of China.”

That puts the next move into the hands of the administrative law judge, says Flemmons. The most extreme possible decision would be to bar the firms from practicing before the SEC, he says. That means the firms could not sign audit reports to be submitted to the SEC, nor could they do support work under another audit firm that will sign the report.

Such maneuvering would put U.S. registrants in China into a significant scramble to find a new auditor, he says. The judge also has other remedies at his disposal, Flemmons says, such as barring firms from issuing audit reports but permitting them to serve in support roles, or simply censuring the firms.

The proceedings are expected to be resolved within 300 days of the filing, Flemmons says. He believes it's too early for public companies relying on firms that have been targeted by the SEC to take preemptive measures, but suggests they stay alert to developments.

In addition to Deloitte, the SEC also has pursued administrative proceedings against affiliates of Ernst & Young, PricewaterhouseCoopers, KPMG, and BDO.

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