Big 4 Ban Raises Challenging Conflict-Of-Law Issues

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...