US court judgment ups stakes on China audits

In its "Initial Decision" No. 553 (22 January 2014), a US Securities and Exchange Commission (“SEC”) administrative law court decided that the Chinese affiliates of five international accounting firms breached Section 106 of the US Sarbanes-Oxley Act 2002, in failing to comply with SEC requests for audit documents relating to Chinese companies listed in the US.

In short, the court found that the accounting firms breached Section 106(e) of the Act by apparently "wilfully refusing" to comply with SEC requests for audit papers relating to the firms' audits of 10 Chinese companies listed in the US.

The Big Four firms have announced they will challenge the Initial Decision. The court's decision to suspend the right of the Chinese affiliates of the "Big Four" accounting firms to issue audit reports for US-listed clients for six months does not take effect until the appeal process has concluded (and assuming the appeal is unsuccessful). That could take years.

In the meantime, it is important to keep in mind the following points:

  • an appeal should have reasonable prospects of success. First, the court accepted that the statutory meaning of "wilful refusal" was not simple. Second, the court dismissed difficult issues concerning "conflict of laws"; for example, the accounting firms' argument that to comply with the SEC's Section 106 requests could put them in breach of China's national security laws (protecting, among other things, "state secrets"). Third, the judge accepted that supplementary evidence filed by the accounting firms after the court hearing was "potentially exculpatory";
  • an issue arises as to whether a suspension is in the public interest, all things considered; for example, the effect it could have on audit clients and investors, not to mention who will perform the audits if the suspension takes effect;
  • for now, the Initial Decision should not affect the accounting firms' audits for the current financial year;
  • as readers may recall, in May 2013 the US Public Company Accounting Oversight Board, the China Securities Regulatory Commission (“CSRC”) and the Chinese Ministry of Finance entered into a Memorandum of Understanding on Enforcement Cooperation, providing for mutual assistance and the exchange of information to secure compliance with their respective securities laws. It is feasible that the SEC and the CSRC will cooperate further as regards the SEC's requests in this case;
  • there are already some signs that diplomacy may save the day. In the week after the Initial Decision and after various documents were produced by the CSRC, the SEC agreed to withdraw its action against Deloitte for alleged failure to comply with a subpoena in connection with its work relating to Longtop Financial Technologies Ltd.

- David Smyth, Senior Partner, Smyth & Co in association with RPC