Global Accounting Firms Caught in the Crossfire as SEC
Fails to Reach Agreement with Chinese Regulators onDocument Sharing
December 10, 2012

OVERVIEWThe China affiliates of the biggest accounting firms in the world have been placed in realjeopardy due to the stalled negotiations between U.S. and Chinese regulators over document
sharing. On December 3, the U.S. Securities and Exchange Commission brought anadministrative proceeding against BDO China Dahua CPA Co., Ltd., Deloitte Touche Tohmatsu
Certified Public Accountants Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen (SpecialGeneral Partnership), and PricewaterhouseCoopers Zhong Tian CPAs Limited based on theirrefusal to produce audit work papers and other documents relating to Chinese companies
under investigation by the SEC. The accounting firms claim that their hands are tied because
their Chinese regulators have refused to authorize the document production. A decision infavor of the SEC could result in these Chinese affiliates being denied the ability to appear andpractice before the Commission, rendering it difficult for Chinese companies who rely on theirservices to list on American exchanges, and ultimately hindering the competitiveness of U.S.
markets.

CATCH-22 FOR ACCOUNTING FIRMS
Last week’s administrative proceeding brings to a head a simmering dispute between public
accounting firms operating in China and the SEC. The conflict first surfaced in September 2011,
when the SEC brought a federal court action to compel Deloitte Touche Tohmatsu CPA Ltd.
(“DTTC”) to comply with a subpoena calling for the production of documents relating to one ofits clients, Longtop Financial Technologies Limited, a Chinese company that the SEC latercharged with failing to provide current and accurate financial reports. In court papers, DTTC
argued that producing the requested documents would run afoul of Chinese law and could
result in Chinese regulators dissolving the firm entirely and seeking prison sentences up to life
in prison for any partners and employees who participated in the violation. In July 2012 theSEC sought a six month stay of the action to permit it to continue ongoing discussions with theChina Securities Regulatory Commission (“CSRC”) regarding cross-border enforcement
cooperation.
Last week, it became apparent that the SEC’s negotiations with the CSRC over document
sharing had broken down. In addition to instituting the administrative proceeding against thefive Chinese accounting firms, the SEC also filed a motion to lift the stay in its federal court
action against DTTC. In its brief, the SEC disclosed it had reached an impasse with the CSRC,
accusing the Chinese regulator of being “unwilling or unable to provide the SEC with

Memorandum – December 10, 2012

meaningful assistance in its enforcement investigations.” The SEC made plain that going
forward it will seek production directly from Chinese audit firms in connection with its
investigations of Chinese issuers.

UNCHARTERED LEGAL TERRITORY
The law in this area is quite unsettled. The December 3 administrative proceeding was brought
under Section 106(b) of the Sarbanes-Oxley Act of 2002, which directs a foreign public
accounting firm that issues an audit report, performs audit work, or conducts interim reviews toproduce its audit work papers and other documents related to its audit work to the Commission
or Public Company Accounting Oversight Board (“PCAOB”) upon request. In the first decade
after Sarbanes-Oxley was enacted, the Commission never brought an enforcement action underSection 106. Then, in May of this year, the SEC instituted a first-of-its kind administrative
proceeding against DTTC under Section 106. The SEC alleged that DTTC had refused toprovide the agency with audit work papers relating to an unidentified China-based company
under investigation for potential accounting fraud. That proceeding is separate from both thesubpoena enforcement action filed in federal court against DTTC last year in connection with
the Longtop investigation and last week’s administrative proceeding against DTTC and the fourother Chinese accounting firms. There has been no reported decision in the earlier Section 106
proceeding.
Adding to the complexity are the amendments to Section 106 contained in Section 929J of theDodd-Frank Wall Street Reform and Consumer Protection Act. Among other additions, DoddFrank added a subsection (f) to Section 106 under which the SEC “may allow a foreign public
accounting firm…to meet production obligations under this section through alternative means,such as through foreign counterparts of the Commission or the [PCAOB].” DTTC has argued in
the federal court action that Congress intended for this subsection to alleviate the burden offirms trying to mediate the competing demands of the SEC and their home regulators.
However, the SEC has taken the position that the statute’s inclusion of the term “may” meansthat it is not required to work through foreign regulators to obtain audit papers. Considering
the current lack of cooperation between the SEC and the CSRC, it seems unlikely that the SEC
will view cooperation with the CSRC as a viable option for the foreseeable future. In addition,Section 929J amended Section 106(b)(1)(B) to make clear that U.S. courts have jurisdiction overforeign public accounting firms for enforcement of any SEC or PCAOB document requests.
As DTTC has done in the federal court action, the accounting firms are likely to invoke
principles of international comity to defend against the administrative proceeding. Where there
is a conflict of laws, courts generally weigh a number of factors to determine which law willcontrol, including evaluating the competing interests of each state in enforcing its laws, thehardship imposed on the accounting firms if the U.S. law is enforced, and whether the SEC has
an alternative means of obtaining the documents sought by the subpoena. The outcome of thisbalancing test, as applied to these facts, is not clear.

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Memorandum – December 10, 2012

In general, the balancing of competing state interests is considered the most important factor in
a comity analysis. While the case law in this area is still developing, courts typically find theU.S. interest in regulating corporations traded on domestic exchanges and ensuring theintegrity of its financial markets to be important. However, courts can also be sensitive to thedictates of non-U.S. laws, particularly when the likelihood of enforcement of such laws is
relatively high and the consequences of violating such laws are relatively severe. Courts also
seem to be particularly sensitive to the difficulties faced by non-parties that are caught up in
U.S. litigation and/or investigations while simultaneously being subject to non-U.S. law.
The accounting firms may also challenge the SEC’s calculated decision to bring a public
administrative proceeding under Rule 102(e)(1)(iii) of the SEC’s Rules of Practice. The SEC
likely chose to proceed in this setting because an administrative law judge (ALJ) has the power
under Rule 102(e)(1)(iii) to prohibit the accounting firms from continuing to practice before theSEC. This carries a bigger stick than a subpoena enforcement action in federal court. But thestandard is also higher. The ALJ must find there to have been a “willful” violation of thesecurities laws. Although the SEC generally has adopted a broad interpretation of the term
“willful,” there may be a defense in this case that the accounting firms acted under compulsion
and duress as a result of the severe sanctions they faced from Chinese regulators if they
complied with the SEC’s document requests. In addition, even if the ALJ finds there to havebeen a willful violation of the securities laws, the ALJ has discretion to impose a less severe
sanction, including censuring the accounting firms or a time-limited bar from practicing beforethe Commission. It is interesting to note that each of the Big Four and BDO’s China affiliates
put securities regulators on notice when they initially registered with the PCAOB and stated intheir registration forms that they may not be able to comply with any future document requests
due to conflicting Chinese laws. In addition to highlighting this issue, none of the firms signed
the form’s consent to comply with future document production requests, notwithstanding thatsuch a consent is a condition to registration with the PCAOB. Despite this, the PCAOB
approved all five audit firms for registration.1 Should the ALJ find a willful violation, perhaps
his or her discretion regarding sanctions will be impacted by the five firms having highlighted
this issue at the time of their initial PCAOB registrations.
Finally, there may be jurisdictional and service related defenses available to the accounting
firms. As mentioned above, Section 106(b)(1)(B) of Sarbanes-Oxley mandates that foreign
accounting firms be subject to the jurisdiction of the “courts of the United States.” However, theDecember 3 filing instituted a public administrative proceeding, not a U.S. court action.
Similarly, with respect to the validity of service, the Order instituting the administrative
1Perhaps the PCAOB permitted registration of the audit firms despite these issues because it
viewed Section 21(b) of the Exchange Act as broad enough to reach foreign auditor work papers
even if the firms did not consent to compliance with Section 106(b) and the PCAOB’s production
requirements. Section 21(b) permits the SEC to take a variety of actions in connection with its
general investigative powers, including compelling production of documents. Indeed, the SEC
instituted the federal court action against DTTC pursuant to Section 21(b) rather than Section
106(b), arguing that long before Sarbanes-Oxley and Dodd-Frank, it had authority under Section
21(b) to compel production of documents. DTTC argues Section 21(b) does not extend todocuments located outside the U.S. and that only Section 106 can reach them.

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Memorandum – December 10, 2012

proceeding specified a number of methods through which the firms could be served but it
remains to be seen whether service can be perfected.

IMPLICATIONS
The administrative proceeding filed on December 3 may have significant ramifications forChinese companies doing business within the U.S. The largest and most important Chinesecompanies would be forced to scramble to replace their auditors if the China affiliates of the Big
Four accounting firms are prohibited from practicing before the SEC. Moreover, any
replacement auditors would likely face the same competing demands from U.S. and Chinese
regulators in future investigations. As such, it is not beyond the realm of possibility that someof these companies would reconsider the feasibility and attractiveness of their U.S. listings andturn to foreign exchanges. This could especially be the case if the ALJ finds a willful violation ofsecurities laws in the SEC’s administrative action and a similar finding by the PCAOB follows,which could result in the revocation of the audit firms’ registration with the PCAOB. The SEC
Division of Corporate Finance’s Financial Reporting Manual notes that it is the SEC’s view that
financial statements previously audited by a de-registered firm, even those of companies notunder SEC investigation, would need to be re-audited by a registered firm to be included infuture filings. Alternatively, it is possible that the SEC may provide some administrative
accommodation for Chinese companies that have not been the target of SEC investigation but
whose registered public accountants have nonetheless been de-registered. For example, in thewake of the 2002 criminal indictment of Arthur Andersen LLP, the SEC instituted temporary
rules to give certain of Arthur Andersen’s auditing clients time to address the temporarydisruptions they faced due to the loss of their registered public accountant, while still ensuring
investors would be provided with the timely financial information required under the federal
securities laws.
Also placed in jeopardy by last week’s filing are the well established mechanisms traditionallyused by the SEC to obtain documents in other countries, including through the use ofmultilateral, bilateral, and ad-hoc agreements. It undeniably takes substantial time and effort toproceed through the proper judicial channels. Should the SEC be successful in overridingChinese law in this instance to demand document production directly from the accounting
firms, the SEC may be emboldened to bypass foreign regulators in the future in favor ofemploying aggressive tactics on the firms themselves.

CONCLUSION
The failure of the SEC and CSRC to reach an agreement on document sharing is unwelcome
news for everyone involved. We hope that the regulators can return quickly to the negotiatingtable and reach a compromise that enables the SEC to obtain the documents it needs for its
current investigations. In the long term, it is clear that there needs to be a comprehensive anddurable framework through which audit work papers and other documents maintained byaccounting firms based in China can be accessed by the U.S. regulator.

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Memorandum – December 10, 2012

For further information, please contact:
Peter H. Bresnan
202-636-5569
pbresnan@stblaw.com

Leiming Chen
+852-2514-7630
lchen@stblaw.com

Alexis S. Coll-Very
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Paul C. Curnin
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Daniel Fertig+852-2514-7660
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Nicholas Goldin
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ngoldin@stblaw.com

William H. Hinman, Jr.
650-251-5120
whinman@stblaw.com

James G. Kreissman
650-251-5080
jkreissman@stblaw.com

Joshua A. Levine212-455-7694
jlevine@stblaw.com

Chris K.H. Lin+852-2514-7650
clin@stblaw.com

Jin-Hyuk Park+852-2514-7665
jpark@stblaw.com

Cheryl J. Scarboro
202-636-5529
cscarboro@stblaw.com

Mark J. Stein
212-455-2310
mstein@stblaw.com

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Page 5Memorandum – December 10, 2012

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