By Anthony Phillips and Bing Zhang Ryan
In a welcome development for investors, the Securities and Exchange Commission is trying to force China-based affiliates of the “Big Four” accounting firms to disclose more information about their audits of clients who are later accused of fraud. The December 2012 SEC administrative action focuses on the auditors’ “work papers,” which until now they have refused to produce, citing Chinese laws aimed at protecting state secrets.
The administrative action names as defendants the China-based affiliates of Deloitte Touche, Ernst & Young, PricewaterhouseCoopers, KPMG and that of a fifth firm, BDO International. These firms have so far resisted all efforts to discover their audit material, creating a major hurdle for U.S. investors suing Chinese-based companies trading on U.S. exchanges.
As the Chinese economy boomed in recent years, stock offerings by Chinese companies to U.S. investors on American exchanges also exploded. U.S. enthusiasm for hot Chinese stock picks frothed as reports of rapid growth and high profits increased. In particular, between 2007 and 2010, more than 150 Chinese companies entered U.S. markets through “reverse mergers,” which allow private companies to quickly and cheaply access public stock exchanges by acquiring shell companies whose only asset may be an established public listing. The reverse merger process also subjects companies to far less regulatory scrutiny than a conventional IPO.
By 2011, this reverse merger trend gave rise to allegations of rampant fraud among many of the reverse merger companies whose inner workings lacked the transparency customary in American business. Some cases identified major discrepancies between earnings reported to the SEC and earnings reported to Chinese regulators. In others, large accounting firms resigned and withdrew their audit reports. In the most lurid cases, short sellers conducted and published investigations into Chinese companies replete with stories of fake factories, non-existent customers, and brazen self-dealing by insiders and related-parties. Litigation in American courts by aggrieved investors soon followed, peaking in 2011 with 31 U.S. lawsuits filed against Chinese reverse merger companies, then tapering in 2012, when only 10 new such lawsuits were filed.
Investors bringing suits against these Chinese companies faced serious challenges once the evidence-gathering discovery phase began. Most especially, the China-based affiliates of the international accounting firms responsible for auditing the defendant-companies doggedly refused to produce their work papers. They did this despite the fact plaintiffs had invested on U.S. stock exchanges, in companies that filed the disclosures required by the SEC, and had done so with the imprimatur of the major accounting firms.
Rather, the China-based accountants uniformly cited Chinese state secrets law in refusing to comply with U.S. discovery requests. Because of extensive state investment in and control over many Chinese companies, the Chinese government apparently considers even commonplace data and business information a potential state secret. Consequently, disclosure of internal corporate records and audit work papers to a foreign entity – even in response to a valid subpoena – is supposedly forbidden and may carry severe criminal penalties for entities and individuals caught doing so.
Moreover, the carefully segmented corporate structure of the “Big Four” accounting firms gave the auditors a further basis to resist producing discovery. While auditors often trumpet their global reach in marketing materials, when litigation arises, each entity suddenly becomes an island. As such, auditors routinely challenge subpoenas on grounds that the individual national offices of each audit firm operate as wholly independent entities, and argue that U.S.-based auditors cannot compel their China-based counterparts to cooperate and that American courts have little recourse against the business units based within their jurisdiction.
As with private plaintiffs, China-based auditors have stymied the SEC’s investigations into Chinese reverse merger companies by asserting the same state secrets defense. For example, in the case of Longtop Financial Technologies, Inc., the SEC commenced an investigation – prompted by the resignation of the company’s China-based auditor, Deloitte Touche Tohmatsu CPA, Ltd (“Deloitte Tohmatsu”). In May 2011, the SEC revoked Longtop’s U.S. registration and the company’s stock was delisted on the New York Stock Exchange. Deloitte Tohmatsu nevertheless resisted SEC subpoenas seeking the work papers from the audit it conducted on mainland China, arguing that doing so would violate Chinese law. The SEC brought a motion in the U.S. District Court for the District of Columbia to force Deloitte Tohmatsu to comply with the subpoena. That motion remains pending.
Unlike private plaintiffs, however, the SEC has additional powers it can bring to bear. In the administrative action, filed on December 3, 2012, the SEC accused the China-based auditors of violating Section 106(b) of the Sarbanes-Oxley Act, compromising its ongoing investigations into nine U.S.-traded companies with their principal places of business in China. Section 106(b) requires foreign public accounting firms to produce to the SEC any work papers prepared in connection with any audit report prepared for a publicly-traded company in the U.S.
An SEC victory in its administrative action could have severe repercussions for the defendants – up to and including “deregistration.” Deregistration would forbid the defendant-accountants from practicing before the SEC and from auditing U.S.-traded companies. Such a drastic outcome could severely impact not only Chinese companies seeking access to U.S. capital markets, but also American companies with significant Chinese operations, such as Apple and Qualcomm. According to The Wall Street Journal, approximately 126 U.S.-traded companies are now audited by one or other of the five China-based defendants.
Commentators predict the effect of the SEC’s action will most likely be renewed negotiation between the SEC and Chinese authorities to reach a compromise on disclosure of work papers. Whether private plaintiffs will enjoy the fruits of any accommodation between the regulatory counterparts remains to be seen. Nevertheless, the SEC’s firm stance in favor of protecting U.S. investors is a welcome development that hopefully signals a renewed commitment to bringing corporate fraudsters to justice wherever they may be. A decision in the administrative proceeding is expected by September 2013.
– January 31, 2013
Eds. Note: Anthony Phillips and Bing Zhang Ryan are attorneys who have litigated against Chinese entities, including in the LDK Solar Securities Litigation case, which alleged securities fraud claims against a China-based solar panel manufacturer. Discovery in that case included extensive efforts to subpoena work papers from the defendant’s China-based auditor, KPMG Huazhen, and depositions in China. Ms. Ryan is a native of Shanghai, China, who obtained a law degree in Beijing and speaks Chinese fluently in multiple dialects. She is a member of the Chinese American Lawyers of Bay Area, for which she will be making a keynote presentation on securities litigation risks for Chinese companies listed on the U.S. exchanges.