As U.S. regulators press forward with their pursuit of access to documentation from audits conducted in China, public companies with units or subsidiaries there are becoming concerned that they won't be able to meet their bedrock requirement to file audited financial statements if regulators in both countries don't resolve the standoff.

Currently China prohibits audit firms there from providing audit work papers to any regulator outside of China. At the same time, audit firms operating in U.S. capital markets are required to hand over to the Securities and Exchange Commission or the Public Company Accounting Oversight Board audit work papers on demand, under the Sarbanes-Oxley Act. The two laws are at odds, forcing audit firms to decide which countries' laws it will follow. The SEC signaled in December that it is losing hope for an agreement with government officials in China to resolve the conflict.

If U.S. officials can't somehow convince China to grant access to evidence behind the accounting that is relied on in U.S. capital markets, regulators could bar the China affiliates of Big 4 and other leading global audit firms from practicing before the SEC.

The conflict simmered over several years as the PCAOB sought access to China-based, U.S.-registered audit firms to perform routine regulatory inspections. It came to a head, however, as the SEC began investigating accounting irregularities arising from China-based U.S. registrants, most notably Longtop Financial, audited by Deloitte Touche Tohmatsu in Shanghai. The SEC demanded Deloitte's work papers on Longtop, and Deloitte refused, citing Chinese laws that would potentially result in criminal penalties and prison time for Deloitte auditors.

The SEC expanded the hunt in early December when it renewed its proceedings with Deloitte, which had been halted for several months while negotiating a diplomatic solution, and began administrative proceedings against affiliates of PwC, Ernst & Young, KPMG, and BDO. An administrative law judge will hear evidence and determine appropriate sanctions against the firms, which could include bars from practicing before the SEC. The SEC has already deregistered the securities of nearly 50 companies and filed fraud charges against more than 40 issuers and executives to address concerns about reverse mergers and foreign issuers.

Most legal experts are counting on a diplomatic solution to the audit regulatory standoff between the United States and China, but few can envision what kind of agreement could possibly satisfy both countries' interests. “These audit firms are between a real rock and a hard place,” says Trace Schmeltz, a corporate securities attorney with Barnes & Thornburg. “I don't think you can have it both ways,” he says, meaning it's hard to imagine how audit firms can continue to operate in both China and the Unites States in the long term under their current conflicting laws.

Jay Hanson, a board member at the PCAOB, said at a December accounting conference that the difficulty with negotiations so far is that the United States is making all the demands but has little to offer in return. “China doesn't want anything from us,” he said. Chinese officials so far seem unfazed by the SEC's delisting, most of which were small, development-stage companies that entered U.S. markets through reverse mergers.

“The history over the past 10 years has been to accept most Chinese violations with minor protests or pursue them with weak options. We have not taken a tough stance with China for fear of losing access to a very large future market.”

—Richard D'Aveni,


Dartmouth College

That likely prompted the SEC to file its recent batch of administrative proceedings, which could lead to bars against the audit firms, and begin signaling that it is considering more delistings, says Thomas Shoesmith, a partner with law firm Pillsbury whose practice focuses on corporate transactions involving China. “The SEC is understandably pretty frustrated,” he says. “As it makes more public noise about its frustration, that often has the effect of breaking some movement in negotiations.” He believes as long as officials in China perceive they can continue to do business without consequence, they will not make any serious moves to answer the SEC's concerns. And if China agrees to any kind of concessions, it will likely happen only if there's a way for China to save face and appear to surrender no sovereignty, he says.

No Clear Solutions

Richard D'Aveni, professor at Dartmouth College, says the United States doesn't have a strong track record of making and winning demands with China. “The history over the past 10 years has been to accept most Chinese violations with minor protests or pursue them with weak options,” he says. “We have not taken a tough stance with China for fear of losing access to a very large future market.”

As D'Aveni sees the situation, China holds much more leverage over the United States. China holds a good portion of the United State's debt load, and U.S. companies are generally protective of China because they see it as a massive growth market, he says. D'Aveni also believes public companies aren't eager to see their audit work papers get into the hands of U.S. regulators for fear of what they might reveal. “If they start getting work papers on Chinese companies, soon they'll start asking for the work papers of Chinese divisions of American companies,” he says. “I'm sure the accounting is just as bad.”


What follows is an excerpt from the administrative proceeding against Deloitte Touche Tohmatsu outlining what steps the SEC has taken in order to obtain audit work papers from D&T Shanghai.

1. Beginning in April 2010, Commission staff has made extensive efforts to obtain D&T Shanghai's audit work papers connected to the firm's independent audit work for an issuer-client (“Client A”) in relation to a Commission investigation into potential accounting fraud.

2.On April 9, 2010, staff served Deloitte, the U.S. member firm of the Global Firm with a subpoena requesting audit work papers relating to the Global Firm's audit of Client A's financial statements for the period Jan. 1, 2008 through April 9, 2010.

3.Between April 13, 2010 and May 18, 2010, staff had several communications with U.S.-based counsels for both Deloitte and the Global Firm.

4.Counsel for Deloitte initially informed the staff that Deloitte did not perform any audit work for Client A, that all audit work was conducted by Respondent, and that Deloitte did not have possession, custody, or control of the documents called for by the subpoena.

5.Counsel for Deloitte subsequently informed the staff that Deloitte performed some review work of Client A's periodic reports and produced certain documents relating to this review to the staff.

6.Counsel for the Global Firm informed the staff that the request for audit work papers, as contained in the staff's April 9th subpoena, had been communicated to Respondent, but that Respondent would not produce the relevant audit work papers because of Respondent's interpretation that it was prevented from doing so by PRC law.

7.Commencing in June 2010, Commission staff sought to obtain the relevant audit work papers through international sharing mechanisms, however, these efforts have been unsuccessful.

Source: SEC.

Schmeltz believes the SEC might be bold enough to take serious action against at least one firm, likely Deloitte since it was the first pursued, to send a signal. “If you're a Deloitte client (in China), you're going to have to find another auditor,” he says. “That's where this is going to go.” He believes companies in China would be wise to hire a new auditor, one listed with the PCAOB but not operating in China to eliminate China's control over the work papers. “I don't know under Chinese regulations and laws whether that's even feasible,” he admits. “Can one go in with computerized audit records and get on a plane and fly them back out?”

Jim Feltman, senior managing director at Mesirow Financial Consulting, says hiring a new auditor won't solve the problem. “There are only a handful of firms that can do the heavy lifting for the large enterprises,” he says. He believes the standoff will be resolved with some kind of legal workaround for U.S.-listed companies in China, perhaps establishing a new way for China-based companies to operate in the United States.

Terence Healy, a partner at law firm Reed Smith and former litigator for the SEC, says it's hard to imagine Chinese officials will back down on their protection of audit work papers, so the SEC has no choice but to pursue the “nuclear option.” He agrees that there's likely not enough audit talent to be found that's not currently ensnared in the present legal conflict, even if there were a way for such auditors to operate without running afoul of China's protection over audit work papers. “The hope of everyone is that there can be some kind of diplomatic solution,” he says.