March 6, 2015

More on “SEC v. China: Tug-of-War Over Audit Files Finally Ends!”

Recently, I blogged about how the China-based affiliates of the Big 4 (Deloitte Touche Tohmatsu, Ernst & Young, KPMG and PwC) settled SEC administrative charges by each paying $500k and admitting that prior to the commencement of the agency’s enforcement proceedings, they didn’t provide the SEC with the work papers for audits conducted for US companies. Here’s some thoughts from Baker & McKenzie’s Dan Goelzer on the settlements:

While the settlement is a victory for the SEC in the sense that it results in findings that the four firms violated the law and imposes sanctions against them, as a practical matter, the settlement seems to vindicate the firms’ position. In the future, a firm’s obligation in the event of an SEC work paper request will be to provide the work papers to the Chinese authorities, who will then make the final decision as to what should be provided to the SEC. This approach seems to acknowledge that the firms need not violate Chinese law in order to comply with Section 106, just as the firms had argued.

From a public company audit committee perspective, the significance of the settlement is that it removes the risk that the Big Four might be unable, for some period of time, to perform audit work in China, thus complicating the ability of SEC-registered companies with operations in China to complete their audits. However, the settlement leaves unresolved the issue of PCAOB inspections of China-based accounting firms. Unless and until the Chinese government consents to PCAOB inspections in China, the risk remains that the China firms will be de-registered by the PCAOB and that audits of U.S. public companies with operations in China will be disrupted.

In comparison, this WSJ editorial – and piece from the “China Accounting Blog” thinks that the SEC caved; here’s an excerpt:

I believe that the SEC went after the Big Four firms intending to use the lawsuit as a way to coerce China to the negotiating table. The Big Four are not the problem with the widespread fraud that has plagued US listed Chinese companies. The problem, of course, is corrupt company officials. The firms should have done a better job vetting new clients, and have faced challenges with adapting audit processes to Chinese business practices. The explosive growth of these firms has left them short of experience – especially with inadequate numbers of “no-hair, gray haired” partners with well-seasoned judgment. In my opinion, the Big Four are doing their best in a difficult market, and because of the failure of the SEC and PCAOB to effectively regulate US listed Chinese companies, the Big Four are the only meaningful line of defense for investors.

In my view, banning the Big Four was never the objective of the SEC. The suit was a way to show Chinese regulators that the SEC was willing to deploy the “nuclear option” of kicking Chinese companies off U.S. exchanges. The SEC apparently believed that the threat of delisting Chinese companies would bring Chinese regulators to the negotiating table. The SEC miscalculated and Chinese regulators called their bluff. In the end, banning the firms, which would lead to a mass delisting of Chinese companies from US exchanges, was simply a step too far for the SEC to take. I am sure the SEC was heavily lobbied by US investment banks, lawyers, and accounting firms that have lucrative business interests in keeping capital flowing.

So today we have different rules for Chinese companies that list in the US than we have for others. Not only is the SEC dependent on Chinese regulators to decide what documents they can see, the PCAOB remains unable to conduct inspections of auditors. But the different rules go beyond auditing. Other rules, like Regulation Fair Disclosure, do not apply to US listed Chinese firms, creating an unfair market for investors.

My Ten Cents: Alternative Careers for Lawyers

My ten cents is included in this piece entitled “Alternative Careers for Lawyers” from the “ABA Law Journal”…

The SEC Totally Cares About Its Injunctions

In this blog, David Smyth does an about-face from his other blog on the topic of how the SEC handles injunctions. I can relate as blogging sometimes tests your mettle as its challenging to think of all the possible permutations about a topic when writing about it. Here’s an excerpt from the new blog:

Last week I wrote a post discussing the injunctions the SEC typically obtains against defendants in federal court. I noted the oddity of these obey-the-law injunctions and wondered aloud why the Commission never pursues findings of contempt when those defendants disobey the very provisions they were ordered never to disobey again.

In a comment to the post, Robert Knuts noted “[t]wo simple reasons. 1. A permanent injunction triggers potential collateral consequences under various provisions of the Federal securities laws. 2. If such a recidivist went to trial, the violation of the prior injunction would likely lead to maximum civil penalties.”

These are both probably true. The first certainly is. Especially for large financial institutions, limiting and avoiding the collateral consequences of SEC injunctions and other regulatory sanctions can be almost its own practice area. I had meant to mention this in the original post and forgot in the late night fog of composition. As for the second, I don’t have supporting data, but violation of prior injunctions certainly wouldn’t be helpful to a defendant in a second go-round with the SEC in federal court. So the original injunction would have value to the Commission in that respect.

– Broc Romanek