How to Survive a Fight between Two Giants?

How to deal with a difficult situation that competent regulators in different jurisdictions have sent contradicting instructions? Deloitte Touche Tohmatsu Certified Public Accountants Ltd. (“Deloitte Shanghai”) located in Shanghai is in such a dilemma. This article will analyze this dilemma and explore the possibility of finding alternative dispute resolutions.

Facts of the case

Deloitte Shanghai is an accounting firm based in China and registered in the U.S. as a public accounting firm with the Public Company Accounting Oversight Board (“PCAOB”). Longtop Financial Technologies Limited (“Longtop”) is a NYSE-listed company with the principal place of business in Xiamen， China. Deloitte Shanghai served as Longtop’s auditor from 2007 until Deloitte Shanghai resigned in May 2011， when U.S. Securities and Exchange Commission (“SEC”) launched an investigation against Longtop due to fraud allegations. As a part of the Longtop investigation， SEC requested Deloitte Shanghai to produce its audit work papers on Longtop. However， Deloitte Shanghai submitted a letter to SEC， saying it was refusing to produce the required documents because， among other reasons， submission of any of the required documents may subject it to penalties under Chinese law. In September 2011， SEC filed an enforcement action against Deloitte Shanghai in U.S. federal court after Deloitte Shanghai failed to produce the required documents relating to the Longtop investigation.

In a separate case， on May 9， 2012， SEC announced another enforcement action against Deloitte Shanghai for its refusal to provide SEC with audit work papers related to an unidentified China-based company under investigation for potential accounting fraud against U.S. investors.

Case analysis

I Theory of SEC

Pursuant to Section 106 of the Sarbanes-Oxley Act of 2002 (“Sarbanes Act”)， as amended by Section 929J of the Dodd-Frank Wall Street Reform and Consumer Protection Act， if a foreign public accounting firm performs material services upon which a registered public accounting firm relies in the conduct of an audit or interim review， issues an audit report， performs audit work， or conducts interim reviews， the foreign public accounting firm shall(i) produce the audit work papers of the foreign public accounting firm and all other documents of the firm related to any such audit work or interim review to SEC upon request; and (ii) be subject to the jurisdiction of U.S. courts for purposes of enforcement of any request for such documents. Under Section 106(e) of the Sarbanes Act， a willful refusal to comply， in whole or in part， with any request by SEC under this section， shall be deemed a violation of the Sarbanes Act. According to Section 3 of the Sarbanes Act， a violation of the Sarbanes Act constitutes a violation of the Securities Exchange Act of 1934.

According to SEC， Deloitte Shanghai may be censured or denied the privilege of appearance and practice before SEC， since Deloitte Shanghai willfully violated Section 106 of the Sarbanes Act. In other words， if Deloitte Shanghai cannot deal with SEC’s document requests properly， it may be prohibited from providing auditing service to any companies which are or propose to be listed in U.S. capital market.

II Arguments of Deloitte Shanghai

Deloitte Shanghai’s major argument for denying production of audit work papers related to Longtop or other China-based companies is that it is prohibited from doing so by Chinese law. Without prior authorization and approval from several different Chinese regulatory authorities， Deloitte Shanghai cannot submit required documents to SEC. Chinese authorities have not consented Deloitte Shanghai’s production of the documents required by SEC. Under Chinese law， activities of transferring documents out of China are heavily regulated. An entity violating relevant rules may be subject to civil penalties or criminal penalties.

On October 20， 2009， China Securities Regulatory Commission(“CSRC”)， China’s securities market regulator， together with State Secrecy Bureau and State Archives Administration issued the Provisions on Strengthening Confidentiality and Archives Administration of Overseas Issuance and Listing of Securities (“Regulation 29”). Under the Regulation 29， if work papers created in China by securities companies or securities services institutions during the process of overseas issuance and listing of securities involve state secret， national security or vital interest， such work papers shall not be exported out of China via any methods without approvals of competent authorities. The Regulation 29 provides the principal legal basis supporting Deloitte Shanghai’s arguments.

China’s State Secrets Protection Law was first issued in 1988 and amended in 2010 (“State Secrets Law”). Under the State Secrets Law， no entity or individual shall send any material containing state secret out of China by mail or consignment， and shall not carry or transmit any material containing state secret out of China without approvals of competent authorities; otherwise， they shall be subject to administrative sanctions or criminal charges. China’s Criminal Law and the Supreme People’s Court’s criminal-related interpretations (“Criminal Law”) fur- ther enlarge the scope of information under the export prohibition. According to the Criminal Law， information that is not state secret but nonetheless is related to state security and interest (“Sensitive Information”) shall also be protected as the state secret. Any entity illegally providing state secret or sensitive information to overseas entities shall be criminally charged. As a financial software solutions provider， Longtop’s clients include some of China’s state-owned commercial banks. As such， Deloitte Shanghai’s audit work papers related to Longtop very likely fall within the scope of Sensitive Information. This is the other argument of Deloitte Shanghai.

III Potential resolutions

If Deloitte Shanghai is prevented by SEC from providing auditing service to any U.S.-listed companies， this case will constitute a terrible precedent unfavorable to other China-based accounting firms， which face the same dilemma as Deloitte Shanghai， as well as Chinese companies listed in U.S. stock market. As stocks of over 230 Chinabased companies have being traded on NYSE or Nasdaq， several Chinese accounting firms which are providing auditing service to these U.S.-listed companies may be adversely affected by such a precedent. Additionally， many China-based U.S.-listed companies may also face such problem， when they are under SEC’s investigation and requested by SEC to provide relevant sensitive documents. It is reported that unless a compromise can be reached by SEC and CSRC， SEC may forcibly delist Chinese companies currently listed on U.S. stock exchanges. The logic behind the foregoing speculation is stated as below. If China-based accounting firms are blocked from providing auditing service， the U.S. listed Chinese companies would be without auditors. Whereas an auditor is a requisite listing requirement in U.S. capital market， these Chinese companies may face delisting according to SEC rules. As such， Deloitte Shanghai case is of great significance and will have farreaching effects on Chinese and U.S. capital markets.

In essence， Deloitte Shanghai case reflects a conflict between the securities regulators of China and U.S. Actually， SEC and CSRC should try to develop a new relationship to increase both parties’ co-operation and collaboration through an enhanced bilateral dialogue. Taking lawsuits unilaterally obviously is not a good choice， although it may enhance SEC’s barging power at the negotiation table.

In July 2012， SEC said that it was in negotiations with CSRC to establish a framework for the production of documents from China-based accounting firms involved in SEC investigations. The results of such negotiations may have significant implications for the future of SEC investigations involving China as well as the regulatory cooperation between both parties. A Deloitte spokeswoman welcomed both parties discussion by saying， “we are pleased that the SEC and the CSRC are making progress in their discussions regarding the production of documents from China-based accounting firms and are hopeful that the two sides will be able to reach an agreement through diplomatic efforts”. Indeed， the diplomatic method might be the most efficient and practical way to solve this conflict.

IV Outlook

Although both parties’ negotiation is reportedly making progress， we should bear in mind that this is not the first time for SEC and CSRC to talk about the possibility of forming a joint regulatory framework on securities markets. China and U.S. have executed several documents， such as memorandums and joint announcements， while none of those documents created any binding obligations in connection with producing documents to securities market regulators of the other country. These historical records cast a shadow over the outcome of the Deloitte Shanghai case at issue.