(This ACFCS.org story is adapted from an article in the February 2013 International Enforcement Law Reporter, published by attorney Bruce Zagaris. A partner at Berliner, Corcoran & Rowe, in Washington, DC, Mr. Zagaris is member of the ACFCS Advisory Board and a leading world expert on international tax, treaties, and financial crime matters.)
The obstacles US regulatory and enforcement agencies face when they are investigating financial crime that originates in another country are highlighted in the action the US Securities and Exchange Commission commenced on December 3, 2012.
The SEC formally launched administrative proceedings against the China-based affiliates of Big 4 and other large accounting and consulting firms for refusing to produce audit work papers and other records related to China-based companies that it is investigating for possible accounting fraud against US investors.
The SEC charged BDO China Dahua Co. Ltd., Deloitte Touche Tohmatsu Certified Public Accountants Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian CPAs Limited with violating the Securities Exchange Act and the Sarbanes-Oxley Act. These laws require foreign public accounting firms to provide the SEC, upon request, with audit work papers involving any company trading on US markets.
Audit firms refused to provide workpapers to SEC
The SEC’s order alleges that its investigators for several months have attempted to obtain audit materials and other documents from these firms as part of investigations into potential wrongdoing by nine China-based companies, whose securities are publicly traded in the US. The firms have refused to cooperate in the SEC investigations.
Robert Khuzami, Director of the SEC’s Division of Enforcement, has said the SEC can test the quality of the underlying audits and protect investors from the dangers of account fraud only when it has access to the work papers of foreign public accounting firms.
An administrative law judge will hear the dispute and determine if sanctions against the firms are appropriate.
The SEC action is part of an initiative that addresses issues that have arisen from reverse mergers and foreign issuers. Through the work of a Cross Border Working Group, the SEC has deregistered the securities of nearly 50 companies and filed fraud cases related to more than 40 foreign issuers and executives.
China-based audit firms also under SEC pressure
The SEC’s Enforcement Division has also taken a series of actions against China-based audit firms. In 2012, the SEC announced an administrative proceeding against Shanghai-based Deloitte Touche Tomatsu for refusing to produce documents in an SEC investigation of one of its China-based clients. The proceeding is ongoing. Previously, the SEC initiated a federal enforcement action against the firm for failing to produce documents in response to a subpoena pertaining to its longtime client, Longtop Financial Technologies Ltd.
In a separate administrative proceeding against Longtop, an administrative law judge found that it was delinquent in its reporting obligations and ordered the securities registration of Longtop to be revoked.
The action was coordinated by the Cross Border Working Group and involved various SEC investigative teams in Washington, DC, Boston, New York, Fort Worth and Los Angeles.
The accounting firms that are the subject of the most recent SEC action say they were cooperating with regulatory authorities, but must obey conflicting Chinese laws. The potential stakes for them are high. The firms could be prohibited from practicing before the SEC temporarily or permanently.
Chinese businesses use ‘reverse mergers’ to attract investment
In recent years, many Chinese-based businesses have raised money in the US through so-called reverse mergers. These listings, which permit companies to go public without the high costs and regulatory scrutiny of traditional offerings, have been popular with investors.
These companies have also come under more frequent investigations and investors have lost billions of dollars on the stocks. The SEC has deregistered the securities of almost 50 Chinese-based companies and has filed 40 related fraud cases.
Increasingly, the SEC and other regulators are focusing on the auditors, but the SEC, the US Public Company Accounting Oversight Board, China’s Ministry of Finance, and the China Securities Regulatory Commission have been unable to resolve differences over the inspection of audit documents. Chinese law prohibits the removal from China of audit papers and does not allow foreign regulators to work or operate in China.
Canadian regulator also questions a Big 4’s work on Chinese company
In Canada, the Ontario Securities Commission accused Ernst & Young’s Canadian affiliate of failing to detect problems concerning its disclosures during its audit of Sino-Forest Corp., a timber company that filed for bankruptcy protection in 2012. The Ernst & Young Canadian affiliate agreed to pay about $118 million to settle separate shareholder allegations that it misled Sino-Forest investors. It was the largest settlement ever paid by an auditor in Canadian history.
The Ontario Securities Commission alleged that Ernst & Young did not exercise sufficient objectivity and thoroughness in its audits of Sino-Forest to verify the ownership and existence of the company’s most significant assets.
Sino-Forest was a large forest-product companies listed in Canada, when a 2011 report by U.S. short-seller Muddly Waters LLC alleged it had engaged in fraud. The Ontario Securities Commission started administrative proceedings against Sino-Forest. Several of its former executives already face charges by the commission that they inflated timber purchases. They deny they committed fraud.