Judge Suspends Chinese Units of Big Four Auditors; Ruling Bars Firms From Audit Work for Six Months

Judge Suspends Chinese Units of Big Four Auditors
Ruling Bars Firms From Audit Work for Six Months
MICHAEL RAPOPORT
Updated Jan. 22, 2014 8:47 p.m. ET
The Chinese units of the Big Four accounting firms should be suspended from auditing U.S.-traded companies for six months, a judge ruled, a move that could complicate the audits of dozens of Chinese companies and some U.S.-based multinationals.
The audit firms, plus a fifth China-based accounting firm, broke U.S. law when they refused to turn over documents about some of their clients to the Securities and Exchange Commission to aid the commission in investigating those U.S.-traded Chinese companies for possible fraud, ruled Cameron Elliot, an SEC administrative law judge.
Judge Elliot’s ruling Wednesday doesn’t take effect immediately, and the firms can appeal the ruling, first to the commission itself, then to the federal courts. But if the ruling stands, it could temporarily leave more than 100 Chinese companies that trade on U.S. markets without an auditor. It also could throw a monkey wrench into the audits of U.S. multinational companies that have significant operations in China, because the Chinese affiliates of the Big Four—PricewaterhouseCoopers, Deloitte Touche Tohmatsu, KPMG and Ernst & Young—often help their U.S. sister firms complete those audits.
Without audited financial statements, a company can’t sell securities in the U.S. or stay listed on U.S. exchanges.
“This is a body blow to the Big Four,” said Paul Gillis, a Beijing-based professor at Peking University’s Guanghua School of Management. “It’s really quite a harsh ruling.”
The ruling will be inconvenient for the companies those Chinese firms audit, said Jacob S. Frenkel, a former SEC enforcement attorney now in private practice. It is a middle ground, he said. The judge could have gone further and permanently barred the Chinese firms from issuing audit reports on U.S.-traded companies, as the SEC had requested and as the accounting industry had feared.
In a joint statement, the Big Four firms in China called the judge’s decision “regrettable” and said they would appeal. “In the meantime the firms can and will continue to serve all their clients without interruption.”
The SEC said it was gratified by the ruling and that it upholds the commission’s authority to obtain records that are “critical to our ability to investigate potential securities law violations and protect investors.”
The fifth firm, Dahua CPA, was censured by Judge Elliot but not suspended. Dahua was an affiliate of another large accounting firm, BDO, until last April, but the two are no longer affiliated.
The SEC had sought audit work papers from the firms to assist its investigations of some of the 130-plus Chinese companies trading on U.S. markets that have encountered accounting and disclosure questions in the past few years. Many of those companies have their independent audits performed by the Chinese affiliates of the Big Four, and the SEC had wanted to know more about what the auditors had found about the companies. (All the major accounting firms are international networks made up of individual, free-standing firms in each country in which they do business.)
But the Chinese firms refused to turn over the documents. They said their hands were tied, as Chinese law treats the information in such audit documents as akin to “state secrets.” The firms said their auditors could be thrown in jail if they cooperated with the SEC without the Chinese government’s blessing.
That led the SEC to file an administrative proceeding against the five firms in December 2012, arguing that U.S. law compels the firms to cooperate with such requests.
The judge agreed, saying the firms “have failed to recognize the wrongful nature of their conduct” and showed “gall” in complaining that complying with the SEC’s demands would hurt them. The firms knew when they registered with U.S. regulators and built their businesses in China that they might ultimately be put between a rock and a hard place in providing documents, the judge said.
The judge wasn’t deterred by an agreement last year between the U.S. and Chinese governments that somewhat alleviated the stalemate over documents, by allowing some documents from the audit firms to come to the U.S. after they were funneled through Chinese regulators. Since July, documents the SEC had sought relating to at least six companies have either been provided to U.S. regulators or were “in the pipeline” to be provided, the audit firms said in filings in November and December.
The five Chinese firms involved in the case have a total of 103 U.S.-traded companies that they audit or in which they played a substantial role in the audit, according to their 2013 annual reports filed with U.S. regulators. The companies might have to make other arrangements for audits if their firm is suspended during the period when their yearly audit is being performed.
The potential effect on U.S. multinationals is less clear, because most multinationals don’t specify when a Chinese affiliate or other foreign audit firm contributed to their audit, though a pending proposal from U.S. regulators would require them to do so. KPMG Huazhen, KPMG’s Chinese affiliate, indicated in its annual report with U.S. regulators that it had participated in the audits of U.S.-based companies like Yum Brands Inc. and SanminaCorp. SANM +0.44% by auditing Chinese subsidiaries of the companies. Yum and Sanmina couldn’t immediately be reached for comment.