Foreign-listed China-based companies and multinationals with significant operations in China should take note of the conflict involving the audit work papers underlying the financial statements of China-based companies listed overseas and China’s State Secrecy Laws.
As a result of the Chinese units of the Big Four accounting firms refusing to provide audit work papers for fear of violating China’s State Secrecy Laws, a U.S. Securities and Exchange Commission (“SEC”) administrative law judge on Jan. 22, 2014, issued an order suspending the Chinese units of the Big Four accounting firms
The resolution of this question of regulatory access to China-based entities that tap the U.S. or Hong Kong capital markets will have an impact on the numerous China-based public companies listed in the U.S. and Hong Kong markets and global multinationals that have significant operations in China.
The evolution of this conflict is described in the timeline below.
- 2007 – 2010 — Wave of Chinese companies listing in the U.S. via reverse mergers.
- September 8, 2011 — SEC filed a subpoena enforcement action (the “Deloitte Enforcement”) against Deloitte Touche Tohmatsu CPA Ltd. (“Deloitte”) related to its work on the audit of the financial statements of China-based Longtop Financial Technologies Limited (“Longtop”).
- August 27, 2012 — The Hong Kong SFC sued Ernst & Young’s Hong Kong branch (“EY”) demanding that EY hand over certain audit work papers of Standard Water Limited, a China-based company that had attempted to list on the Hong Kong Stock Exchange.
- September 21, 2012 — The China Securities Regulatory Commission (“CSRC”), the Ministry of Finance of China (“MOF”) and the Public Company Accounting Oversight Board of the United States (“PCAOB”) reached a preliminary agreement regarding the handling of audit data. This preliminary agreement would allow the PCAOB to have periodic observational visits to China, but no permission to conduct on-site inspections of Chinese audit firms that audit U.S. public companies.
- December 4, 2012 — The SEC brought an administrative proceeding against the Chinese branches of the Big Four accounting firms as well as BDO International, Ltd. (“BDO”) for their refusal to turn over audit work papers related to ongoing SEC investigations or enforcement actions of China-based companies listed in the U.S.
- May 7, 2013 — The CSRC, the MOF and the PCAOB signed a Memorandum of Understanding on Enforcement Cooperation (“MOU”). This MOU set up a preliminary mechanism for exchanging documents and information between the parties during enforcement situations.
5According to the MOU, audit work papers held by audit firms can be provided to the PCAOB and shared with the SEC as long as the PCAOB first requests assistance from the MOF and the CSRC and follows certain procedures. 6However, routine inspections of audit firms by the PCAOB in China are not covered by this MOU.
- January 23, 2014 — Pursuant to the December 4, 2012, administrative proceeding, an SEC administrative law judge issued an order suspending the Chinese units of the Big Four accounting firms for six months (“Suspension Order”). The Big Four accounting firms appealed.
- January 27, 2014 — The SEC dismissed the Deloitte Enforcement against Deloitte for its failure to surrender audit work papers and other documents related to the SEC’s investigation into Deloitte’s former audit client, China-based Longtop.
- April 21, 2014 — The MOF promulgated the Interim Provisions on the Cross-Border Implementation of Audit Business by Accounting Firms (Draft for Comments) (“MOF Interim Provisions”) for public comment.
- May 9, 2014 — The SEC granted the Big Four accounting firms’ petition for review of the Suspension Order, together with a leave to adduce additional evidence.
- May 23, 2014 — A Hong Kong Court of First Instance rejected EY’s argument that China’s State Secrecy Laws prevented it from handing over information to the SFC and ordered that it do so.
- July 1, 2014 — The SEC barred EFP Rotenberg LLP, a New York accounting firm, and its partners from auditing U.S.-traded companies based in China. This appears to be the first time the SEC has imposed such a targeted ban, specifically aimed at the auditing of Chinese companies.
In 2007, reverse mergers became popular among Chinese companies as a short cut to become listed public companies in the U.S. From 2007 to 2010, 159 China-based companies listed in the U.S. through the reverse merger process.
During this period, both the SEC and the PCAOB experienced significant difficulties in inspecting relevant audit work papers from China-based issuers, and they sought assistance from the Chinese regulators, the MOF and the CSRC, with little success. The Big Four accounting firms refused to turn over audit work papers, despite being required to under the Sarbanes-Oxley Act of 2002 (“SOX”), claiming that doing so would violate China’s State Secrecy Laws.
This conflict ultimately led to the suspension ruling for a period of six months under the SEC administrative law proceeding against the Big Four accounting firms and BDO in January 2014, and the Big Four accounting firms and BDO appealed. Suspending an accounting firm for six months means that it cannot perform audit work on any U.S.-listed entities. That would leave an estimated 200+ China-based entities without an audit firm, and may impact how U.S.-listed multinationals with significant operations in China conduct their global audits.
As compared to the U.S., many more China-based companies are listed on the Hong Kong Stock Exchange. Therefore, it is not surprising that the SFC encountered the same difficulties as the SEC when trying to exert similar regulatory oversight on the financial reporting of China-based companies listed in Hong Kong. The SFC also resorted to litigation after multiple unsuccessful requests for information. On August 27, 2012, the SFC filed suit against EY to compel it to produce certain accounting work papers and records of Standard Water, a company that attempted to list in Hong Kong. EY argued that it was prevented from turning over such accounting work papers due to China’s State Secrecy Laws.
The surprising thing was that the SFC had requested the assistance of the CSRC to obtain all audit work papers pursuant to the “Memorandum on Regulatory Cooperation,” dated June 19, 1993, between, inter alia, the SFC and the CSRC as well as the International Organization of Securities Commissions’ Multilateral Memorandum of Understanding, to which both the SFC and the CSRC are signatories. The CSRC made the request to the China associate firm of EY, and it still refused to provide the requested documents on the grounds of its duty of confidentiality and the CSRC’s lack of jurisdiction over Standard Water.
More interestingly, this litigation revealed certain informal instructions the CSRC appears to have given to China-based audit firms, where it clearly instructed these firms that, if any foreign regulator requested to review the audit work papers and documents relating to a Chinese company, such materials must be acquired through cooperation with the CSRC.
This lawsuit was deemed to be a test for how far China’s State Secrecy Laws can shield disclosure of sensitive corporate matters in Hong Kong.
State secrecy is not a new concept in China. The main basis for secrecy prohibitions for audit work papers rests with the Archives Law of the People’s Republic of China, effective on July 5, 1996; the Law of the People’s Republic of China on Guarding States Secrets, effective October 1, 2010; and the Provisions of the China Securities Regulatory Commission, the State Secrecy Bureau and the State Archives Administration on Strengthening Confidentiality and Archives Administration Relating to Overseas Issuance and Listing of Securities, effective October 20, 2009. However, the control of audit work papers seemed to have progressively tightened after the various reporting difficulties, auditor resignations and civil lawsuits prompted by the reverse merger wave of China-based companies in the U.S. from 2007 to 2010.
The MOF promulgated the Interim Provisions on the Cross-Border Implementation of Audit Business by Accounting Firms (Draft for Comments) for public comments on April 21, 2014. The MOF Interim Provisions focus on domestic and overseas accounting firms that provide audit services for domestic China-based enterprises that list overseas, either during initial public offerings (“IPOs”) or periodic reporting after the IPOs. According to these provisions, international accounting firms are barred from sending their staff to audit China-based companies under temporary practice licenses. Instead, they are required to team up with local accounting firms (one of the top 100 Mainland accounting firms ranked by the Chinese Institute of Certified Public Accountants) and have the local accounting firm conduct the audit work within China. The provisions also clearly note that, under this type of arrangement, the international accounting firm will issue the audit report and bear all liabilities for such audit report. In addition, the provisions reinforce the requirement that all accountants must strictly follow China’s State Secrecy Laws and cannot pass on any information to overseas regulators or stock exchanges.
State Secrets under Chinese Laws
The Law of the People’s Republic of China on Guarding State Secrets (“State Secrets Law”) was revised and promulgated on April 29, 2010, and became effective October 1, 2010. According to this revised State Secrets Law, “State Secrets” are matters that, if divulged, would harm state security and national interests in the fields of political affairs, economy, national defense and diplomacy.
The State Secrecy Administration Bureau (“SSSB”) and other administrative ministries or departments are authorized to promulgate detailed rules to further regulate State Secrets protection in various industries.
Are Audit Work Papers State Secrets?
Certain information in audit work papers falls into the category of State Secrets. However, it is quite obvious that not all information in audit work papers would constitute “State Secrets.”
According to the No. 2 Chinese CPA Practice Guide — Audit Working Paper
Legal Liability Related to State Secrets
Any persons who disclose State Secrets may be subject to criminal or administrative liability. According to the PRC Criminal Law, whoever illegally provides State Secrets to an organization, institution or person outside China shall be sentenced to 10 years of imprisonment, or a lifetime sentence when circumstances are “especially serious.” If the circumstances are “extremely abominable,” such person may be sentenced to death and the property of such person could be confiscated.
Thus, if any accountant or company officer, whether a PRC national or not, provides audit work papers involving State Secrets to the SEC, the SFC, U.S. courts or Hong Kong courts without obtaining the proper government approval, such behavior is likely to be defined as “illegally providing state secrets,” and such accountant or company officer could be subject to criminal liability based on the seriousness.
Administrative liability for persons illegally disclosing State Secrets is murkier than criminal law liability. According to China’s State Secrecy Laws, if the illegal disclosure of State Secrets does not constitute a criminal offense, the relevant secret-guarding administrative department shall urge the punishment from the organization where such persons worked.
It is precisely this lack of clarity as to what constitutes a “State Secret,” combined with the potentially heavy criminal and administrative liability, and the various commentary from the MOF and the CSRC, indicating that audit work papers are considered, partially at least, “State Secrets,” that puts the audit profession, China-based foreign listed companies and multinationals with significant operations in China in a quandary.
Steps to Take
The murkiness of legal limitations is a fact of life in China, and the quandary of what to do with audit work papers appears, in part, to be driven by political considerations.
For now, a prudent course of action for foreign-listed China-based companies and multinationals with significant operations in China should include the following:
- A company’s Audit Committee should be made aware of this situation and the potential consequences of being trapped between different regulators in the foreign listed jurisdiction and Chinese regulators.
- A company should discuss this situation with its auditor and determine its position on the issue and work out potential contingency plans.
- A company should consider its internal auditing function and determine where audit data should be kept.
- A company should strengthen its internal policies regarding protection of audit data, particularly such data that may contain “State Secrets.”
Liza Mark is the Administrative Partner of the Shanghai office of Haynes and Boone, LLP. She may be contacted at firstname.lastname@example.org.
The author wishes to thank Gary Li, an Associate in the Shanghai office of Haynes and Boone, LLP, for his research for this article.