Will Morrison End the Debate Over PRC Based Audit Work Papers?
In Morrison v. National Australia Bank Ltd., 136 S.Ct. 2869 (2010) the Supreme Court held that Exchange Act Section 10(b) only reaches to the water’s edge, the Section has no extraterritorial reach beyond the shores of the United States. Since the decision is based largely on a tenant of statutory construction which is intended to avoid interference with foreign legal regimes by U.S. statutes absent specific Congressional authorization, its approach has potentially wide application. Now Morrison may resolve a significant international issue, ending a dispute between the SEC and the Peoples Republic of China or the PRC regarding the availability audit work papers for issuers in China.
The SEC has brought an action in Federal District Court and administrative proceedings focused on the question of whether affiliates of international accounting firms based in the PRC must produce audit work papers for Chinese issuers despite the dictates of local law which preclude such action. The actions center on the Sarbanes Oxley Act of 2002 or SOX requires the independent audit firm for any issuer who has a class of securities registered with the SEC be registered with the Board. SOX Section 106(b) specifies that an audit firm registered with the PCAOB must produce its work papers on request by the SEC or the Board.
Despite the mandate of SOX, U.S. regulatory officials have not been able to access the accounting work papers for PRC based issuers whose shares are traded in the U.S. capital markets. The Commission has brought three key actions:
SEC v. Deloitte Touche Tohmatsu CPA, Ltd., File No. 1:11-MC-00512 (D.D.C. Filed Sept. 8, 2011)(“subpoena enforcement action”);
In the Matter of Deloitte Touche Tohmatsu Certified Public Accountants Ltd., Adm. Proc. File No. 3-14872 (May 9, 2012)(“DTT action”); and
In the Matter of BDO China Dahua CPA Co., Ltd., Adm. Proc. File No. 3-15116 (Dec. 3, 2012)(“industry wide action”).
The subpoena enforcement action seeks an order requiring the production of PRC based audit work papers held by Deloitte Touche Tohmatsu and prepared as part of an audit of a China based issuer. Although the firm is registered with the PCAOB it declined to produce the work papers, citing local PRC law which precludes the production of such papers to a foreign regulator. According to court papers filed by the firm, at the time it registered with the PCAOB it stated on its application that PRC law precluded compliance with SOX Section 106. The action was stayed for a period at the request of the SEC while talks were conducted with PRC officials. Apparently those talks failed to produce an agreement. The audit firm has now moved for a stay, arguing that the industry wide administrative proceeding should, as a matter of judicial economy, proceed first.
The DTT administrative action is based on Rule 102(e) of the Commission’s Rules of Practice. It is against the same audit firm in the subpoena enforcement action but involves work papers for a different issuer. Initially the Respondent moved to dismiss the proceeding, contenting that the enforceability of the request for documents under SOX Section 106 had to be determined by a Federal District Court before any administrative proceeding could be brought. Before that motion could be resolved the industry wide action was filed. This action was consolidated with that proceeding.
The industry wide action is similar to the DTT administrative proceeding in that it is based on Rule 102(e). It seeks orders against the affiliates of five international accounting firms: BDO China, Ernst & Young Hau Ming LLP, KPMG Huazhen (Special General Partnership), Deloitte Touche Tohmatsu Certified Public Accountants Ltd. and PricewaterhouseCoopers Zhong Tian CPAs Ltd. Each Respondent is registered with the PCAOB. Each has been served with a document request for work papers from the audit of a PRC based issuer. Each firm has declined to produce the papers, citing PRC law.
If the industry wide action proceeds first, the five audit firms plan to move for dismissal, according to papers filed by Deloitte Touche Tohmatsu in the subpoena enforcement action. That motion will be based on the theory that the enforcement of the document requests at the center of the proceeding must be determined before there can be a resolution of the Rule 102(e) issues. Since the enforceability of Commission investigative subpoena is a matter for the Federal courts, the audit firms will apparently argue that a new subpoena enforcement action must be filed on an industry wide basis. Deloitte Touche Tohmatsu acknowledges in court papers however that a Section 106 request is not a Commission investigative subpoena.
In an industry wide subpoena enforcement action the firms would again move to dismiss, according to Deloitte Touche Tohmatsu’s court papers. The motion would argue that the SOX Section 106 document requests are contrary to Morrison. The motion would argue that since Section 106 does not specify it has extraterritorial effect it cannot be used to compel the production of work papers located in the PRC. This argument would appear to tie to the theory of the Morrison presumption which is to avoid permitting U.S. law to interfere with foreign regulatory schemes absent specific Congressional authorization. If this argument were sustained it would represent a victory for the audit firms.
Whether a victory by the audit firms in these proceedings would permit PRC based issuers to continue accessing the U.S. and other world capital markets is at best problematic. Hong Kong regulators, for example, have brought an action against the PRC affiliate of an international audit firm for failing to produce work papers. In the end when companies raise money from investors in public capital markets whether in the U.S. or abroad, transparency concerning the handling of other people’s money is required.