There was a major escalation today in the battle between U.S. and Chinese regulators over the accounting profession in China. The SEC has filed a subpoena enforcement action against Deloitte Tohamtsu CPA Ltd (Deloitte Shanghai). Deloitte Shanghai is Deloitte’s member firm in China.
The SEC seeks to have Deloitte Shanghai turn over its working papers on Longtop Financial Technologies, which has been alleged to be a major Chinese accounting fraud. The SEC argues that the working papers related to prior year audits may reveal how any fraud schemes at Longtop were able to continue undetected for years. There is no indication that Deloitte Shanghai is under investigation, although the SEC points out its objective is the ferret out whether there was a fraud, and if there was, who was behind it, how significant it was, and how it was conducted.
According to the court filings, Deloitte has refused to produce the working papers for two reasons. First, they argue that the recent Dodd Frank legislation that makes it clear that they must produce this information was not effective when these working papers were prepared (these provisions of Dodd Frank became effective on July 21, 2010). The SEC argues that they were entitled to the information even before Dodd Frank. Secondly, and more significantly in my view, Deloitte Shanghai argues that producing the information would violate China’s state secrecy laws. Deloitte Shanghai unsuccessfully sought authorization to produce the documents from the China Securities Regulatory Commission (CSRC), which the filing says told Deloitte to seek authorization from the Ministry of Finance, the State Secrets Bureau, and the State Archives Bureau.
I will have further analysis of this situation in the days to come. This situation will lead to a major escalation of the simmering dispute between U.S. and Chinese regulators over Chinese auditors. I don’t see an easy compromise here. The SEC is unlikely to back down, since they cannot effectively prosecute the case against Longtop without this information. Chinese regulators have more scope to compromise, since it is unlikely that the Longtop case includes significant state secrets. However, I think they are unlikely to allow Deloitte to produce the documents for fear of setting up a precedent for future disclosures. Disclosure of the corrupted bank confirmation process may also prove embarrassing at a minimum for China’s big state-controlled banks. Deloitte may end up with Sophie’s Choice – follow China’s rules and lose the right to audit U.S. listed companies or give in to the SEC and lose the right to practice in China.