U.S. Court Fight May Not Solve Chinese Accounting Mess

By | September 14, 2011

U.S. regulators appear to be on strong footing in a legal battle over a Chinese auditor’s work papers, though their ability to act may have limits and a victory in court may not resolve a widening international accounting mess.

At issue are attempts by the U.S. Securities and Exchange Commission to investigate possible fraud at Longtop Financial Technologies Ltd., one of dozens of U.S.-listed companies based in China that have been caught up in accounting scandals.

The SEC raised the ante last week by seeking a federal court order to force the Shanghai arm of accounting giant Deloitte to turn over its work papers on Longtop. Deloitte has resisted, saying Chinese law prohibits it from turning over documents to foreign regulators.

“Uniformly, the courts have enforced SEC subpoenas because the SEC has such extraordinarily broad subpoena power in its enabling statutes,” said Duke University securities law professor James Cox.

That power can reach beyond U.S. borders in such cases as this one, since Longtop’s shares trade in the United States. Yet even if the SEC wins in court, the case will come down to whether the Chinese authorities cooperate in seeing the court order honored, legal experts said.

U.S. powers to enforce the order are limited. “You are not sending the U.S. Marshals over to China to enforce this,” said Adam Pritchard, a professor at the University of Michigan Law School who specializes in securities law.


Lawyers representing investors who have lost billions of dollars on investments in China-based companies have long complained that their cases have been thwarted by trouble gathering crucial evidence from foreign audit firms.

Auditors have resisted turning over documents, fearing repercussions for violating China’s state secrets laws.

The U.S. auditor watchdog, the Public Company Accounting Oversight Board, has been frustrated also in attempts to inspect auditors in China despite meetings with Chinese authorities to search for common ground.

“I think they (Chinese authorities) are less concerned with whether they make the SEC happy, but they do need to make investors comfortable that the quality and extent of audits and financial reports meets the needs of those investors,” said Jim Feltman, national co-leader of litigation, investigative and intelligence services for Mesirow Financial Consulting.

“I would expect that competing regulatory agencies need to find a protocol to work these things out, and that domestic courts are not going to be an effective tool in that process,” Feltman said.

The accounting scandals have already raised questions about whether companies not subject to U.S. rules should be selling shares in the United States, and that issue will only take on more importance as the legal battle escalates.

“The solution to me is to say, ‘If you’re publicly listed in the United States, then you have to use an accountant whose work papers are available in the United States,”‘ said Herbert Milstein, a partner at Cohen Milstein who represented investors in a 2007 lawsuit against China-based LDK Solar Co. Ltd. that was settled for $16 million.

Milstein suggested as much in a letter to the SEC last year, though he said he has not heard back from the agency.


A federal judge in the LDK case last year expressed shock that companies whose audit documents are outside the reach of U.S. courts are allowed to list shares on U.S. exchanges.

Chinese auditors of financial reports used by U.S. investors “ought to be subject to the same discovery obligations as an auditor here in the United States,” U.S. District Judge William Alsup in San Francisco said at a settlement hearing on LDK last year.

Deloitte may argue in court that its Chinese arm is a separate Chinese entity that should be bound by Chinese law, though it is questionable whether that argument will hold up, said Nicholas Howson, professor of law at the University of Michigan.

“I’m sure the SEC will say, ‘You are Deloitte, a worldwide firm. You just happen to have established your China entity this way,”‘ Howson said.

That, in fact, was precisely the SEC’s argument in its court filing.

While Deloitte’s Shanghai arm is formally a Chinese entity, “it has also long benefited from its international connections, minimizing any protection it should get from being foreign,” the SEC said.

Howson said he doubts that the production of Deloitte’s work papers is being actively resisted by Chinese authorities, as they also have an interest in trying to curtail the accounting scandals.

China, however, may be reluctant to “default to foreign regulatory agencies to police its own business practices,” said Mesirow’s Feltman.

“You have different business cultures which are producing the results we’re seeing — where Chinese business relationships may not lend themselves naturally to the type of transparency and disclosure … that U.S. regulators have come to expect,” he said.

(Additional reporting by Carlyn Kolker and Nanette Byrnes; Editing by Howard Goller and Steve Orlofsky)

Topics USA China

Was this article valuable?

Here are more articles you may enjoy.