On January 22, 2014, the U.S. Securities and Exchange Commission (“SEC”) Administrative Law Judge Cameron Elliot levied sanctions pursuant to SEC Rule of Practice 102(e) against the Chinese affiliates of the “Big Four” accounting firms (“the Firms”) for violating Section 106(e) of the Sarbanes-Oxley Act of 2002 (“Section 106”) by withholding audit documents the SEC requested in the course of enforcement investigations. Judge Elliot censured and suspended the Firms from serving as auditors to companies whose securities are traded in the U.S. for a period of six months.
As Construed by the ALJ, the Motive for Noncompliance is Irrelevant Under Section 106
The Firms contended that Chinese law prohibited them from producing audit work papers and other related documents to the SEC or other foreign regulators. Notwithstanding any such prohibition, Judge Elliot determined that “willful refusal to comply” under Section 106 means “choosing not to act after receiving notice that action was requested” and that under such a definition, “the motive for the choice is irrelevant.” Because each of the Firms had not complied with at least one properly served Section 106 request, Judge Elliot determined that each had violated Section 106.
The ALJ Discussed and Rejected Four Additional Arguments
Judge Elliot also considered and rejected four arguments advanced by the Firms as affirmative defenses: (1) international comity prevents enforcement of the Section 106 requests; (2) the Firms did not act “willfully” under Section 106 because their legal obligations were “objectively unclear”; (3) the SEC lacks authority to request documents created prior the enactment of Dodd-Frank; and (4) the proceeding before Judge Elliot violated due process and equal protection and constituted selective prosecution.
Judge Elliot did not consider the first two arguments to be affirmative defenses. Ruling that judicial enforcement of the Section 106 requests was not a prerequisite to the administrative proceeding, Judge Elliot dispensed with the first argument on the ground that it was therefore irrelevant whether the Section 106 requests were enforceable. Based on his construction of Section 106, Judge Elliot next found “nothing objectively unclear” about Section 106 or the SEC’s requests. Referencing his construction of the meaning of “willfully” under Section 106, he stated that the Firms “knew exactly what was expected of them.”
Judge Elliot considered the third and fourth arguments as affirmative defenses but rejected both. Being “aware of no authority barring the use of a Sarbanes-Oxley 106 request to obtain documents created prior to Dodd-Frank’s effective date,” he found no merit to the third argument. Judge Elliot questioned his authority to consider the due process or equal protection claims but found that due process is satisfied where a party understands the issues and is afforded a full opportunity to meet the charges during the course of the proceeding. Finding no evidence of violations of due process or equal protection or of selective prosecution claims, Judge Elliot rejected the Firms’ fourth argument as well.
The ALJ Reduced the Sanctions Sought by the SEC
The SEC requested that the Firms be censured, permanently barred from issuing audit reports filed with the SEC and permanently barred from playing a 50 percent or greater role in the preparation of or furnishing of an audit report filed with the SEC. In considering sanctions, Judge Elliot emphasized the factors of public interest and good faith, finding only censure and a temporary practice bar before the SEC to be appropriate.
With respect to the public interest, Judge Elliot found that the Firms had disregarded the SEC’s regulatory authority. Based in part on the Firms’ arguments that recognition of their wrongfulness was an inapplicable factor and that their occupation presented no opportunities for future violations, Judge Elliot also ruled that they had failed to recognize the wrongful nature of their conduct and were oblivious that their occupation presented opportunities for future violations.
The Firms urged a finding of good faith because they “were ready, willing and able to produce documents, but were unable to do so because Chinese law prevented it.” Judge Elliot rejected the invitation, finding the Firms were aware of this potential legal conflict when they pursued business in the United States and chose to take this “calculated risk.” Although he therefore found that the Firms “acted willfully and with a lack of good faith,” Judge Elliot also rejected the SEC’s argument that the Firms had acted with scienter because “they obviously had no intent to defraud, nor were they reckless.”
The Firms also argued that a practice bar would have the substantial negative collateral consequences that: no other auditing firms could replace them; China-based U.S. issuers would no longer be able to trade on U.S. exchanges; the market capitalization of such issuers would fall; and investors would be harmed. Judge Elliot found that: the protection of future investors outweighed any potential harm to existing investors; ensuring the integrity of the SEC’s processes overrode the Firms’ potential losses of business, reputation, and investment; and the Firms’ predictions of a lack of adequate substitute auditors were unpersuasive.
Balancing these factors, Judge Elliot rejected the SEC’s request for a permanent practice bar, finding that the public interest factors weighed in favor of a total six-month bar. Judge Elliot also rejected the SEC’s request for a “role” bar because the SEC lacked any authority for imposing such a bar and because it would be insufficient to remedy the potential harms that might result from a future violation. Judge Elliot found a censure to be justified by the public interest factors and noted that it imposed no greater burden on the Firms than that imposed by the temporary practice bar. The Firms have indicated that they will file a petition for review of Judge Elliot’s initial decision. The sanctions ordered in the initial decision will not become effective until an order of finality is issued by the SEC.
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Barnes-DaleThis article was originally published by Bingham McCutchen LLP.