Chinese units of the global "Big Four" accounting firms should be suspended from practicing in the United States for six months, a U.S. judge ruled, in an escalation in a long-running dispute over regulators' access to audit documents.
In a harshly worded 112-page ruling, Securities and Exchange Commission Administrative Law Judge Cameron Elliot censured the Chinese affiliates of KPMG, Deloitte & Touche , PricewaterhouseCoopers and Ernst and Young .
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The four firms said that they intended to appeal the ruling.
"In the meantime the firms can and will continue to serve all their clients without interruption," the four said in a joint statement.
Elliot also censured a fifth firm, Dahua, previously a member of the BDO international network, but did not impose a six-month suspension.
The decision is not expected to be disruptive to U.S.-listed Chinese companies relying on these firms to review their 2013 books as the ruling does not go into immediate effect.
However if the firms are unsuccessful in the appeal process, which could last for years, then it could cause havoc for companies down the line as they will need to find a new auditor during the suspension period or else be unable to file accounts, a move likely to see their shares suspended.
"If the Big 4 can't sign these audits, all these companies are in a hell of a pickle," said Paul Gillis, an accounting professor at Peking University.
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The move by the SEC may also impact a wave of Chinese listings in the U.S. that were expected to return this year.
Last year's U.S. market rally, in particular the jump in tech shares, re-ignited a push by China-based companies to seek stock offerings on U.S. exchanges.
"There are a lot of IPOs that are picking up steam now, so the companies need to be up front now and speak to their auditors right away, see if they can find a back-up plan," said Paul Boltz, a partner at Ropes & Gray law firm in Hong Kong.
Elliot, an SEC judge who operates independently, sided with the SEC and said the companies "willfully" failed to give U.S. regulators the audit work papers of certain Chinese companies under investigation for accounting fraud.
Auditors have refused to turn over such papers for fear of violating Chinese secrecy laws.
Just last July, U.S. Treasury Secretary Jack Lew announced that an agreement had been reached whereby Chinese regulators would hand over some audit documents of U.S-listed Chinese companies to the SEC.
However, the judgment sheet shows that while some audit papers had been produced, not all the ones the SEC demanded were handed over, prompting their decision and suggesting last year's agreement had not gone as smoothly as hoped.
"This decision will be a huge shock in Beijing. The SEC has pushed a lot of chips out on the table," said Peking University's Gillis.
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Gillis noted that some of the Big Four's smaller competitors, such as Grant Thornton and RSM, do not have the capacity to handle the workload if they are asked to take on the extra audits.
While the firms will be readying their appeal, experts said the spat may only be settled at the highest diplomatic levels, given China's expected reluctance to budge any further on its secrecy act.
In an expert witness testimony in the SEC judgment, former SEC Commissioner Paul Atkins said that the issue may have to be dealt with by the U.S. President and the Chinese premier.
"He did not think the Commission would obtain the materials any sooner through this administrative proceeding than by some other means," a write up of his testimony read.
The judge's decision marks a major victory for the SEC, which for years tried with limited success to gain access to audit work conducted by Chinese accounting firms for Chinese companies that list in U.S. markets.
Several companies that have listed on U.S. stock exchanges have been plagued with accounting scandals.
The SEC has tried to delist or de-register some troubled companies, but has said investigations into possible fraud were stymied by the firms' failure to turn over audit work papers.
The accounting firms have repeatedly declined to share their audits, saying Chinese secrecy laws forbid it. They urged the SEC to pursue a diplomatic solution with China instead.
After years of often strained negotiations with Chinese regulators, the SEC decided in late 2012 to pursue sanctions against the firms.
The judge declined to impose a permanent bar as the SEC requested, but said a six-month bar was in the public interest, and said he had "little sympathy" for the firms.
"Respondents operated large accounting businesses for years, knowing that, if called upon to cooperate in a Commission investigation into their business, they must necessarily fail to fully cooperate and might thereby violate the law," he said.
"Such behavior does not demonstrate good faith, indeed, quite the opposite - it demonstrates gall."
The SEC said it was gratified by the decision, which upholds its authority.
"These records are critical to our ability to investigate potential securities law violations and protect investors," said Matthew Solomon, the chief litigation counsel in the SEC's Enforcement Division.
It is not clear what impact the decision could have on major U.S. firms that had become concerned that they could be drawn into the international dispute in a way that could compromise their ability to produce audited accounts.
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U.S. firms with major Chinese businesses include fast food group Yum Brands Inc, tech firm Qualcomm and construction equipment maker Caterpillar.
Diplomatic efforts in jeopardy?
It remains to be seen whether Wednesday's ruling could hinder the SEC's diplomatic bid to convince China to provide greater access to audit work papers, an effort that has led to improved ties since the summer.
During testimony in this case, the SEC revealed that China had agreed to send 20 boxes of audit work for Longtop Financial Technologies, one of the companies under investigation for fraud. In addition, the Public Company Accounting Oversight Board, which registers, inspects and disciplines auditors, has been pursuing a diplomatic solution for gaining access to the work papers.
In May, the PCAOB reached a deal with China that has allowed it to get some audit documents in connection with investigations. The board is still hoping for cross-border cooperation so its inspectors can also examine China-based audit firms.
Recognizing the risk that the ruling could strain diplomatic ties, Elliot said he decided to seal large portions of his decision that delve into Chinese-SEC relations.
"I am hopeful that the commission and the (China Securities Regulatory Commission) will continue to constructively engage one another," he wrote.
A PCAOB spokeswoman declined to comment on the ruling.