The SEC’s tough stance on intermediary institutions: compliance and litigation risks
Wilson Wei Huo
Zhong Lun Law Firm, Hong Kong
On 23 September 2019 accounting firm PricewaterhouseCoopers (PwC) was charged by the United States Securities and Exchange Commission (SEC) with improper professional conduct in relation to 19 engagements on behalf of several publicly listed companies. In addition, PwC was also found to have violated audit independence by performing prohibited non-audit services during an audit engagement, including the exercise of decision-making power and management functions in the design and implementation of software related to auditing client financial reports.
PwC was fined more than $7.9m by the SEC for this conduct. On the matter, Associate Director of the SEC’s Division of Enforcement, Anita B Bandy, stated:
‘auditors play a fundamental role in protecting the reliability and integrity of financial reporting and must ensure that non-audit services do not come at the cost of their independence on audits of public companies.’
She added that 'PwC repeatedly provided non-audit services without having effective quality controls in place for monitoring whether the services impaired its independence on audit engagements and were properly disclosed to audit committees.’
SEC’s enforcement history against intermediary institutions
This was not the first time PwC had been penalised by the SEC for breach of audit independence. As early as 14 January 1999, the SEC found two PwC employees guilty of professional misconduct and unsatisfactory compliance with the independence standards of certified public accountants (CPAs). This was also not the first time the SEC imposed exemplary penalties on one of the Big Four accounting firms: in the past three years Ernst & Young, KPMG and Deloitte have all faced charges for improper professional conduct and fined more than $100m between them. These are perhaps the toughest enforcement actions against the accounting firms in the SEC’s recent history.
In a broader context, these events may have wider implications beyond the US market, signaling a new era of strengthened financial regulation globally. This is particularly true in mainland China, which has significantly widened its market access for overseas investors, in particular in the banking, financing, financial services and capital markets sectors, by introducing the People’s Republic of China Foreign Investment Law (中华人民共和国外商投资法) and the Special Administrative Measures for Foreign Investment Access (Negative List) (2019 Edition) (外商投资准入特别管理措施 (负面清单) (2019年版)). Multinational corporations – in particular those that have business in, or are planning to enter the mainland China market – should bear in mind that with the further relaxation of requirements for foreign investors, mainland China regulators will likely keep pace with global regulatory practice.
The growing strength of mainland China regulators
Compared to the SEC’s tough regulatory regime and constant scrutiny of intermediary institutions, the most severe enforcement action available to mainland Chinese regulators is an administrative penalty of up to RMB 600,000 (no more than $100,000). This is considered ‘a drop in the ocean’ for big corporate accounting firms; however, as exemplified by the China A-share Market Intermediary Institutions Risk Disclosure Watch List (2008–2018), in response to the frequent recurrence of accounting fraud among A-share listed companies, as shown in the table below, mainland China regulators have increasingly tightened enforcement actions against intermediary institutions and broadened the scope of supervision. New enforcement methods have also been introduced to expand the China Securities Regulatory Commission’s (CSRC) armory, giving it greater efficiency and flexibility.
CSRC enforcement actions
Yunan Lvdadi Biotechnology Ltd (002200.SZ), a gardening and horticultural company listed on China’s Small and Medium Enterprises Board (SME Board).
In 2012 Yunan Lvdadi Biotechnology Ltd was found guilty of inflating revenues by approximately RMB 296m and was subsequently found guilty by the Kunming Intermediate People’s Court of fraud in a public offering, forgery of financial instruments and illegal destruction of accounting documents.
Wanfu Biotechnology Ltd (300268.SZ), an agricultural company listed on the ChiNext Board (a National Association of Securities Dealers Automated Quotations-style board of the Shenzhen Stock Exchange).
In 2013 Wanfu Biotechnology Ltd was found guilty of falsifying financial statements, inflating revenues by approximately RMB 740m and fraud in a public offering.
Dandong Xintai Electric Ltd (300372.SZ), a ChiNext-listed company principally engaged in the research, development, manufacture and distribution of energy-saving electrical transmission and transformation equipment.
In 2017 Dandong Xintai Electric Ltd was found guilty of falsifying financial statements, inflating revenues by approximately RMB 469m and fraud in a public offering. Consequently, it became the first company to be forcibly delisted from the ChiNext Board.
Jiangsu Yabaite Technology Ltd (002323.SZ), a photovoltaics company listed on the SME Board.
Jiangsu Yabaite Technology Ltd was found guilty of falsifying financial statements and inflating revenues by approximately RMB 580m and was forcibly delisted from the Shenzhen Stock Exchange in 2018.
In relation to the newly established STAR Market (an experimental board designed to support technology companies that operate in line with national strategies to make breakthroughs in core technologies), the CSRC has vowed to take a market-oriented, law-based and international approach.
Intermediary institutions must also take on more responsibilities and become an important nexus of the market. With regulators performing examinations as a ‘formality’, rather than conducting substantive reviews, investors are forced to place greater reliance on the information disclosed by intermediary institutions and the professional services they provide. Regulators have clearly stated in the Measures for the Administration of the Registration of Initial Public Offerings of Shares on the Science and Technology Innovation Board (Trial Implementation) (科创板首次公开发行股票注册管理办法 (试行)) and other relevant regulations that they will impose more severe penalties on intermediary institutions found responsible for malpractice in relation to fraudulence/non-disclosure during public offerings and other banking and financing business.
Tougher regulatory and enforcement regime in the new era
It should be noted that in the current regulatory environment in mainland China, the term ‘intermediary institutions’ no longer applies only to traditional accounting firms, law firms, evaluation agencies and credit rating agencies. Now, underwriters, underwriting sponsors, trustees, investment advisors and asset managers – many of which are so-called ‘licensed’ financial institutions – are also subject to more stringent supervision and regulation.
Against the backdrop of the economic slowdown, alongside the introduction of the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions (关于规范金融机构资产管理业务的指导意见) in 2018, it is foreseeable that tightening supervision of, and imposing stricter liability on, intermediary institutions will remain important regulatory measures in the banking and financing sector.
Judicial reinforcement in a tightened regulatory regime
The responsibility of ‘intermediary institutions’ to conduct due diligence and offer independent services has also attracted judicial attention. In a recent benchmark case, Dongyi Lawyers & Partners v China Securities Regulatory Commission, a law firm sought to repeal the imposition of penalties by the CSRC for its alleged breach of the duty of due diligence in advising Xintai Electric’s initial public offering. The Beijing First Intermediate People’s Court held that when discharging its duty of due diligence, a law firm shall conduct a comprehensive analysis of all relevant materials, including ‘but not limited to’ the audit report, and based on its prudent review issue its ‘independent’ legal opinion, for which it shall be responsible. Such remarks suggest a judicial tendency to expand the scope and raise the standard of responsibilities and obligations to which intermediary institutions will be held in capital market and banking and financing businesses.
Compliance and litigation risks for intermediary institutions
The increasingly important role of intermediary institutions in the market comes with greater compliance risks and more direct and stringent liabilities, which guarantees that more claims and disputes shall arise in future. In this regard, it would be prudent for accounting firms and financial institutions to mitigate this risk by seeking professional legal advice on the duty of due diligence.
The liability exposure to intermediary institutions is substantial. Take the case of an accounting firm, for example, that was engaged by a prominent state-owned enterprise in a large-scale cross-border M&A transaction. Unfortunately, about a year after the completion of the transaction, the acquired company filed for bankruptcy. The state-owned enterprise then sued the accounting firm and the US international law firm that assisted the accounting firm, alleging that both had breached the duty of due diligence in their provision of professional services by failing to discover the material defects in the assets of the target company, and thus should be liable for full compensation.
Reducing exposure to compliance and litigation risks
For those who are interested in entering the Chinese market, learning how to survive in an increasingly strengthened Chinese regulatory environment is essential.
On the one hand, professional service providers and other intermediary institutions should ensure strict compliance with relevant laws, regulatory rules and contractual terms, and fulfil their duty of prudence and due diligence as far as possible. Otherwise, they may face risk of administrative, civil and even criminal liabilities.
On the other, it is practicable and necessary for intermediary institutions to protect themselves from compliance and litigation risks by raising the level of legal awareness and implementing relevant internal rules and policies. For instance, proper process control measures in business management would reduce the risk of malpractice by individual employees, and an effective recording and tracking system could help preserve evidence in case of any potential disputes. Intermediary institutions should observe a higher standard of professionalism, prudence and due diligence throughout the provision of services, as well as in the process of self-defence against any alleged claims or disputes, so as to fulfil their responsibilities to both the public and to themselves.
The regulatory regime of mainland China is being reformed and continuously tightened to keep in line with international standards as measures to open up the market continue. In this regard, the SEC’s enforcement action against PwC is very helpful to show how far mainland Chinese regulators may be willing to go, in terms of enforcement, in the foreseeable future.
 PQ, ‘PwC to pay $7.9m settlement’ https://www.pqmagazine.com/pwc-to-pay-7-9m-settlement/#:~:text=The%20SEC's%20Anita%20Bandy%20said,non%2Daudit%20services%20without%20having accessed 20 April 2022.
 Namely the People’s Bank of China (PBOC), the China Banking and Insurance Regulatory Commission (CBIRC) – created in early 2018 via the merger of the China Banking Regulatory Commission and the China Insurance Regulatory Commission (CIRC) – and the CSRC, which together are governed by the special cabinet level committee, the Financial Stability and Development Committee.
 A consolidation of several regulations previously issued by PBOC, CBIRC, CSRC, CIRC and State Administration of Foreign Exchange, which aim to set out a strengthened, unified regulatory framework for the asset management industry.
 This is an actual case in which Zhong Lun Law Firm represented the accounting firm in court. Due to confidentiality obligations, it is not possible to release the names of the case or the parties.