Compliance and Litigation Risks: the SEC's Tougher Stance on Intermediary Institutions

This was not the first time PwC had been penalized by the SEC for breach of audit independence. As early as Jan 14, 1999, two PwC staff were found by the SEC to be  guilty of professional misconduct and unsatisfactory compliance with the CPA's independence standards. Moreover, this was not the first time the SEC imposed exemplary penalties on one of the Big Four and other accounting firms. In the last three years, Ernst & Young, KPMG and Deloitte all faced charges for malpractice and were fined more than US$100 million in total. It is fair to say that these are perhaps the toughest enforcement actions in the SEC's recent history against the accounting firms.

In a broader context, these events may have wider implications beyond the U.S. market and somewhat signal the advent of a new era of strengthened financial regulation globally. This is particularly true in mainland China, which has significantly loosened market access for overseas investors, in particular, in sectors of banking, financing, financial services and capital markets by introducing the PRC 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)). It is foreseeable that with the implementation of further opening-up measures, mainland China regulators (namely the People's Bank of China (PBOC), the China Banking and Insurance Regulatory Commission (CBIRC) created via the merger of the China Banking Regulatory Commission (CBRC) and the China Insurance Regulatory Commission (CIRC) in early 2018 and the China Securities Regulatory Commission (CSRC), which together are governed by the special cabinet level committee, the Financial Stability and Development Committee) will also keep pace with global regulatory practice, and this is notable for MNCs to keep in mind especially for those who have businesses in or are planning to enter into the mainland Chinese market.

… 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 regulator's armory with greater efficiency and flexibility

II . The Growing Strength of Mainland China Regulators

Compared to SEC's tough regulatory regime and constant scrutiny over "intermediary institutions", the most severe enforcement action available to mainland Chinese regulators is merely an administrative penalty of up to Rmb600,000, which is no more than US$100,000 and this is considered to be 'a drop in the bucket' for big corporate accounting firms. However, as exemplified by the China A-share Market Intermediary Institutions Risk Disclosure Watch List (2008-18), 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 regulator's armory with greater efficiency and flexibility.

In relation to the newly established STAR Market, which is an experimental board designed to support technology companies that are 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 only formality examinations instead of substantive reviews by regulators, investors would have to place greater reliance on the information third-party institutions disclose and the professional services they provide. As 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, they will impose more severe penalties upon "intermediary institutions" who are found responsible for malpractice in relation to fraudulence/non-disclosure during public offerings and other banking and financing businesses.

Now, underwriters, underwriting sponsors, trustees, investment advisors and asset managers have all been subject to more stringent supervision and regulation, many of which are so-called "licensed" financial institutions

III . Tougher Regulatory and Enforcement Regime in the New Era

It should be noted that in the current regulatory environment in mainland China, the connotation of "intermediary institutions" as the regulated entities is no longer limited to the traditional ones such as accounting firms, law firms, evaluation agencies, and credit rating agencies. Now, underwriters, underwriting sponsors, trustees, investment advisors and asset managers have all been subject to more stringent supervision and regulation, many of which are so-called "licensed" financial institutions.

Against the backdrop of the economic slowdown and further upon 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 (a consolidation of several regulations previously issued by PBOC, CBRC, CSRC, CIRC and State Administration of Foreign Exchange), which aim to set out a unified strengthened regulatory framework for asset management industry, it is foreseeable that further tightening the supervision and imposing stricter liability on "intermediary institutions" would remain important regulatory measures in the banking and financing sector.

…  the Beijing First Intermediate People's Court held that when discharging its duty of due diligence, a law firm shall conduct a comprehensive analysis in the light of all the 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

IV . Judicial Reinforcement in a Tightened Regulatory Regime

Echoing the call for a tougher regulatory regime, intermediary institutions' responsibility of diligence and independence has been within the orbit of judicial attention. In the recent benchmark case of Dongyi Lawyers & Partners v. China Securities Regulatory Commission (CSRC), where 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 IPO, the Beijing First Intermediate People's Court held that when discharging its duty of due diligence, a law firm shall conduct a comprehensive analysis in the light of all the 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 are suggestive of a judicial tendency to expand the scope and raise the standard of responsibilities and obligations that "intermediary institutions" must take in capital market and banking and financing businesses.

V . Compliance and Litigation Risks for the Intermediary Institutions 

There is an increasing importance of the role of intermediaries in the market that comes with greater compliance risks, more direct and stringent liabilities, along with more potential claims and disputes that may arise in future. In this regard, it would be prudent for accounting firms and financial institutions to seek professional legal advice on the duty of due diligence. Take the case of the accounting firm as an example. The firm was engaged by a prominent state-owned enterprise in a large-scale cross-border M&A transaction. Unfortunately, about one year after the completion of the transaction, the acquired company went into bankruptcy. The state-owned enterprise then sued the accounting firm and another international law firm from the U.S. for compensation with an astronomical figure, alleging that they had breached the duty of due diligence in their provision of professional services and failed to discover the material defects in the assets of the target company, and thus should be liable for full compensation.

… intermediary institutions should not be afraid to take legal actions to defend their legitimate interests and rights

VI . Reducing Exposure to Compliance and Litigation Risks

For those who are interested in entering the Chinese market, learning how to survive from an increasingly strengthened Chinese regulatory regime is a must. On the one hand, professional service providers and other intermediary institutions should ensure strict compliance with relevant laws, regulatory rules and contractual terms, and fulfill their duty of prudence and due diligence as far as possible. Otherwise, they may face severe risk of administrative, civil and even criminal liabilities. On the other hand, 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. More importantly, intermediary institutions should not be afraid to take legal actions to defend their legitimate interests and rights. Intermediary institutions should observe a higher standard of professionalism, prudence and diligence throughout the provision of services, as well as in the process of self-defense against any claims or disputes alleged, so as to fulfill their responsibilities to the public at large and also to themselves.

VII . Conclusion

With increasingly more opening-up measures being implemented, the regulatory regime of mainland China is also being reformed and continuously tightened to keep in line with the international standards. In this regard, the SEC's enforcement action against PwC is very helpful to show how far mainland Chinese regulators are willing to go, in terms of enforcement, in the foreseeable future.