The Securities and Exchange Commission has filed charges in an enforcement action against Deloitte’s affiliate in Shanghai, China, accusing the firm of violating U.S. securities laws by refusing to produce audit work paper documents.

The SEC said Wednesday it has charged Deloitte Touche Tohmatsu CPA Ltd. in Shanghai for refusing to produce the work papers related to a Chinese company under investigation for potential tax fraud.

The move represents the latest escalation in the legal skirmish between the SEC and Deloitte’s Shanghai member firm. Last year, the SEC filed a subpoena enforcement action against the same member firm after it refused to produce work papers for its audits of Longtop Financial Technologies Limited, another Chinese client company suspected of accounting fraud (see SEC Presses Deloitte's Shanghai Firm for Audit Documents). The SEC later filed charges against Longtop for alleged reporting failures.

The SEC said Wednesday that the latest enforcement action involved a different client, identified only as “Client A.” The SEC said this is the first time it has brought an enforcement action against a foreign audit firm for failing to comply with a Section 106 request.

According to the SEC’s order instituting administrative proceedings against D&T Shanghai, the agency has been making extensive efforts for more than two years to obtain documents related to the firm’s work for the company, which issues U.S. securities registered with the SEC.

The firm is charged with violating the Sarbanes-Oxley Act, which requires foreign public accounting firms to provide audit work papers concerning U.S. issuers to the SEC upon request. D&T Shanghai has nonetheless failed to provide the documents, citing Chinese law as the reason for its refusal.

“As a voluntarily registered U.S. public accounting firm, D&T Shanghai cannot benefit from the financial and reputational rewards that come with auditing U.S. issuers without also meeting its U.S. legal obligations,” said Robert Khuzami, director of the SEC’s Division of Enforcement, in a statement. “Foreign firms auditing U.S. issuers should not be permitted to shield themselves from regulatory scrutiny to the detriment of U.S. investors.”

According to the SEC’s order in this latest enforcement action, D&T Shanghai is a public accounting firm registered with the Public Company Accounting Oversight Board. In April 2010, SEC staff began seeking D&T Shanghai’s audit work papers related to its independent audit work for the client involved in an SEC investigation. The SEC served Deloitte LLP, the U.S. member firm, with a subpoena requesting various related documents. Counsel for Deloitte LLP informed the staff that the U.S. firm did not perform any audit work for the client and therefore did not possess the documents related to the subpoena.

According to the SEC’s order, in the SEC staff’s continuing quest for the audit work papers in D&T Shanghai’s possession, they were later informed by counsel for Deloitte’s global firm that the agency’s request for audit work papers had been specifically communicated to D&T Shanghai.

Subsequently, the staff served D&T Shanghai with a request through Deloitte LLP for the audit work papers pursuant to Section 106 of the Sarbanes-Oxley Act. D&T Shanghai would not produce the relevant audit work papers because of its interpretation that it is prevented from doing so by Chinese law. SEC staff also has sought to obtain the relevant audit work papers through international sharing mechanisms, yet these efforts have been unsuccessful.

Deloitte argued that the SEC document request would put the firm in danger of violating Chinese law. "This action against Deloitte Touche Tohmatsu CPA Ltd. (Deloitte Shanghai) arises solely because, under China law and specific directives issued by the China Securities Regulatory Commission (CSRC), accounting firms in China are not permitted to produce documents directly to any foreign regulator without Chinese government approval," said a statement forwarded by Deloitte spokesperson Lauren Mistretta. "In 2010, the CSRC, at the request of the U.S. Securities and Exchange Commission (SEC), asked Deloitte Shanghai for copies of certain documents relating to a China-based company registered in the U.S. and audited by Deloitte Shanghai. Deloitte Shanghai provided the requested documents to the CSRC with the hope that the CSRC and the SEC would be able to reach an agreement on their production. Unfortunately, that has not happened. In 2011, the SEC requested the documents directly from Deloitte Shanghai, but because of China legal impediments, Deloitte Shanghai was prohibited from producing the documents directly to the SEC, resulting in the current 102(e) complaint against Deloitte Shanghai. The charges here arise exclusively from Deloitte Shanghai’s inability to produce the documents.

"Deloitte Shanghai is caught in the middle of conflicting laws of two different governments," Deloitte added. "This is a profession-wide issue and not one that is specific to Deloitte Shanghai. Because the China legal impediments apply to all accounting firms in China, if a diplomatic resolution is not reached, it is likely that all of the major accounting firms in China will find themselves having to choose between violating their own national laws or facing a similar 102(e) proceeding by the SEC.

"DTTL is hopeful that this diplomatic disagreement will be resolved soon," Deloitte added. "The filing of the complaint will not disrupt the ability of Deloitte member firms to deliver professional services to U.S. and other multinational clients with operations in China."

In the SEC’s order, the Enforcement Division alleges that D&T Shanghai willfully violated the Sarbanes-Oxley Act and the Securities Exchange Act of 1934 by failing to provide the SEC with the audit work papers. The administrative proceeding will be assigned to an Administrative Law Judge at the agency. The judge would determine the appropriate remedial sanctions if the judge finds in favor of the SEC staff.

“Without access to work papers of foreign public accounting firms, our investigators are unable to test the quality of the underlying audits and fulfill our responsibilities to investors,” said Scott Friestad, associate director of the SEC’s Division of Enforcement.