It's not unusual for the United States to get pushback from foreign countries or foreign companies on new regulations. When Sarbanes-Oxley first passed, several U.S.-listed European firms (as well as many U.S. companies) objected to a provision requiring listed firms to perform an annual audit of internal controls, in addition to the traditional audit of financial statements. They argued that this extra requirement was so costly and burdensome, they might no longer bother to maintain their stock listings in the United States, seriously undermining the position of the U.S. capital markets on the world stage. In response, the SEC temporarily suspended the rule for foreign companies, and eventually scaled down the requirement for all companies to a less onerous "top-down review."
Recent events, however, have made it a lot harder for the SEC to show similar flexibility toward China. Since 2010, a number of short-sellers researching in China have leveled high-profile accusations of fraud against Chinese firms listed on U.S. markets. Five companies targeted by Muddy Waters, the best-known of those short-sellers, lost almost $5 billion in market value through June 2011. Several others have seen their shares rendered nearly worthless or been forced to declare bankruptcy. These firms allegedly engaged in malfeasance ranging from questionable accounting practices to inflate revenues and profits, making up numbers out of thin air (and hoping no one has the resources to prove otherwise), embezzling funds, and even being total shams.
The SEC has also raised concerns about a popular holding structure, called the Variable Interest Entity, that many U.S.-listed "China stocks" use to operate in certain industries in China, such as media and education, where foreign ownership is prohibited. The U.S.-listed company exercises operational and financial "control" via contracts, allowing it to claim the China business as its own. Virtually all Chinese Internet start-ups listed in the United States are structured this way. The SEC worries that Chinese authorities could someday invalidate the contracts as illegal, leaving U.S. investors holding completely worthless shares.
In response, the SEC has launched fraud investigations into several U.S.-listed Chinese companies and their executives, ordering their China-based auditors to hand over confidential documents to examine for potential evidence of wrongdoing. In the most visible case, the SEC in May 2011 handed lawyers for Deloitte China a federal court subpoena to turn over its audit work papers for Longtop Financial Technologies, a Hong Kong-based maker of financial software that short-seller Citron Research had accused of fraudulent accounting (prompting Deloitte to resign the account, citing "recently identified falsity" in Longtop's financial statements).
Deloitte China fired its lawyer for accepting the subpoena, and refused to comply. In a court filing explaining why, Deloitte claimed that Chinese regulators had issued an extraordinary threat, telling auditors that handing over audit work papers would violate China's (vague and draconian) State Secrets law, allowing China to "dissolve the firm entirely and to seek prison sentences up to life in prison for any [Deloitte] partners and employees who participated in the violation."
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