Publications

10 Oct 2011

Hurdles ahead as the DOJ initiates criminal investigations of Chinese public companies

Securities Litigation Alert

Perrie Michael Weiner
Patrick Hunnius
Stephanie V. F. Smith

Robert Khuzami, director of enforcement at the Securities and Exchange Commission, recently let slip in an interview that the Department of Justice is actively engaged in investigating the accounting practices of Chinese companies listed on US stock exchanges. This comment raises the possibility that the DOJ may be considering bringing criminal charges against some of these China-based companies, their officers or their directors.

But the DOJ faces formidable procedural and jurisdictional challenges in actually prosecuting an action against entities or individuals located in China, as the Securities Exchange Commission is now learning.  Since the beginning of 2010, the SEC, NYSE and NASDAQ have suspended trading, halted trading or delisted the securities of at least 29 US-listed Chinese companies when significant questions arose regarding the accuracy of those companies’ financial reporting.¹  The SEC Division of Enforcement currently is investigating many of these companies.  However, the SEC has encountered numerous procedural and jurisdictional hurdles endemic to litigating in China, and, despite more than a year of investigations, has yet to initiate a single enforcement action. 

The DOJ will face the same hurdles, and more, if it attempts to prosecute a criminal action against individuals or entities in China.  So while political pressures to do something about alleged fraud at certain US-listed Chinese companies may push the DOJ towards considering the filing of criminal charges, the daunting challenge of actually prosecuting any such action should give the DOJ pause. 

The SEC increases focus upon US-listed Chinese companies

It comes as no real surprise that US-listed Chinese companies are being scrutinized by the DOJ, given the past year’s steady drumbeat of high-profile media reports and lawsuits² questioning the veracity of these companies’ financial statements.  The SEC already has taken notable actions, including opening a large number of non-public investigations; issuing subpoenas; forming an internal task force to investigate fraud in overseas companies with listings in the US; and sending a delegation to China to discuss, with Chinese regulators, ways to enhance Sino-US cooperation on audit oversight of US public companies. 

Given the sheer number of SEC investigations and the incendiary allegations made by class action plaintiffs and bloggers, which if true potentially could give rise to criminal exposure, we have been anticipating DOJ involvement.  (Indeed, this is precisely why, when we formed DLA Piper's China Rapid Response Team earlier this year, we included white collar lawyers.³)  It is not uncommon to see the DOJ partner with the SEC and FBI to investigate securities fraud allegations.  The fact that the DOJ’s current investigation of China-based companies was disclosed by the SEC’s enforcement chief clearly suggests that the two agencies are working closely together in this area.

One thing that the SEC has not done – yet – is commence an enforcement action against any officer or director of a US-listed Chinese company that is a subject of the recent wave of investigations, trading suspensions and delistings.  In some instances, it appears that the SEC has not even been able to obtain meaningful documentation in response to its subpoenas.  We believe the reason why the SEC has not yet initiated an enforcement action may be that it has had difficulties obtaining evidence due to significant jurisdictional issues and conflicts with Chinese law.⁴  The DOJ likely will face the same or even greater obstacles.

Difficulties obtaining documents for the SEC

It is apparent that the SEC is encountering difficulties obtaining documents from some issuers and individuals based in China.  To date, we believe that the SEC enforcement staff has asked China-based entities and individuals to provide documents only on a voluntary basis.  In certain situations, these requests for voluntary production have been ignored or resisted.  We have been told by individuals at the SEC that, at this point, the Commission will not issue a subpoena into China as a matter of policy.  If that policy were changed, the SEC likely would need to attempt to effect service of a subpoena in China through the procedures set forth in the Hague Convention on Taking of Evidence Abroad in Civil or Commercial Matters (Hague Evidence Convention), which may add additional steps in the discovery process.  But serving a subpoena via the Hague Evidence Convention procedures still does not ensure a response.  Ultimate delivery of a subpoena in China requires the assistance of local authorities, and there is no means to ensure that these local authorities actually will deliver a subpoena.  In practice, there have been instances where the local authorities failed to complete service.

The SEC currently is struggling to find a way around these hurdles.  For example, even though the process remains difficult and time-consuming, the passage of the Dodd-Frank Act arguably makes it easier for the SEC and PCAOB to obtain documents held by foreign parties.⁵  And the outcome of the SEC’s current enforcement action aimed at requiring a Shanghai-based accounting firm to turn over documents responsive to a SEC subpoena, if successful, also may make it easier for the SEC to obtain documents located in China.  In that matter, the SEC brought a subpoena enforcement action against a Shanghai-based accounting firm⁶ for failing to produce documents related to the SEC’s investigation into possible fraud by the Chinese-based company for which the accounting firm was the auditor.⁷  The accounting firm has not produced the documents, alleging that Chinese law prohibits it from turning over documents to foreign regulators.  It has been intimated, as a leverage point, that the accounting firm may lose its registration with the PCAOB if it refuses to comply with the SEC subpoena. 

Difficulties obtaining oral discovery for the SEC

Obtaining oral discovery from witnesses in China is even more difficult.  China does not consider itself bound by Articles 16-22 of Chapter II of the Hague Evidence Convention, which governs depositions.  In fact, it is considered a violation of China’s judicial sovereignty for an American lawyer to take the deposition of someone in China.  Doing so could result in the arrest, detention, expulsion or deportation of the American lawyer and other participants.  While, theoretically, the SEC could ask a US court to issue an order compelling a deposition, there simply is no way to enforce such an order upon someone in China who refuses to comply. 

The DOJ may face even bigger hurdles to obtaining evidence. 

As noted above, the DOJ often obtains access to evidence gathered by the SEC.  But in cases where the SEC cannot obtain evidence, or the DOJ chooses to gather evidence itself, the DOJ’s primary investigative tools are grand jury subpoenas and search warrants. 

If the company and all of its documents are located in China, even upon issuing the subpoena, “[t]here is little that can be done if a [Chinese] corporation, especially one with tenuous contacts with the United States, declines to produce documents.”⁸  In fact, there is no mechanism for the DOJ even to serve a grand jury subpoena on a Chinese company not incorporated in the US  (Clearly, a search warrant also would be out of the question, particularly in a country like China that has no Mutual Legal Assistance Treaty (MLAT) with the US and, thus, would be unlikely to cooperate in raiding a business location.)  If the Chinese company is incorporated in the US, the DOJ might be able to serve the grand jury subpoena on the company’s registered agent in the state of incorporation.  Then, if the Chinese company refuses to comply, it could be held in contempt by a US court.  However, enforcing the contempt charge essentially would be almost impossible unless the Chinese government chose to cooperate.  As noted above, there is no MLAT between the US and China, although there is a Mutual Legal Assistance Agreement (MLAA) between the countries. ⁹   Although the MLAA was a significant milestone for bilateral cooperation in law enforcement matters between the US and China when it was signed in 2000, and there have been a few notable examples of cooperation by the Chinese, the MLAA contains a number of provisions that give the Chinese government (and the US) great flexibility to determine when to grant and when to deny assistance.  It, therefore, has not been a reliable or particularly effective tool for the DOJ to obtain evidence from China.¹⁰ The SEC also has an agreement with China: a Memorandum of Understanding with the China Securities Regulatory Commission.  But this Memorandum of Understanding does not create any legally binding obligations, consists largely of platitudes, and is not likely to result in the Chinese authorities ordering the production of documents.  

Obtaining oral discovery for the DOJ is even more difficult , because the DOJ does not have authority to take depositions; rather, the DOJ is limited to the Grand Jury process.  In rare cases, the DOJ can take depositions under Federal Rule of Criminal Procedure 15 if that is the only way to preserve evidence for trial; but, that is only after indictment and, even then, the DOJ would come up against the same hurdles faced by any non-Chinese lawyer seeking to depose a witness residing in China. 

The DOJ faces an uphill battle

With so many allegations and investigations pending against Chinese companies, it was anticipated that the DOJ eventually would enter the fray.  But, like the SEC, the DOJ will face an uphill battle.  Without access to key documents or witnesses, it will be very difficult in most cases for the DOJ to prove elements of scienter or intent, both of which are key requirements to support a criminal securities fraud case.

Even so, it is prudent to presume that, despite these challenges, the DOJ at some point will commence a criminal proceeding against a China-based US issuer or its management if warranted by that company’s particular facts and circumstances.  Accordingly, it would be wise for any US-listed Chinese company facing a class action lawsuit or SEC investigation to also involve white collar defense lawyers early on as part of an overall litigation team and strategy given the potential for criminal exposure. 

For more information about these issues, please contact:

Perrie Weiner

Patrick Hunnius

Stephanie Smith