THE Shanghai unit of accounting giant Deloitte Touche Tohmatsu finds itself caught between East and West in a dispute over possible accounting fraud in a Chinese company listed in the United States.

Last Friday, its Shanghai office received a subpoena from a United States federal court, issued at the request of the US Securities and Exchange Commission, asking Deloitte to hand over records related to Longtop Financial Technologies, a former client of Deloitte's Shanghai unit.

The firm pledged its "full cooperation," but handing over the accounts is a stickier matter.

Deloitte resigned in May as the auditor for the Beijing-headquartered Chinese financial software company after discovering what it called falsified financial records. But it says it can't turn over its records to the SEC without approval from China's own regulatory authorities.

"As a matter of national sovereignty, the law of the People's Republic of China precludes our firm from producing the requested documents for a foreign regulator without approval from the China Securities Regulatory Commission," the statement said.

It said the SEC request has been passed on to Chinese regulators, as required under Chinese law.

"But so far the Chinese regulators have not given us permission to provide papers to the SEC," the statement said.

As an auditor of Chinese firms listed in the US, the Shanghai Deloitte branch has been registered with the US Public Company Accounting Oversight Board, which oversees auditors, since June 2004.

More to lose

According to the Shanghai unit's most recent annual report to the oversight body, the branch has issued audit reports for 48 US-listed companies, including Longtop.

Deloitte's statement described its dilemma as "essentially a matter between regulators in China and the United States." The company "will be happy to comply with any outcome that is agreed between them," the statement said.

Caught in the middle, Deloitte has a lot to lose in this case.

"If Deloitte were to comply (with the SEC) it runs the risk of China saying it violated Chinese rules and having its license yanked," Paul Gillis, a visiting professor of accounting at Peking University, told Reuters in an interview. If Deloitte does not comply with the SEC, it risks sanctions in the US, he said.

The SEC's action could ultimately escalate friction between US and China regulators, according to Gillis, who said it's just a matter of time before the other three of the world's "Big Four auditors" are ensnared in similar problems.

In fact, Deloitte's three big rivals -- KPMG, Ernst & Young and PricewaterhouseCoopers - are in the same boat as accounting problems mount in some US-listed Chinese companies.

Ernst & Young has been named in at least two class action lawsuits over its work on Sino-Forest, a Toronto-listed firm shot down by short-seller Muddy Waters' accounting fraud allegations.

KPMG in January said it had found possible irregularities in the books of China Forestry, and online business services firm Subaye announced in April that PwC Hong Kong resigned as its auditor amid concerns about its accounting.

Compliance with a SEC subpoena is a legal obligation in the US. Failure to comply may lead to a company losing registration with the US accounting oversight board, according to Gillis.

Fifty-five Chinese mainland-based accounting firms are now registered with that body, including affiliates of the Big Four accounting firms, according to the oversight board's website.

The potential risk of losing their registration could force auditors to stop working for Chinese companies that list in the US, Reuters cited Gillis and other legal and accounting experts as saying.

Full cooperation

But Wei Gang, senior vice-president of Marsh (Beijing) Insurance Brokers Co, said it's "highly unlikely" that will happen.

"As a US firm, Deloitte and the other Big Four accounting firms will definitely offer full cooperation as much as they can," said Wei, whose firm handles insurance for many overseas-listed Chinese companies. "Deloitte's lawyers are probably now contacting the SEC to clarify its position."

Whatever the arguments, the solution to Deloitte's subpoena headache rests heavily on cooperation between regulatory authorities in China and the US.

But common ground is not necessarily easy to find.

Securities and accounting regulators in the two countries met in July in Beijing to try to iron out differences. The two-day closed-door discussions included the SEC, the US accounting oversight board, the CSRC and the Ministry of Finance.

The result of the meetings wasn't publicly disclosed, but it was obvious no accord was reached.

Caijing magazine, citing an unidentified person close to the talks, said the US side produced a list of Chinese companies and their accounting firms, asking for records as part of investigations into financial reports.

Chinese officials declined the request, saying it was "a matter of national sovereignty," the source told the Beijing-based magazine.

"Although China signed some cooperative pacts with the European Union earlier this year, even the Europeans don't even have the right to come into China to assert their supervisory power," the source said. "China and the US have not reached any accord on cooperation."

In fact, Chinese officials do have their reasons to say no.

Most of the US-listed Chinese firms that are now embroiled in fraud accusations landed in US markets via a loophole called a reverse merger, which bypasses the SEC scrutiny typically imposed on a conventional initial public offering.

The reverse merger is a form of backdoor listing in which a foreign company takes over a listed US shell company to gain a berth in a US stock market. That procedure is a matter for the US to resolve, not China, the source said.

There's also a desire by Chinese officials to protect mainland companies, the source told the magazine. The fear is that industry data obtained by US investigators might be used to take advantage of Chinese firms and their market shares, the source said.

Interests of both firms

"Cooperation requires two equal parts," the source said. "If the Americans are allowed to come to China to carry out their investigations, then China should also have that right if it wants to carry out investigations in the US. So far, that is not the case."

Wei, the senior executive with Marsh, said he remains optimistic that both sides will eventually realize that cooperation is in both their interests.

Indeed, if China is going to launch its long-awaited international board, allowing foreign firms to list in mainland stock markets for the first time, it will also need supervisory help from the other side of the world.

It's not just the accounting realm at stake. The US and China have not formed any cooperation pacts related to legal systems, enforcement of laws or economic crimes.

"Cooperation between the two sides has already been seen on many other levels," Wei said. "It's just differences between the two countries' legal and cultural systems that stand between them."

US and Chinese regulators are due to meet again in Washington next month for a second round of talks on joint inspection of auditing firms in China.