For well over a decade, the PCAOB has been unable to fulfill its SOX mandate to inspect audit firms in “Non-Cooperating Jurisdictions,” or “NCJs,” including China. To address this issue, in December 2020, the Holding Foreign Companies Accountable Act, was signed into law. The HFCAA amended SOX to prohibit trading on U.S. exchanges of public reporting companies audited by audit firms located in foreign jurisdictions that the PCAOB has been unable to inspect for three sequential years. (See this PubCo post.) The U.S.-China Economic and Security Review Commission reported that, as of March 31, 2022, Chinese companies listed on the three largest U.S. exchanges had a total market capitalization of $1.4 trillion. As a result, the trading prohibitions of the HFCAA could have a substantial impact. Years of negotiation to resolve the deadlock over audit inspections notwithstanding, China and Hong Kong have still not permitted PCAOB inspections, largely because of purported security concerns. (Interestingly, the WSJ reported that, in a “departure from what officials have said previously, the Chinese stock regulator said on Friday that audit working papers generally do not contain state secrets, individual privacy, companies’ vast user data or other sensitive information.”) In May, in remarks to the International Council of Securities Associations, YJ Fischer, Director of the SEC’s Office of International Affairs, indicated that, although there had been progress, “significant issues remain[ed],” and reaching an agreement would be only “a first step.” In other words, there was still “a long way to go.” On Friday, however, the PCAOB took that first step by signing a Statement of Protocol with the China Securities Regulatory Commission and the Ministry of Finance of the People’s Republic of China governing inspections and investigations of audit firms based in China and Hong Kong. According to a statement from SEC Chair Gary Gensler, the “agreement marks the first time we have received such detailed and specific commitments from China that they would allow PCAOB inspections and investigations meeting U.S. standards.”
Why are these inspections and investigations important? As Gensler has repeatedly said in this context, “[w]e have a basic bargain in our securities regime, which came out of Congress on a bipartisan basis under the Sarbanes-Oxley Act of 2002. If you want to issue public securities in the U.S., the firms that audit your books have to be subject to inspection by the [PCAOB].” In Gensler’s statement, he contends that it is a “privilege for foreign issuers to access our markets—the largest, deepest, most liquid markets in the world. Investors in U.S. markets should be protected—and have trust in a company’s financial numbers—regardless of whether an issuer is foreign or domestic. Further, if foreign issuers want access to our public capital markets, they must be on a level playing field with U.S. firms.” That is, if “you want to issue public securities in the U.S., the registered public accounting firms that audit your books have to be subject to inspections and investigations by the PCAOB.”
The HFCAA requires the SEC to “identify” each public reporting company that has retained a registered public accounting firm to issue an audit report if that firm has a branch or office in a foreign jurisdiction and the PCAOB has been “unable to inspect or investigate [that firm] completely because of a position taken by an authority in the foreign jurisdiction.” In addition, once a public reporting company has been so “identified” by the SEC, the HFCAA imposes requirements on the company to submit certain documentation to the SEC establishing that it is not owned or controlled by a governmental entity in the foreign jurisdiction and to provide certain disclosures. The HFCAA prohibits trading on exchanges and other markets in the U.S. of companies that have been so “identified” for three sequential years. (See this PubCo post.) In the absence of compliance with the new SOP, approximately 200 identified issuers could face potential trading prohibitions and, ultimately, delisting in the U.S.
According to the SEC’s fact sheet, under the SOP’s new framework, “PCAOB inspectors and investigators can travel to Hong Kong to start their work and inspect and investigate completely” as required by the HFCAA. The SOP “includes commitments from Chinese authorities on four issues that have historically impeded the PCAOB’s ability to inspect and investigate completely.” As summarized by Gensler, these four critical items are as follows:
- “First, in accordance with the Sarbanes-Oxley Act, the PCAOB has independent discretion to select any issuer audits for inspection or investigation;
- Second, the PCAOB gets direct access to interview or take testimony from all personnel of the audit firms whose issuer engagements are being inspected or investigated;
- Third, the PCAOB has the unfettered ability to transfer information to the SEC, in accordance with the Sarbanes-Oxley Act; and
- Fourth, PCAOB inspectors can see complete audit work papers without any redactions. On this last item, the PCAOB was able to establish view only procedures—as it has done in the past with certain other jurisdictions—for targeted pieces of information (for example, personally identifiable information).”
As Fischer intimated, however, the signing of the agreement is not the end of the matter, it’s more like the beginning. As Gensler phrased it, the “proof will be in the pudding. While important, this framework is merely a step in the process. This agreement will be meaningful only if the PCAOB actually can inspect and investigate completely audit firms in China. If it cannot, roughly 200 China-based issuers will face prohibitions on trading of their securities in the U.S. if they continue to use those audit firms.” According to PCAOB Chair Erica Williams, “[o]n paper, the agreement signed today grants the PCAOB complete access to the audit work papers, audit personnel, and other information we need to inspect and investigate any firm we choose, with no loopholes and no exceptions. But the real test will be whether the words agreed to on paper translate into complete access in practice.” Going forward, Gensler added, “will our markets include China-based issuers? That still is up to our counterparts in China. It depends on whether they comply with the requirements of U.S. law, as detailed in the framework. Either way, I look forward to ensuring key investor protections in our markets—with China-based issuers, if this framework is followed; or without China-based issuers, if it is not.”
What happens now? According to the SEC’s FAQs, the “PCAOB will notify the audit firms of its plans to inspect, including the specific engagements. PCAOB inspectors will be in Hong Kong by mid-September to start their inspection work.” With regard to PCAOB investigations, the PCAOB has “issued document requests to audit firms in China, and the testimony notifications have been sent to witnesses. These audit firms must provide the requested documents to the PCAOB, through the CSRC, on a timely basis such that PCAOB inspectors may conduct inspections of audit documentation and investigators will be able to conduct the interview of witnesses and collect testimony in Hong Kong.”
And what happens if some audit firms comply but others do not? The fact sheet indicates that the “PCAOB’s determination under the HFCAA is a jurisdiction-wide determination, not firm-specific….The PCAOB must be able to access audit documentation from all of its registered public accounting firms and select any audit engagement—not just some of the firms or some of the engagements—to be able to conduct complete inspections and investigations in China and Hong Kong.”
