You might recall that, for well over a decade, the PCAOB has been unable to fulfill its SOX mandate to inspect audit firms in “Non-Cooperating Jurisdictions,” including China. Years of negotiation failed to resolve the deadlock over audit inspections and, in 2020, the Holding Foreign Companies Accountable Act 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.) According to the U.S.-China Economic and Security Review Commission, as of March 31, 2022, Chinese companies listed on the three largest U.S. exchanges had a total market capitalization of $1.4 trillion. (See this PubCo post.) As a result, the trading prohibitions of the HFCAA were poised to have a substantial impact. After passage of the HFCAA, more negotiations ensued, and, in August, the PCAOB took an initial 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. (See this PubCo post.) But that was viewed as just an opening; as SEC Chair Gary 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.” To the surprise of many, last week, the PCAOB announced that it had secured unprecedented access to conduct these inspections. According to PCAOB Chair Erica Williams, for “the first time in history, the PCAOB has secured complete access to inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong. And this morning the Board voted to vacate the previous determinations to the contrary. This historic and unprecedented access was only possible because of the leverage Congress created by passing the Holding Foreign Companies Accountable Act. Congress sent a clear message with that legislation that access to U.S. capital markets is a privilege and not a right, and China received that message loud and clear. Investors are more protected today because of Congress’ leadership….” However, she added, she wanted “to be clear: this is the beginning of our work to inspect and investigate firms in China, not the end. The PCAOB is continuing to demand complete access in mainland China and Hong Kong moving forward. Our teams are already making plans to resume regular inspections in early 2023 and beyond, as well as continuing to pursue investigations.” What is the impact? To remove, at least for now, the immediate peril of delisting from U.S. exchanges that was threatening many U.S.-listed China-based companies.
Happy Holidays!
Here is the PCAOB fact sheet and the 2022 HFCAA Determination Report.
Williams reported that the PCAOB was able to satisfy three important conditions:
”One—The PCAOB exercised sole discretion to select the firms, audit engagements, and potential violations it inspected and investigated—without consultation with, nor input from, PRC authorities….
Two: PCAOB inspectors and investigators were able to view complete audit work papers with no redactions, and the PCAOB was able to retain information needed to complete our work.
And Three: The PCAOB had direct access to interview and take testimony from all personnel associated with the audits the PCAOB inspected or investigated.”
However, she noted, the PCAOB staff did identify a substantial number of deficiencies. But even audit deficiencies had a positive spin—deficiencies are normal for first-time audit inspections and actually demonstrate that the process is effective. While any potential deficiencies “are troubling,” she said, “it is not unexpected to find numerous deficiencies in jurisdictions that are being inspected for the first time.” Moreover, the potential deficiencies “are consistent with the types and number of findings the PCAOB has encountered in other first-time inspections around the world. The fact that we found those potential deficiencies is a sign that the inspection process worked as it is supposed to.”
Gensler observed that these inspections and investigations followed the signing of the Statement of Protocol in August 2022. At the time, he said that “the proof would be in the pudding. Today, we know that the proof was indeed in the pudding, at least in 2022. Chinese authorities complied with the four key pillars laid out in the Statement of Protocol.” However, he contended, “a lot of work remains to protect investors and ensure ongoing compliance. First, the PCAOB must have continued access for complete inspections and investigations in 2023 and beyond. Second, registered public accounting firms headquartered in China and Hong Kong must work to strengthen audit quality. Third, Chinese-based issuers that access U.S. capital markets must provide specific and prominent disclosures about the heightened operational and legal risks that they face.”
Gensler also echoed Williams’ take on audit quality: the PCAOB, he remarked, “identified numerous deficiencies at audit firms in China and Hong Kong, as has been the case in other jurisdictions in the first year of PCAOB inspection,” noting that “[i]mproving audit quality takes time, and one of the PCAOB’s accomplishments of the past two decades is strengthening audit quality in jurisdictions around the world.” Significantly, the SEC Chair also highlighted the importance, for China-based companies that seek to access the U.S. capital markets, of “specific and prominent disclosures about the heightened operational and legal risks” faced by China-based companies:
“Under the HFCAA, Chinese-based issuers must disclose relevant details about the extent of governmental ownership in their company and any Chinese Communist Party (CCP) participation on their boards of directors in their annual reports filed with the SEC. Separate from the disclosures specified under the HFCAA, the SEC continues to emphasize to Chinese-based issuers their obligations to provide other material disclosures to U.S. investors. In 2021, in light of regulatory developments in China and the overall risks with the China-based variable interest entity (VIE) structure, I directed SEC staff to seek enhanced disclosures from Chinese-based issuers related to their corporate structures. This includes, for example, whether the China-based entity is a VIE and whether it distributes cash to the offshore issuer that could be available to investors. Lastly, Chinese government or party involvement in issuers’ governance and operations may be material to investors and thus would need to be disclosed.”
