Making Workpapers Available to the PCAOB Might Violate China’s Sovereignty
On January 23, 2014, the SEC came down hard on Chinese units of big-4 firms, ruling that these units should be barred from auditing U.S.-traded companies for six months. The ruling came after the firms failed to show the SEC their audit work and said that doing so would have violated Chinese law and regulations.
The audit requirement has gained steam recently because of a major fraud at Chinese company Luckin Coffee in 2020 that has raised questions whether Chinese firms with shares listed on the New York Stock Exchange or Nasdaq made it urgent that Chinese firms should be held to the same standards as U.S. companies to protect investor interests.
At Luckin, a company listed in the U.S., it was disclosed that its chief operating officer fabricated the company’s 2019 sales by about 2.2 billion yuan ($310 million). As a result, the company’s shares were delisted by Nasdaq and Luckin was fined $180 million. Perhaps an audit of its books by U.S. regulators would have cleaned up the mess.
Fast forward from 2014 to the present and the same old song is being sung—the need for Chinese companies, including American companies operating in China, to undergo an inspection by the U.S. Public Company Accounting Oversight Board (PCAOB). The PCAOB inspects the audits of publicly owned companies and seeks to do the same for Chinese companies listed on the US exchanges. Still, China continues to stall and has failed to cooperate with the board.
The Holding Foreign Companies Accountable Act of 2020 (HFCAA)
According to a Wall Street Journal article, an increased urgency for compliance by Chinese companies has come as a three-year countdown for China to comply with a U.S. law, the Holding Foreign Companies Accountable Act of 2020 (HFCAA), looks increasingly likely to be shortened.
The HFCAA sets up a framework by which the SEC is required to ban trading in the U.S.-listed securities of China-based companies if obstacles to PCAOB access are not removed within the time-period prescribed by the law. The HFCAA banned U.S. trading of securities of companies whose auditors can’t be inspected by the PCAOB for three consecutive years. That gives Beijing until spring 2024 to comply. Striking and executing any deal would entail a lengthy process, and the new timetable could see U.S. stock-trading bans for some Chinese companies starting as early as next March.”
Views of the China Securities Regulatory Commission (CSRC)
The China Securities Regulatory Commission (CSRC), the agency coordinating Chinese government responses to the talks, has issued multiple statements this year signaling that progress has been made in negotiations with their U.S. counterparts. However, China has done this before. Its end game seems to be to delay, delay, delay and hope something happens to save it from the oversight of the PCAOB. Moreover, can we really trust anything the Chinese government says?
Just read this statement to The Wall Street Journal: “China and the U.S. maintain close communications and are committed to reaching collaborative arrangements that comply with both countries’ laws and regulations. Overall, the negotiation process is going smoothly.” Seriously?
Now read what the SEC has said: “We continue to meet and engage with Peoples Republic of China (PRC) authorities, and speculation about a final agreement remains premature. It is important to note that reaching an agreement, while an important and necessary first step, will not alone satisfy the requirements of the HFCAA.”
The core issue is whether China will allow the PCAOB to routinely inspect the auditors of U.S.-listed Chinese companies. China has long argued that unfettered access to the audit papers could threaten its national security, as some of the companies are state-owned, do business with state-owned companies, or hold large amounts of data on Chinese citizens. That may be so but the need for transparency is more important to protect U.S. and foreign investors who own stock in Chinese companies.
China’s sweeping view of what constitutes a national-security risk is one reason for the impasse. The unadulterated information from large Chinese companies could provide insights into the nation’s economy that aren’t apparent in China’s tightly controlled official data.
The scope and depth of such inspections was a contentious point in previous rounds of talks. In pilots conducted during 2016, China handed over heavily redacted audit papers and barred the PCAOB from accessing the records of the most valuable U.S.-listed Chinese companies, including Alibaba. Chinese officials were also present in interviews that the PCAOB conducted during the inspection, potentially interfering with the process. Eventually, the negotiations broke down.
It's important to note that bills passed by Congress would shorten the deadline by a year. That means the legislation would likely be included in a broader “China bill” that is still under negotiation, and which aims to boost America’s competitiveness against China. SEC Chairman Gary Gensler supports the shortened timetable.
If the bill passes later this year, and China-based auditors still can’t be inspected, Chinese companies could be delisted starting from March 2023, once their 2022 annual reports are published. The CSRC said the proposed acceleration of the timeline is “not conducive to protecting investor interests, nor to resolving the audit oversight issues.”
“The purpose of the bill is not to kick companies off the exchange. The purpose is to apply PCAOB oversight,” said Rep. Brad Sherman (D., Calif.), who introduced the House version of the accelerated timeline bill. He said that shortening the timeline will lead to faster negotiations.
There are currently more than 250 Chinese companies that are listed on U.S. exchanges. The PCAOB doesn’t have to inspect all of their audit papers at the initial stage, but it needs to be able to examine a meaningful sample to determine that China as a jurisdiction is HFCAA compliant. Overall, it could be a painstaking process, even if China makes concessions on areas it wasn’t willing to before.
As the Wall Street Journal article points out, “The clock is ticking, and unless China shows more flexibility than it has shown today, the delisting of some or all of its companies is inevitable,” said Mr. Willems.
I’m not confident the CSRC and Chinese government will ever comply with U.S. law on audit inspections of Chinese companies. They may choose to delist the affected companies and go elsewhere and list their stock including on the Hong Kong and/or British stock exchanges. Perhaps this is best because of the old adage: Trust but verify.
Blog posted by Dr. Steven Mintz, The Ethics Sage, on June 2, 2022. You can sign up for Steve’s newsletter and learn more about his activities on his website (https://www.stevenmintzethics.com/) and by following him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.
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