Congress Considers Legislation to End the Listing of Chinese Companies with Uninspectable Auditors
After years of fruitless negotiations between the PCAOB and Chinese regulators, Congress now has before it bipartisan legislation that would address a longstanding challenge — the PCAOB’s inability to conduct inspections in China of audits of U.S. listed companies. On June 19, the House Financial Services Committee held hearings on two of these bills. Separately, two Senators, a Republican and a Democrat, have urged the U.S. Trade Representative to include the roadblocks to PCAOB inspections in trade negotiations with China. Whether any action will be taken on the problem of uninspectable Chinese auditors is far from clear, but this somewhat obscure issue finally seems to be generating interest beyond the walls of the PCAOB.
The Sarbanes-Oxley Act requires all accounting firms that audit, or substantially participate in the audit of, companies that report to the SEC to register with the PCAOB, and the PCAOB is required to periodically inspect registered firm audits of U.S. public companies. Many foreign companies are listed in the U.S., and in most cases their financial statements are audited by accounting firms based in the company’s home jurisdiction. These foreign accounting firms, like U.S.-based firms, are subject to the PCAOB’s oversight.
Initially, many countries were reluctant to permit the PCAOB to conduct inspections in their territory. Over time, however, the PCAOB negotiated with its foreign counterparts and obtained permission to perform inspections. In some cases, the PCAOB inspects foreign accounting firms in conjunction with the home country accounting oversight body, while in others, it inspects on its own. Last December, the PCAOB reported that it had entered into cooperative agreements with 23 foreign regulators as a result of which it either conducts joint inspections or shares inspection findings with regulators in those jurisdictions. All told, the PCAOB has inspected firms in 50 different non-U.S. jurisdictions. See SEC Chairman Clayton, SEC Chief Accountant Wes Bricker, and PCAOB Chairman Duhnke, Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally — Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China (December 7, 2018) (Joint Statement).
The exception to this pattern of international cooperation is China. China does not permit the PCAOB to inspect PCAOB-registered Chinese audit firms (including Hong Kong-based audit firms, to the extent their audit clients have operations in mainland China). This refusal apparently stems from the Chinese government’s concern about what the inspectors might see. China has a broad concept of state secrets, which encompasses many business records, particularly in the case of companies with some degree of state ownership. There has also been speculation that in some cases audit work papers might shed light on the undisclosed ownership or other role of the Communist Party in particular public companies.
Whatever the causes, the result of the Chinese position is a significant gap in the PCAOB’s inspections program. According to the Joint Statement, there are 213 U.S-listed companies with auditors based in mainland China or Hong Kong as to which the PCAOB is unable to conduct inspections. The PCAOB maintains a list of U.S.-traded foreign companies with auditors that it cannot inspect. That list includes such well-known names as Alibaba Group, Baidu, China Petroleum & Chemical, and China Mobile, each of which has a multi-billion-dollar market capitalization. In the Joint Statement, Messrs. Clayton, Bricker, and Duhnke observe that “investors in these companies do not receive the tangible, quality-enhancing benefits that can result from PCAOB inspections.”
Two bills (each of which has House and Senate versions) have been introduced in Congress to address the PCAOB’s inability to inspect in China.
The Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges Act (the Equitable Act), would require that the rules of a national securities exchange prohibit the initial listing of any security of an issuer audited by a foreign public accounting firm that the PCAOB is unable to inspect because of a position taken by a foreign governmental authority. For foreign companies with securities listed on a U.S. exchanges at the time of enactment of the Equitable Act, exchange rules must prohibit continued listing, beginning in 2025, if the PCAOB has been unable to inspect the company’s auditor in three consecutive years. In addition, foreign companies with securities listed on U.S. exchange would be required to disclose the percentage of company shares owned by governmental entities and the name of any official of the Chinese Communist Party who is a member of the board of directors.
The Holding Foreign Companies Accountable Act would require the SEC to prohibit an SEC registered company from trading on a U.S. exchange or alternative trading system if the company retains a foreign public accounting firm that the PCAOB is unable to inspect for three consecutive years. If the company subsequently retains an accounting firm that that PCAOB has inspected, the trading ban ends, but, if the company’s new auditor cannot be inspected during a particular year, the trading ban would be re-imposed for five years. This bill would also require an issuer to disclose whether it is state-owned or government-controlled.
On June 12, Senators Kennedy and Van Hollen, sponsors of the Senate version of the Holding Foreign Companies Accountable Act, sent a letter to Robert Lighthizer, the United States Trade Representative, and urged that the substance of their legislation be included in the ongoing trade negotiations with China. They argue that the “current failure of China to comply with our laws and play by the same rules as everyone else puts American investors and the credibility of our markets at risk” and that their legislation should be a “guidepost” for negotiations with the Chinese government.
It is hard to disagree with the objectives of the Equitable Act and the Holding Foreign Companies Accountable Act. Congress directed the PCAOB to inspect foreign accounting firms that audit companies that avail themselves of the U.S. securities markets. The PCAOB has devoted considerable time and effort to making that mandate a reality. There is no principled reason why accounting firms based in China should be an exception. Indeed, if Chinese companies are permitted to continue raising capital in the U.S. despite the uninspectability of their auditors, accounting firms and regulators in other countries might begin to ask why they should cooperate with the PCAOB. If that were to happen, the PCAOB’s foreign inspections program could unravel.
At the same time, efforts to delist Chinese companies may end up having somewhat different consequences than their proponents intend. First, the group most negatively impacted, at least in the short run, would be U.S. investors. Delisting would make their shares less liquid and drive down prices. These investors might regard this as a high price to pay for a jurisdictional dispute between regulators. The SEC already has the authority to take enforcement action, which could result in delisting, against foreign companies that don’t comply with the auditor requirements. Presumably, the Commission has declined to do so because of the adverse impact on U.S. investors.
Second, the result of a listing ban would likely be that Chinese companies currently trading in the U.S. would relist in Hong Kong and that future Chinese issuer public offerings would occur outside the U.S. While U.S. investors would be “protected” against the risks of investing in these companies, they would also be deprived of opportunities to participate in one of the fastest growing economies in the world. The dominance of the U.S. securities markets would suffer.
Finally, while not covered in the current legislation, the problem of uninspectable Chinese auditors is not limited to Chinese companies. PCAOB-registered Chinese accounting firms also audit the Chinese operations of many U.S.-listed multi-nationals. Even though the Chinese auditor does not issue the multi-national’s audit reports, the work it performs is relied upon by the company’s principal auditor, which may be based in the U.S. or elsewhere. As the PCAOB observes on its website, that work “is often significant to the audit of the financial statements the multi-national issuer files with the SEC and would also be within the scope of PCAOB inspections.” Consistency would seem to require that the PCAOB’s inability to inspect these firms also be addressed, although it is not clear how that could be accomplished without doing more harm than good.
Ideally, the obstacles to PCAOB inspections in China will eventually be solved by China recognizing that it is in its best interests to accept international investor protection norms by permitting PCAOB inspections. Whether delisting threats will help move China in that direction is unclear. But, in the deteriorating climate of U.S.-China relations, a solution in the near term seems unlikely.
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