May 27, 2022

China-Based Companies: Audit Inspections at “Critical Juncture”

Earlier this week, YJ Fischer, Director of the SEC’s Office of International Affairs, used this speech to sound alarm bells with respect to the continued listings of China and Hong Kong-based companies. Here’s an excerpt with the four main points:

– First, PCAOB-registered public accounting firms must provide the PCAOB with access to their audit work papers, and, any claim that audit work papers cannot be produced because they contain national security materials is questionable at best;

– Second, although there have been ongoing and productive discussions between US and Chinese authorities regarding audit inspections and investigations, significant issues remain and time is quickly running out;

– Third, even if US and Chinese authorities reach an agreement in the near future to commence PCAOB audit inspections and investigations in China and Hong Kong—and I want to emphasize this point—such an agreement will only be the start towards satisfying the PCAOB’s statutory mandate; and

– Finally, should the issuers or the relevant Chinese authorities wish, they can effectuate the voluntary delisting of China-based issuers that they deem “too sensitive to comply” with PCAOB requirements, but allow other companies and audit firms to comply fully with the PCAOB inspection and investigative processes, thereby allowing the remainder of China-based issuers to avoid potential trading prohibitions in the US.

The speech includes a good refresher on the Holding Foreign Companies Accountable Act, which was passed in 2020:

– First, the HFCAA directs the PCAOB to determine whether it is unable to inspect or investigate completely registered firms located in a foreign jurisdiction because of a position taken by an authority in that jurisdiction.

– Second, the HFCAA directs the SEC to identify issuers that file annual reports that include an audit report prepared by auditors covered by the PCAOB’s determination.

– Finally, after three consecutive years of an issuer being identified by the Commission under this process, the HFCAA requires the SEC to impose a trading prohibition on the securities of those issuers.

Since the HFCAA was signed into law, the PCAOB has determined that there are two jurisdictions — China and Hong Kong — where local authorities prevented the PCAOB from inspecting or investigating audit firms completely. And, in a largely administrative process, the SEC has commenced the process of identifying issuers that have filed annual reports with an audit report prepared by an audit firm in a jurisdiction subject to the PCAOB’s determination under the HFCAA. These issuers may face potential trading prohibitions and, ultimately, delisting as soon as 2024. As of May 20, 2022, the Commission had conclusively identified 40 such issuers.

It has been a very busy week for HFCAA determinations, because there are now 128 conclusively identified issuers and another 20 that have been provisionally identified. When I checked in on this two months ago, there were no conclusively identified issuers and only 6 “maybes”! The list already includes Baidu and Weibo. Eventually, it will likely include all China-based stocks that trade on US exchanges, including Alibaba.

This Bloomberg article says that some analysts think that the Chinese & US governments may be able to strike a deal that would avoid delistings – but it could take a year to work that out.

Liz Dunshee