PCAOB and Chinese Authorities Sign Agreement, Taking First Step Toward Complete Access for PCAOB to Inspect and Investigate Auditors in China and Hong Kong
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On August 26, 2022, the US Public Company Accounting Oversight Board (the "PCAOB") signed a Statement of Protocol (the "SOP") with the China Securities Regulatory Commission (the "CSRC") and the Ministry of Finance of the People's Republic of China (the "PRC"), establishing a framework for the PCAOB to conduct inspections and investigations of PCAOB-registered public accounting firms in mainland China and Hong Kong.1 Roughly 200 issuers, representing a market capitalization of approximately $1 trillion to $2 trillion, could face trading prohibitions in the United States if the PCAOB is unable to completely inspect their accounting firms located in mainland China and Hong Kong.
Background
Consistent with its mandate under the Sarbanes-Oxley Act of 2002, the PCAOB inspects and investigates PCAOB-registered public accounting firms around the world, but the PCAOB's access to registered public accounting firms in mainland China and Hong Kong has been restricted. For example, the PCAOB has been unable to completely obtain and review audit workpapers from such firms due to positions taken by PRC regulatory authorities. In 2020, the US Congress passed the Holding Foreign Companies Accountable Act (the "HFCAA"), pursuant to which companies audited by public accounting firms in mainland China and Hong Kong could be delisted from US stock exchanges.
Under the HFCAA, if the PCAOB determines that, for three consecutive years, the positions taken by authorities in the PRC restrict its ability to inspect and investigate registered public accounting firms in mainland China and Hong Kong completely, then the HFCAA mandates that companies audited by those firms would be subject to a trading prohibition in US markets imposed by the US Securities and Exchange Commission (the "SEC"), including delisting from US-based national securities exchanges. In 2021, the PCAOB made its first determination pursuant to the HFCAA that the positions taken by PRC authorities prevented the PCAOB from completing their inspections of PCAOB-registered auditors in mainland China and Hong Kong.2 Following such determination, discussions between US and Chinese regulators intensified in search of a resolution satisfactory to both sides that would prevent numerous companies from eventually being delisted in the US, ultimately resulting in the execution of the SOP.
The Statement of Protocol
The SOP establishes a framework for the PCAOB to conduct inspections and investigations of PCAOB-registered public accounting firms in mainland China and Hong Kong and includes commitments from Chinese authorities on four issues that have historically impeded the PCAOB's ability to inspect and investigate completely:
1. Engagement Selection. The PCAOB will be able, in its sole discretion, to select the audit firms and clients it will examine.
2. No Redaction. PCAOB inspectors and investigators can review all audit workpapers without any redaction.
- For a limited set of "Restricted Data," including personally identifiable information, the SOP Agreement creates a "view only" process for PCAOB inspectors and investigators to view the data in camera. The PCAOB has used an in camera approach in other jurisdictions for inspections and investigations.
- The PCAOB is entitled to retain any of the information it reviews, including Restricted Data, as needed to support the findings of its inspections and investigations.
3. Testimony. The PCAOB can interview and obtain testimony from audit firm personnel in mainland China and Hong Kong.
4. Onward Sharing. The PCAOB can transfer information, including Restricted Data, to the SEC, and the SEC can use the information for all SEC purposes, including administrative or civil enforcement actions.
Next Steps
PCAOB inspectors and investigators are expected to be on the ground in Hong Kong in mid-September 2022, and, pursuant to the SOP, all audit workpapers requested by the PCAOB should be made available to them. The PCAOB will then be required to determine whether it can complete inspections and investigations in mainland China and Hong Kong by the end of 2022.
The Chairs of both the PCAOB and the SEC made statements supporting the SOP, but emphasized that this is only the first step in the process. PCAOB Chair Erica Y. Williams noted that "[o]n paper, the agreement… grants the PCAOB complete access to the…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…Now we will find out whether those promises hold up…Whether our teams are able to complete that work without obstruction will inform the PCAOB's determinations at the end of this year."
Similarly, SEC Chair Gary Gensler noted that this is "the first time we have received such detailed and specific commitments from China that they would allow PCAOB inspections and investigations meeting US standards" but that "[t]he 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 US if they continue to use those audit firms."3
The CSRC's statement acknowledged that "[t]he signing of the agreement is an important step forward by regulators in China and the US towards resolving the audit oversight issue that concern mutual interests, and lays the foundation for proactive, professional and pragmatic cooperation of the next stage."
Conclusion
The SOP marks a significant and positive development both in relations between US and Chinese regulators and economic ties between the two countries. Moreover, the roughly 200 issuers who have engaged auditors based in mainland China and Hong Kong—as well as similarly situated issuers that are looking to access US markets in the future—should take this as a promising and affirmative step in the right direction. At the same time, uncertainties remain over the details of the SOP's implementation, and issuers listed in the US who engage such auditors, as well as investors in such issuers, should closely monitor subsequent developments to confirm that the SOP is implemented successfully and, ultimately, to ensure their continued access to US markets.
1 The PCAOB’s press release is available here. The SEC’s fact sheet is available here and FAQs are available here. The CSRC press release is available here.
2 For more about the HFCAA and the potential consequences if China-based issuers were prohibited from trading on US exchanges, see our article here. The SEC fact sheet regarding the HFCAA is available here.
3 Chair Gensler’s statement is available here.
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