U.S. PCAOB and Chinese CSRC enter into Statement of Protocol

Agreement could resolve conflict over PCAOB inspection of auditors based in China and Hong Kong

In a significant move toward resolving the conflict between U.S. and Chinese regulators over the inspection of China-based auditors and the ability of China-based issuers to list in the United States, the Public Company Accounting Oversight Board (“PCAOB”) has signed a Statement of Protocol with the China Securities Regulatory Commission and China’s Ministry of Finance that could avert the mandatory delisting of Chinese issuers from U.S. stock exchanges required under the Holding Foreign Companies Accountable Act (the “HFCAA”). 

Both the PCAOB and the U.S. Securities and Exchange Commission (the “SEC”) have made it clear, however, that the agreement is merely a first step. The real test will come in September 2022, when PCAOB inspectors begin conducting on-site inspections and investigations of firms headquartered in mainland China and Hong Kong, and the PCAOB determines whether it has been provided full and timely access to the information required for the inspections. Reportedly, the inspections will be conducted in Hong Kong, with the option to move to mainland China later.

If the PCAOB continues to be prohibited from conducting complete inspections and investigations of PCAOB-registered public accounting firms in China and Hong Kong, about 200 China-based issuers will face trading prohibitions and likely delisting in the United States. 

What is the conflict between the regulators? 

Companies that are public in the United States are required to file audited financial statements with the SEC. Under the Sarbanes-Oxley Act of 2002 (“SOX”), the auditors of financial statements filed with the SEC must be registered with the PCAOB, and consequently subject to regular PCAOB inspections to assess the auditor’s compliance with applicable U.S. laws and professional standards in connection with its audits of public companies. Auditing firms that are based in China – including the local affiliates of the “Big Four” accounting firms – have generally refused to allow PCAOB inspections. The China-based auditors have maintained that the production of audit papers would violate Chinese law, potentially as a disclosure of state secrets. The SEC and PCAOB have made accommodations for this situation, to enable listings of China-based issuers, under a 2013 Memorandum of Understanding with Chinese securities regulators. However, PCAOB access to the work papers of China-based auditors has remained restricted.

What does the HFCAA require? 

Under the HFCAA, if the PCAOB is “unable to inspect or investigate completely” registered public accounting firms located in foreign jurisdictions, issuers whose financial statements are audited by such firms for three consecutive years face prohibitions on the trading of their securities, including in the over-the-counter (“OTC”) markets in the United States. The time period could be shortened to two years if legislation currently pending in Congress is adopted. 

As required by the HFCAA, in 2021, the SEC adopted a final rule that requires SEC-registered China-based issuers to submit documentation and make disclosures relating to Chinese government control and influence over these companies. The rule also establishes the process by which the SEC may impose trading prohibitions on the securities of these issuers. In December 2021, the PCAOB announced that it had designated China and Hong Kong as the jurisdictions where the PCAOB is not allowed to conduct full and complete audit inspections. 

Have issuers been delisted under the HFCAA? 

No companies have yet been involuntarily delisted under the HFCAA, but some issuers – including several of China’s largest state-owned companies – have announced that they will be voluntarily delisting from the NYSE. 

Earlier this year, the SEC began to list “Commission-Identified Issuers” on its website shortly after registrants begin filing their annual reports for 2021. A Commission-Identified Issuer is one that has retained, for the preparation of the audit report on its financial statements included in its Form 10-K, 20-F, 40-F, or N-CSR (the “annual report forms”), a registered public accounting firm that has a branch or office that is located in a foreign jurisdiction, and that the PCAOB is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction (a “PCAOB-Identified Firm”). 

What kind of documentation must be submitted?

A Commission-Identified Issuer must submit electronically to the SEC documentation that establishes that it is not “owned” or “controlled” by a governmental entity in the foreign jurisdiction. The SEC’s view is that the terms “owned or controlled” and “owned” and “controlling financial interest” in the HFCAA are intended to refer to a person’s or governmental entity’s ability to “control” the registrant as that term is used in the U.S. Securities Exchange Act of 1934 and its rules.

The SEC does not prescribe the type of documentation that can or should be submitted to the SEC to establish that a Commission-Identified Issuer is not owned or controlled by a governmental entity in the foreign jurisdiction. It is up to the issuer to determine how best to satisfy the requirement. The SEC has declined to provide a non-exclusive list of appropriate documentation. 

Commission-Identified Issuers that are owned or controlled by a foreign governmental entity are not required to submit documentation to the SEC. 

What disclosures must be made?

A Commission-Identified Issuer that is foreign (a “Commission-Identified Foreign Issuer”) must also make additional disclosures in its annual report. For every year that the issuer is identified as retaining a PCAOB-Identified Firm for the preparation of the audit report on its financial statements included in its annual report forms (a “non-inspection year”), it must disclose the following (together, the “HFCAA disclosures”): 

  • that, for the immediately preceding annual financial statement period, a registered public accounting firm that the PCAOB was unable to inspect or investigate completely, because of a position taken by an authority in the foreign jurisdiction, issued an audit report for the issuer; 
  • the percentage of its shares owned by governmental entities in the foreign jurisdiction in which the issuer is incorporated or otherwise organized; 
  • whether governmental entities in the foreign jurisdiction with respect to the PCAOB-Identified Firm have a controlling financial interest with respect to the issuer;
  • the name of each official of the Chinese Communist Party who is a member of the issuer’s board of directors or the operating entity with respect to the issuer; and
  • whether the issuer’s articles of incorporation (or equivalent organizing document) contains any charter of the Chinese Communist Party, including the text of any such charter. 
When must issuers begin to comply with the documentation and disclosure requirements?

Once the SEC makes the identifications, the documentation establishing that a Commission-Identified Issuer is not owned or controlled by a governmental entity in the foreign jurisdiction of the PCAOB-Identified Firm must be submitted on or before the due date of the registrant’s next annual report. Thus, for example, if an issuer is identified as being a Commission-Identified Issuer based on its annual report filing made in 2022 for the fiscal year ended December 31, 2021, it will be required to comply with the documentation and, if applicable, the disclosure requirements in its annual report filing covering the fiscal year ending  December 31, 2022, that it is required to file in 2023.

Registrants will not be subject to a non-inspection year determination for any fiscal year ended on or prior to December 18, 2020. 

When will any trading prohibitions begin?

A registrant must be deemed a Commission-Identified Issuer for three consecutive years before the SEC imposes any trading prohibitions. As discussed above, the SEC began identifying Commission-Identified Issuers after they filed their annual reports for 2021, in the spring of 2022. Consequently, the earliest any trading prohibitions would be imposed is in 2024, once any issuer has been a Commission-Identified Issuer for three consecutive years (i.e., 2022, 2023, and 2024).

However, if the U.S. Congress adopts the Accelerating Holding Foreign Companies Act (the “AHFCA”), trading prohibitions could be triggered if an issuer is a Commission-Identified Issuer for only two consecutive years (i.e., as early as 2023). The Senate passed the AHFCA in 2021, but the House of Representatives has not yet voted on the bill. 

What is the effect of the Protocol? 

In 2021, the PCAOB made determinations that the positions taken by Chinese  authorities prevented the PCAOB from inspecting and investigating in mainland China and Hong Kong completely. It issued a report listing 35 audit firms in mainland China, and 28 audit firms in Hong Kong as PCAOB-Identified Firms. The PCAOB is now required to reassess its determinations by the end of 2022.

Under the Protocol, the PCAOB has sole discretion to select the firms, audit engagements and potential violations it inspects and investigates, without consultation with, nor input from, Chinese authorities. Procedures are also in place for PCAOB inspectors and investigators to view complete audit work papers, and the PCAOB is to have direct access to interview and take testimony from all personnel associated with the audits the PCAOB inspects or investigates.

According to the SEC’s fact sheet about the Protocol, the PCAOB’s determination under the HFCAA is a jurisdiction-wide, not firm-specific, determination. This means the PCAOB must be able to access audit documentation from all of its registered public accounting firms and select any audit engagement – not just some of the firms or some of the engagements – to be deemed able to conduct complete inspections and investigations in China and Hong Kong. 

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This development, although only a first step, is highly favorable for China-based issuers and their advisors. It gives hope that further disruptions in the market for securities of China-based issuers may yet be avoided. We will continue to monitor developments in this area and welcome any queries you may have about the HFCAA and the Protocol.