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Due to a recent agreement between the Public Company Accounting Oversight Board and Chinese securities regulators, many US exchange–listed companies audited by accounting firms based in mainland China and Hong Kong may be able to continue trading on US exchanges, preserving liquidity for investors and ongoing access to US capital markets. However, this agreement could lead to an increased enforcement risk through more regulatory inquiries.

In recent years, securities regulators, US Congress, and the public have expressed concern about ensuring that certain public companies—those that trade on US exchanges while being domiciled outside the United States—abide by the rigorous regulatory requirements intended to protect American investors. Recent attention has been directed at public companies and accounting firms based in the People’s Republic of China (PRC) and Hong Kong, where the Public Company Accounting Oversight Board (PCAOB) has historically been limited in its ability to ensure that audits of companies listed on US exchanges are being conducted in accordance with PCAOB standards and other applicable regulatory requirements.

This is not a small subset of companies; as of September 14, 2022, there were 249 Chinese companies whose securities trade on US exchanges with a total market cap of approximately $915 billion.[1] Partially as a result, and against the backdrop of an increasingly fraught US-PRC relationship, Congress enacted the Holding Foreign Companies Accountable Act of 2020 (HFCAA) to restrict access to the US capital markets by foreign public companies whose financial statements are audited by accounting firms that the PCAOB is unable to fully inspect due to interference by a foreign government. A growing number of PRC- and Hong Kong–based public companies appear wary of continued listing on US exchanges or have transitioned their primary listings to the Hong Kong Stock Exchange.[2] Other such companies with a primary listing on a US exchange have chosen to try to avoid potential delisting pursuant to the HFCAA by switching to US-based auditors.[3]

On August 26, 2022, the PCAOB announced a Statement of Protocol Agreement (SOP) with the China Securities Regulatory Commission and China’s Ministry of Finance regarding cooperation in the oversight of PCAOB-registered public accounting firms in the PRC and Hong Kong, which could prove to be a monumental step forward in the cooperation between the PCAOB and PRC regulators. US Securities and Exchange Commission (SEC) Chair Gary Gensler said, “This agreement marks the first time we have received such detailed and specific commitments from China that they would allow PCAOB inspections and investigations meeting U.S. standards.”[4]

If the SOP is fully implemented and adhered to by PRC authorities, then many public companies audited by PRC- and Hong Kong–based accounting firms may be able to avoid the trading prohibition on US exchanges that the HFCAA would otherwise impose and preserve liquidity for their investors and ongoing access to America’s deep capital markets.

Congress established the PCAOB through the Sarbanes-Oxley Act of 2002 (SOX) to provide oversight of the audits of public companies listed on US exchanges. Its authority includes the registration, inspection, and investigation of audit firms, including firms located in foreign jurisdictions that are engaged to conduct audits of foreign companies listed on US exchanges. With respect to accounting firms headquartered in foreign jurisdictions, the PCAOB typically enters into cooperative arrangements with foreign regulators, and it works with foreign regulators to address any concerns regarding data protection, state secrecy, or other sensitive substantive concerns.

For jurisdictions other than the PRC and Hong Kong, the PCAOB has been able to address foreign regulators’ concerns in a way that is compatible with its core mission. In the PRC and Hong Kong, however, the road to the SOP has been a long one. In 2013, the PCAOB entered into a Memorandum of Understanding (MOU) with PRC authorities that was intended to establish a framework for future cooperation. Despite the MOU, the PCAOB has repeatedly stated that it has received insufficient cooperation to conduct full inspections and investigations of audit firms in the PRC and Hong Kong.

The new SOP seeks to establish a method for the PCAOB to conduct inspections of PCAOB-registered public accounting firms in the PRC and Hong Kong, as contemplated by SOX. Specifically, the SOP includes assurances from PRC authorities on issues that have historically hindered the PCAOB’s ability to conduct its inspections and investigations:

PCAOB inspectors will begin their on-site inspections in mid-September 2022, which would include access to all necessary audit working papers. By the end of 2022, the PCAOB must determine whether it can complete inspections and investigations of public accounting firms headquartered in the PRC and Hong Kong as required by SOX and, thus, reassess whether such public accounting firms continue to present the concerns that the HFCAA was intended to address.

The SOP is a significant sign of potential cross-border cooperation. As part of the PCAOB’s work to ensure that investors in public companies can rely on quality audits, it will investigate the competency and conduct of accounting firms and professionals in the PRC and Hong Kong. The PCAOB has settled disciplinary orders with accountants and accounting firms around the world based on information learned during inspections.[6]

PCAOB inspectors and investigators may also determine that there is reason for the SEC and/or the US Department of Justice (DOJ) to investigate not only the accounting firms over which the PCAOB has jurisdiction, but also the public companies whose audits the PCAOB will now be able to thoroughly inspect. If the PCAOB inspections uncover material compliance issues, enforcement actions by the SEC and DOJ could result from PCAOB referrals.[7] Auditor working papers, and an auditor’s record of the accounting judgments made by the public company that could be memorialized in those working papers, may also reveal possible accounting irregularities in a public company’s financial statements and result in additional regulatory scrutiny or action.

Over the last 15 years, multiple PRC companies have been subjected to enforcement actions and investigations by regulators relating to accounting issues.[8] These past issues may fuel ongoing skepticism from US regulators toward PRC- and Hong Kong–based public companies. Thus, an increasing number of investigations is likely, especially given the emphasis on enforcement at both the DOJ and the SEC—indeed, enforcement is an essential part of the mission statement of both organizations—and the number of PRC- and Hong Kong–based public companies whose accounting firms’ audits will now be subject to scrutiny.

Such investigations can lead not only to enforcement actions, but often are followed by securities class action and shareholder derivative lawsuits. If a public company’s auditor is subject to PCAOB sanctions or the company is made aware of significant concerns about its auditor’s quality control standards, then the public company may want to consider conducting thorough internal investigations to address possible compliance shortfalls, while regulators assess remediation in their enforcement decisions.

Even if these investigations do not lead to enforcement actions, PRC- and Hong Kong–based US public companies and their executives should be prepared for the time, expense, and scrutiny of a potential US regulatory inquiry.

The SOP is a breakthrough in cooperation between the two nations, and should allow PRC- and Hong Kong–based US public companies to avoid delisting pursuant to the HFCAA. Despite the extremely positive nature of this aspect of the SOP for these companies, the level of PCAOB access that the SOP entails warrants preparation by PRC- and Hong Kong–based auditors and public companies for increased scrutiny and possible enforcement risk.

From the auditors’ perspective, if actions by PRC authorities match their commitment under the SOP—PCAOB Chair Erica Y. Williams has noted that the agreement, at present, is merely “on paper”[9]—the PCAOB’s improved access may require additional preparation and planning. If an issuer chooses to engage a US-based accounting firm, that newly engaged firm will be expected to obtain prior year working papers and “should still make inquiries of the predecessor accounting firm about certain matters,” including, among other things, integrity, management disagreements, audit committee communications, unusual or significant transactions, and the reason for the change in auditors.[10]

On the other hand, issuers who maintain non-US-based accounting firms should recognize that the firm’s audit staff likely has not previously been subject to full PCAOB inspections and investigations. Thus, preparation for an inspection is advisable, and could include coordination with US affiliates or secondments by US audit partners familiar with the PCAOB’s process to select and perform its inspections, such as the level of engagement necessary from audit partners with inspectors and the types of informational requests made to audit personnel.

Among other things, these firms must ensure that their personnel cooperate with the PCAOB inspectors and make all requested working papers available to them because the PCAOB requires and takes into consideration cooperation during its inspections and investigations. In addition, the PCAOB has signaled that it may seek to conduct inspections of prior years’ audits given the restrictions that it faced prior to the new SOP. As such, PRC- and Hong Kong–based accounting firms should be prepared for inspections of prior year audits and requests for accompanying working papers by the PCAOB.

From a public company’s perspective, PCAOB inspections under the SOP may result in regulatory and/or disciplinary actions being brought against an accounting firm that the public company engaged and could result in heightened scrutiny of its financial statements and other public disclosures. Proactive engagement of international legal counsel is important to assist public companies when addressing concerns raised about its auditor and the quality of the audit performed as a result of PCAOB inspections, including seeking guidance in the event that the inspection results in a referral to the SEC or DOJ, and counseling on whether to self-report issues to regulators. Counsel should be well versed in US securities laws and enforcement practices and trends, but also have a significant presence in the PRC and Hong Kong that informs a robust understanding of the business and legal considerations facing PRC- and Hong Kong–based public companies. In addition, public companies should pay particular attention to three areas that remain a focus of SEC and DOJ enforcement:

Finally, PRC- and Hong Kong–based companies should also be aware that the SEC and DOJ—like the PCAOB—expect and take into consideration cooperation.

If PRC- and Hong Kong–based auditors and US exchange–listed public companies proactively take steps to address the potential issues discussed, they may be able to significantly limit the discomfort associated with a US regulatory inquiry.

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following:

[1] Stock Market MBA, List of Chinese Companies that trade on U.S. stock exchanges.

[2] Al Barbarino, 5 State-Owned Chinese Cos. To Delist From NYSE, Law360 (Aug. 12, 2022).

[3] Brian Yang, Chinese Firms' Delisting Uncertainty Lifted For Now But Clock Ticking, Scrip (Aug. 29, 2022).

[4] Chair Gary Gensler, US Sec. & Exch. Comm’n, Statement on Agreement Governing Inspections and Investigations of Audit Firms Based in China and Hong Kong (Aug. 26, 2022).

[5] Pub. Co. Accounting Oversight Bd., Fact Sheet: China Agreement (Aug. 26, 2022); US Sec. & Exch. Comm’n, Fact Sheet: PCAOB Agreement with China on Audit Inspections and Investigations.

[6] Pub. Co. Accounting Oversight Bd., Enforcement Actions.

[7] Rule 5112 allows the PCAOB to refer any investigation to the SEC and, at the direction of the SEC, to DOJ.

[8] For example, in March 2014 the SEC charged PRC-based AgFeed Industries, Inc. and its senior executives with accounting fraud, alleging that the company maintained two sets of financial information and that the “real set” reflected revenues that were hundreds of millions of dollars lower than the amounts reported by the company. See US Sec. & Exch. Comm’n, SEC Charges Animal Feed Company and Top Executives in China and U.S. With Accounting Fraud (Mar. 11, 2014). More recently, in December 2020, PRC-based Luckin Coffee Inc. agreed to pay a $180 million penalty to resolve charges brought by the SEC, which alleged that, from at least April 2019 through January 2020, Luckin fabricated more than $300 million in retail sales by using related parties to create false sales transactions. US Sec. & Exch. Comm’n, Luckin Coffee Agrees to Pay $180 Million Penalty to Settle Accounting Fraud Charges (Dec. 16, 2020). The accounting issues for both of these companies highlight the importance of quality audits.

[9] Pub. Co. Accounting Oversight Bd., PCAOB Chair Williams Statement Regarding Agreement with Chinese Authorities, YouTube (Aug. 26, 2022).

[10] US Sec. & Exch. Comm’n, Statement of Paul Munter, Audit Quality and Investor Protection under the Holding Foreign Companies Accountable Act (Sept. 6, 2022).

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