What auditing issues are US-listed Chinese companies facing?
The Holding Foreign Companies Accountable Act, under the Public Company Accounting Oversight Board (PCAOB) rules, requires the US Securities and Exchange Commission (SEC) to prohibit the trading of securities of a non-US issuer listed on US stock exchanges if the PCAOB determines it has been unable to inspect the company’s accounting firm for two consecutive years.
The PCAOB has so far identified 128 Chinese firms that are at risk of being delisted.
In a May 24 speech, YJ Fischer, director at the SEC’s office of international affairs, said that the “PCAOB would need to be able to complete inspections and investigations by early November 2022”. 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 SAR, “such an agreement will only be the start towards satisfying the PCAOB’s statutory mandate”.
The PCAOB must be able to obtain sufficient cooperation and agreement from Chinese authorities so that the PCAOB Board can make a determination that it can inspect and investigate completely in China and Hong Kong SAR, and access audit work papers from all, not some, China-based issuers and their registered public accounting firms.
How has the Chinese Securities and Regulatory Commission reacted?
In early April, the Chinese Securities and Regulatory Commission withdrew a long-standing requirement that on-site inspections should mainly be conducted by Chinese regulatory agencies or rely on inspection results.
“This move could reduce China-US tensions, potentially giving Chinese companies the option to cooperate with US regulators,” said an in-house counsel at a Chinese securities firm.
The CSRC has maintained a positive outlook on reaching a deal and said in a statement in May: “We’ve always maintained that the audit inspection issue should be solved by cooperation on the basis of equality. Our attitude has been positive and constructive.”
What are the wider implications of the PCAOB audit issue on China-US relations?
Sources are optimistic of an agreement, particularly as both China and the US realise the impact of decoupling from each other will have on both economies.
“We’re likely going to see resolution because while decoupling might be appealing in theory, it has material consequences on the Chinese economy, so China is likely going to be more flexible and will be more accommodating to what the US wants,” said an in-house counsel at an international bank. “The Ukraine-Russia conflict has shown that Western countries, plus any country that wants to avoid an alliance with China, will stand up for each other. This has also encouraged China to play ball a bit more.”
He continued: “On the flipside, decoupling from China also hurts the US and it is also seeing the fallout of supply chain disruptions from Covid-19 lockdowns in China and the Ukraine-Russia conflict. Russia and China are joined at the hip and disruptions in both countries have had a dramatic impact globally on inflation and the economy, with the tanking of stock markets and a potential recession.”
The PCAOB issue will be a bellweather on how China and the US deal with each other in the future.
“China will continue to depend on the international community to strengthen its economy and has shown that it is increasingly welcoming of foreign investment with the opening up of its financial markets to Western players,” said the in-house counsel. “The PCAOB issue is the canary in the coal mine and will affect how both countries work with another other in the future.”
While both China and the US are working on an agreement on the audit requirements, what will be the biggest challenges going forward?
If the PCAOB and the Chinese authorities reach an agreement, the PCAOB would still need to be satisfied that it could complete inspections and investigations on the accounting firms of US-listed Chinese companies.
“The audit inspection and investigation issues seem difficult to solve,” said Stephen Chan, partner at Dechert. “There have been disagreements over matters such as redactions and access to firm personnel, audit work papers, and other information.”
He continued: “For more than 15 years, the PCAOB has been trying to access the relevant documents from China-based audit firms but have not been successful. The PCAOB must be able to obtain sufficient cooperation from Chinese authorities such that the board of PCAOB can make a determination that it can inspect and investigate completely in China.”
The in-house counsel at the international bank said that some of the issues that are potentially causing disagreement include the scope of the authority of the PCAOB going into China, what information they can request and expect to receive, limitations on their rights of access, as well as how they use the information and control the data.
“China will also need to consider the types of companies whose data can be reviewed, and may not want foreign access to information held by companies that are vital to its national security, such as technology companies,” said the in-house counsel.
Meng Ding, partner at Sidley Austin, added: “Precisely delineating the scope of information to be included in the audits, which will be subject to PCAOB’s inspection, still needs to be discussed. Additionally, the question of whether exceptions to the implementation could be made for certain issuers due to special circumstance could also arise in the future. Furthermore, whether certain inspections should be physically conducted inside China is another topic for negotiation.”
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What impact have tensions between China and the US been on Chinese companies’ desire to go down the IPO route?
For issuers, the tension between China and the US has sparked uncertainty, especially when the US remains their first choice of listing venue.
“On the one hand, while China would prefer to retain access to US capital markets due to its sophistication with technological investments, it is hesitant to make a significant compromise which might be viewed as trading away its national security or sovereignty in order to achieve that,” said Chan. “On the other hand, China would probably also wish to see its companies return to China. As a result, unless parties manage to reach a settlement on the inspection and investigation issues within the three-year period, the relevant Chinese companies will likely have to look for alternative listing venues such as HKEX.”
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What alternative IPO venues are Chinese companies considering?
The options available to affected companies are a take-private, or relisting on another venue.
“The HKEX likely has benefited from the current geopolitical situation because more companies, especially those China-based, are considering the HKEX as the first listing venue choice for IPO as well as the venue for dual listing if they are already listed on another exchange,” said Ding.
Bonnie Yung, partner at Mayer Brown, agreed and said: “Since listing on the HKEX has become an important means for many US-listed Chinese companies to address investors' concerns about delisting fears in view of such tensions, more US-listed Chinese companies have been considering coming back to Hong Kong SAR for dual primary listings or secondary listings.”
In addition, the relaxation of the requirements for secondary listings in light of new rules to streamline the listing regime for overseas issuers which became effective on January 1 2022 also helps to attract the US listed Chinese companies to consider Hong Kong SAR as a listing venue. The rules allow companies to re-list in Hong Kong SAR with a lower minimum market capitalisation at listing.
“Some companies may consider listing by introduction which does not involve fund raising, unlike a traditional IPO,” said Yung. “There are already two US listed companies being listed in Hong Kong SAR by way of introduction this year (Nio and KE Holdings) and it is expected more will be coming.”
Other sources do not expect a wave of listings on the HKEX until there is a final decision on the PCAOB issue. “Companies are waiting to see whether they can continue to have access to the US stock markets,” said the in-house counsel at the international bank. “If I were the general counsel of a US-listed Chinese company, I wouldn’t spend all the resources needed to change my company listing from New York to Hong Kong SAR,” he said. “The pool of capital is much deeper in the US and right now, people aren’t certain what will happen so they are holding out.”
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