The U.S. Securities and Exchange Commission (SEC) is considering a new standard to disqualify audit work conducted by accounting firms depending on whether they are headquartered in certain foreign jurisdictions – such as China. The new rule will probably accelerate delisting from U.S. exchanges and constitute a substantial obstacle to IPOs of Chinese offshore companies.
The Public Company Accounting Oversight Board (PCAOB) has adopted the new rule and filed with the SEC on September 23, 2021 to seek approval to implement the Holding Foreign Companies Accountable Act (HFCAA), which would prohibit foreign businesses from U.S. exchanges. Under the new rule, the PCAOB adopted a jurisdiction-based approach to disqualifying audit firms. On the one hand, it would be presumed that the PCAOB is unable to investigate all accounting firms headquartered in a particular foreign jurisdiction. On the other hand, the PCAOB also has extensive discretion to make individualized determinations to disqualify a particular firm that merely has an “office” in a noncooperative jurisdiction, even if headquartered elsewhere.
Generally, the HFCAA mandates that the PCAOB inspect registered public accounting firms and their audit work papers conducted for U.S. public companies, including reaching out to any accounting firms that are located outside United States. If the PCAOB determines it is unable to inspect audit work papers for three consecutive years, the issuer will be delisted from U.S. exchanges.
In the event that the new rule becomes effective upon receiving SEC approval, not only will all accounting firms headquartered in a particular foreign jurisdiction, such as China, be barred by the PCAOB, but international firms like PricewaterhouseCoopers and KPMG may also be unable to serve China-based public companies due to a having an office in China. The issuer is obliged to retain a qualified firm in the auditor roster if it pursues listing, which leaves the issuer with limited alternatives.
Will Chinese firms be barred from U.S. markets as a result? Probably, but not definitively. As the new rule indicates, an investigation of audit work is not required in terms of the determination procedure. The PCAOB has discretion to make its determination with multiple factors such as foreign regulations, performance of agreements with the PCAOB, and experience working with foreign authorities.
Under the PRC Securities Law, China-based issuers may not provide documents relating to securities business activities abroad without Chinese government approval. Statistically, Chinese regulators have provided audit work papers for only 14 companies out of 270. Based upon its experience with Chinese authorities, the PCAOB may determine that the general practice in China denies its access to audits. Especially for critical businesses like financial services or state-owned entities, it will be presumed that the position taken by foreign authorities exists to impede the PCAOB’s ability to conduct an inspection.
If China is determined to be a noncooperative jurisdiction, this will be worse for China than merely being deemed a jurisdiction that U.S. regulators cannot inspect. Since employing this more expansive rule, the PCAOB has greater flexibility to make such determinations even for an international firm that has an office in China but is headquartered elsewhere.
Will China invoke the Memorandum of Understanding signed in 2013 with the PCAOB to seek exemption? This does not seem very promising given China’s history of nondisclosure after this memorandum. As a result, China-based issuers will still face a major obstacle: delisting in three years or obtaining governmental approval to disclose documents for auditing abroad.