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The Public Company Accounting Oversight Board (“PCAOB”) announced on December 15, 2022 that it has secured complete access to inspect and investigate audit firms in mainland China and Hong Kong for the first time in history. The PCAOB’s determination resets a three-year delisting clock for Chinese companies on U.S. stock exchanges as regulated by the Holding Foreign Companies Accountable Act (“HFCAA”) (see our prior alert here).
For more than a decade, China and the U.S. had been in a stand-off which argued that PRC authorities had refused to allow the PCAOB to inspect audits of Chinese firms listed in the U.S. and thus causing significant risks to U.S. investors. China softened its stance in April of this year when China Securities Regulatory Commission (“CSRC”) published a draft amendment to the Regulation on Confidentiality and Archives Management for Overseas Listing, which deleted a requirement that PRC regulators shall take the lead with on-site inspections of Chinese companies listed overseas. Later in August, PCAOB, CSRC and China’s Ministry of Finance signed a Statement of Protocol setting forth a cooperation framework on inspecting the audit work papers of U.S.-listed Chinese companies (see our prior alert here).
Following the Statement of Protocol in August, the PCAOB dispatched over 30 staffers to conduct an on-site inspection in Hong Kong for a nine-week period from September to November. As said in a PCAOB statement, Chinese authorities complied with the three criteria laid out in the Statement of Protocol:
The PCAOB exercised sole discretion to select the firms, audit engagements, and potential violations it inspected and investigated – without consultation with, nor input from, PRC authorities.
The PCAOB selected two firms for inspection: KPMG Huazhen LLP in mainland China and PricewaterhouseCoopers in Hong Kong and inspected eight engagements between the two firms, including issuer engagements that the PRC authorities have historically categorized as sensitive, such as large state-owned enterprises and issuers in sensitive industries.
In addition, the PCAOB initiated three investigations before the August Statement of Protocol and later opened additional investigations in mainland China and Hong Kong.
PCAOB inspectors and investigators were able to view complete audit work papers with all information included, and the PCAOB was able to retain the information as needed.
PRC authorities provided PCAOB inspectors access to all documentation without withholding or redacting any information and documents were able to be transferred to the U.S.
The PCAOB had direct access to interview and take testimony from all personnel associated with the audits the PCAOB inspected or investigated.
CSRC facilitated all the interviews and testimony requested by the PCAOB.
As a result, the PCAOB issued a determination report which vacated the previous 2021 determinations that the PCAOB was unable to completely inspect or investigate any registered public accounting firms headquartered in mainland China and Hong Kong because of a position taken by one or more authorities in such jurisdictions.
CSRC welcomed the new PCAOB determination in a statement just hours after the PCAOB issued its report. CSRC’s statement also mentioned that the U.S. gained access to auditing documents of Chinese companies through Chinese regulatory authorities and carried out interviews with accounting firms’ employees with China’s participation and assistance, and China tweaked some data with personal information in the audit documents to meet its information security requirements.
As said in a PCAOB statement, “this is the beginning of the PCAOB’s work to inspect and investigate firms in mainland China and Hong Kong, not the end.” Each year, the PCAOB will determine whether it can completely inspect and investigate audit firms in China and Hong Kong, among other jurisdictions. If the Chinese authorities do not allow the PCAOB complete access for inspections and investigations for three consecutive years, the SEC would prohibit trading in the securities of issuers engaging those audit firms, as required under the HFCAA. The PCAOB’s 2022 determination only resets the three-year clock for compliance and temporarily removes the risk of forced delisting of Chinese companies from American stock markets.
Chinese authorities have agreed to an inspection schedule in 2023 and 2024, as well as any investigations that commence in 2023 and beyond, the PCAOB said. The PCAOB may also consider issuing a new determination whenever PRC authorities obstruct or otherwise fail to facilitate the PCAOB’s access without waiting another year to reassess its determinations.
PCAOB staff identified numerous potential deficiencies at audit firms in China and Hong Kong, as has been the case in other jurisdictions in the first year of PCAOB inspection. As said in the PCAOB statement, inspection reports will be finalized and made public next year detailing the findings from the inspections of the audit firms.