Looming U.S. delisting of Chinese companies averted, at least for now
Following its successful inspections of China- and Hong Kong-based audit firms, the Public Company Accounting Oversight Board (“PCAOB”) has announced that it has vacated its December 2021 designations of China and Hong Kong as jurisdictions where the PCAOB is not allowed to conduct full and complete audit inspections under the Holding Foreign Companies Accountable Act (the “HFCAA”). Significantly, this means that China-based issuers avoid, at least for now, involuntary delisting from U.S. exchanges under the Act HFCAA.
Companies that are public in the United States are required to file audited financial statements with the U.S. Securities and Exchange Commission (the “SEC”). Auditors of financial statements filed with the SEC must be registered with the PCAOB, and are thus subject to regular PCAOB inspections. The HFCA Act was adopted in 2020 to address the fact that Chinas-based audit firms – including the local affiliates of the “Big Four” accounting firms – had for many years refused to allow PCAOB inspections.
Under the HFCAA, if the PCAOB is “unable to inspect or investigate completely” registered public accounting firms with branches or offices in a non-U.S. jurisdictions because of a position taken by an authority in the jurisdiction, 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 markets, in the United States.
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. It issued a report listing 35 audit firms in mainland China, and 28 audit firms in Hong Kong as “PCAOB-Identified Firms.” Following the designation, the SEC identified more than 170 China-based companies retaining a PCAOB-Identified Firm (“Commission-Identified Issuers”).
The HFCAA also directed the SEC to require Commission-Identified Issuers to make specific disclosures in their annual reports regarding Chinese government control and influence over these companies. For further details on these requirements, please see our earlier client briefing.
In September 2022, the PCAOB signed a Statement of Protocol with the China Securities Regulatory Commission and China’s Ministry of Finance establishing 2 a framework to allow the PCAOB to conduct on-site inspections and investigations of firms headquartered in mainland China and Hong Kong.
The PCAOB staff conducted on-site inspections and investigations in Hong Kong over a nine-week period from September to November 2022. The PCAOB’s determination that it was able to completely inspect and investigate firms in mainland China and Hong Kong, is a significant development that for now means less disruption in the market for the securities of Chinabased issuers. Such issuers should bear in mind, however, that:
- The PCAOB’s successful inspections this year do not permanently end the delisting risk for China-based registrants. The PCAOB will be making determinations every year regarding whether it can inspect and investigate completely audit firms in China and Hong Kong. If Chinese authorities obstruct the PCAOB’s access to inspect or investigate completely, China-based issuers may again be at risk of delisting. The PCAOB’s 2022 determination does, however, reset the clock as to the risk of an adverse PCAOB determination, since the HFCAA only prohibits the trading in the securities of Commission-Identified Issuers if they use a PCAOB-Identified Firm for three consecutive years. The PCAOB also does not have to wait another year to reassess its determinations. If necessary, it can immediately consider the need to issue new determinations consistent with the HFCAA.
- The PCAOB’s determination addresses only its ability to access audit firms for inspections and investigations, not the quality of the audits. PCAOB inspectors identified numerous deficiencies at audit firms in China and Hong Kong, and the PCAOB is instructing audit firms to improve their quality control processes, as well as remedy other issues. The PCAOB will release inspection reports in 2023 detailing findings from their inspections of these audit firms.
- Although the audit firms are no longer deemed to be PCAOB-Identified Firms, SEC Chair Gary Gensler noted in a statement that “[u]nder the HFCAA, Chinese-based issuers must disclose relevant details about the extent of governmental ownership in their company and any Chinese Communist Party (CCP) participation on their boards of directors in their annual reports filed with the SEC.”
- Chair Gensler also stated that, separate from the HFCAA disclosures, the SEC continues to emphasize to Chinese-based issuers their obligations to provide other material disclosures to U.S. investors. This includes disclosures regarding regulatory developments in China and the overall risks with the China-based variable interest entity (VIE) structure, as the SEC staff highlighted in 2021 guidance. Chinese government or party involvement in issuers’ governance and operations may also be material to investors and thus would need to be disclosed.
We will continue to monitor developments in this area and welcome any queries you may have about the HFCAA.
