By Soyoung Ho
President Donald Trump is ratcheting up pressure on Chinese authorities to allow U.S. regulators to inspect China-based accounting firms that audit companies whose shares trade in U.S. stock markets.
“For decades, Chinese companies have availed themselves of the benefits of United States financial markets, and capital raised in the United States has helped fuel China’s rapid economic growth,” according to a June 4, 2020, memorandum signed by President Trump. “While China reaps advantages from American markets, however, the Chinese government has consistently prevented Chinese companies and companies with significant operations in China from abiding by the investor protections that apply to all companies listing on United States stock exchanges.”
Accounting firms that audit companies who raise capital in U.S. markets must be registered with the PCAOB—the American audit regulatory board—and follow tough U.S. audit standards and be inspected for compliance. But the PCAOB has not been able to get Chinese authorities to agree to a joint inspection program despite over 13 years of off-and-on negotiations.
The problem has been especially acute as there have been a string of accounting frauds over the years at Chinese companies with the latest at Luckin Coffee Inc. The Chinese coffee chain which competes against Starbucks Corp. in April admitted that it booked fake sales last year, and Americans who have invested in Luckin lost a lot of money as a result after its stock price tanked.
“Long-term investors, companies, and the economy all benefit from the efficient allocation of capital that results, in part, from the effective enforcement of the investor protections contained in the U.S. securities laws,” said Jeff Mahoney, general counsel of the Council of Institutional Investors. “Policymakers should insist that those protections be enforced for all companies that are listed on the U.S. stock exchanges or otherwise registered with the U.S. Securities and Exchange Commission.”
To try to address the issue, in the past year, lawmakers have introduced several bills intended to protect American investments in Chinese companies. The bills gained little traction until in May when the Senate passed the Holding Foreign Companies Accountable Act, introduced by Sens. Chris Van Hollen, a Maryland Democrat, and John Kennedy, a Louisiana Republican.
Under the bill, a foreign company traded on a U.S. exchange would be delisted if the PCAOB is unable to inspect its auditor for three straight years. Companies would also be required to make new disclosures on the extent of state control over them. The House of Representatives has yet to take up a companion bill, but observers say it will likely pass.
“It is both wrong and dangerous for China to benefit from our capital markets without complying with critical protections that investors in those markets rightfully expect and deserve,” Trump said in the memo.
The audit regulatory board has been unable to gain access to Chinese accounting firms because Chinese officials fear that audit work papers may contain state secrets, among other concerns. Auditors in China say they are unable to violate Chinese laws that prohibit them from handing over documents to foreign regulators without first getting permission from Chinese authorities. This means that U.S. investors who have bought stocks of Chinese companies do not know if their financial statements are properly scrutinized by independent auditors because the PCAOB cannot inspect their audit work.
“The time has come to take firm action in an orderly fashion to put an end to the practice that has tacitly permitted companies with significant Chinese operations to flout protections United States law requires for investors in United States markets,” the White House memo said.
President Trump’s action on the matter also comes as he has been unhappy with China’s handling of the novel coronavirus outbreak, which has so far taken more than 100,000 American lives. Moreover, he was reportedly incredulous upon learning that the Thrift Savings Plan (TSP) for federal employees included investments in Chinese companies that are believed to be tied to the Chinese military and intelligence agencies. He instructed top aides to stop such investments.
Administration Actions to be Taken
The memo said that the Treasury Secretary, currently Steven Mnuchin, must convene the President’s Working Group on Financial Markets (PWG) to discuss the risks to investors and financial markets posed by the Chinese government’s refusal to allow the PCAOB to inspect audit firms in China.
The PWG then must submit a report within 60 days to the President recommendations for actions that the executive branch may take to protect investors in U.S. markets.
The report should also include recommendations for actions the SEC or the PCAOB should take, including enforcement actions, when audit firms that are regulated by the board fail to provide requested audit working papers or otherwise fail to comply with U.S. laws. The SEC has oversight authority over the PCAOB.
The President’s memo said the working group report should also provide recommendations for additional actions the SEC or any other federal agency or department should take as a means to protect investors in Chinese companies, including rule proposals that would set new listing rules or governance standards.
“Any such actions should take into account the impact on investors and ensure the continued fair and orderly operation of United States financial markets,” the memo said.
“I believe this makes a lot of sense and will result in a more deliberate and well-reasoned approach to this longstanding issue,” said Shaswat K. Das, a counsel at King & Spalding LLP who previously worked at the PCAOB as its primary negotiator with the Chinese regulators on cross-border audit oversight from 2011-2015. “Presumably, as required, the Working Group will consult with a wide range of stakeholders, ranging from the exchanges to institutional investors, to arrive at the most viable recommendations. NASDAQ’s recently proposed rule provides a good template that should be closely considered.”
Das was referring to NASDAQ’s three proposals intended to tighten listing standards for certain companies in emerging markets that have laws restricting access to information. One requires companies to have management or advisers that understand regulatory and listing requirements, including controls over financial reporting. The second proposal requires a minimum offering size or public float. The third proposal would apply additional listing criteria when an auditor of an applicant or NASDAQ-listed company has not been or cannot be inspected by the PCAOB.
SEC Efforts to Raise Awareness on Risks of Investing in Chinese Companies
In the meantime, the SEC has been trying to raise investor awareness about risks of investing in Chinese companies. SEC and PCAOB officials have put out a series of joint statements since December 2018 warning investors. The commission’s Investor Advisory Committee discussed the problem during a meeting in May, and the market regulator is also planning to hold a roundtable in July.
“The roundtable could serve as an input source and sounding board for ideas that might be included in the report,” former PCAOB Acting Chairman Daniel Goelzer said.
Some have criticized that disclosures about the risk in not enough, and more needs to be done. But during Bloomberg Invest Talks conference on June 2, SEC Chairman Jay Clayton said disclosure is only the first step to resolving the issue.
“I do think we need to do more to level the playing field. I think the bill… the Kennedy-Van Hollen is a very sensible way to look at this if you are going to do more because it gives people a period of time to level the playing field,” he said. I am not a guy that wants to take precipitous, hit the nail on the head with a hammer tomorrow. But I like the way they have approached it. There is a period of time to come into compliance, and if you don’t, then it’s time to take measures just beyond disclosure.”
Goelzer noted that the PCAOB could deregister the audit firms it cannot inspect. The SEC could then delist the companies that then do not have auditors that are registered with the PCAOB.
“But it’s never been clear whether that ‘nuclear option’ would really be in the best interests of U.S. investors,” Goelzer said. “Between the roundtable and the report, hopefully those issues will be explored.”
This article originally appeared in the June 08, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.
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