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US Securities and Exchange Commission

SEC Investor Advocate: Disclosure Alone Will Not Protect Investors in China-PCAOB Impasse

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

By Bill Flook

Resolving a stand-off between U.S. audit regulators and Chinese authorities over the inspection of audits of Chinese companies listed in the U.S. “may involve a complex balancing of interests such as international trade and foreign relations,” SEC Investor Advocate Rick Fleming told two senators in an April 27, 2020, letter. Disclosure alone will not be enough to protect U.S. investors, he wrote.

Fleming penned the letter in response to Sens. Chris Van Hollen, a Maryland Democrat, and John Kennedy, a Louisiana Republican, who had written Fleming in March urging him to hold a hearing and educate investors about the regulatory “loophole” that has allowed the Chinese companies to escape the same sort of audit scrutiny that applies to American companies.

In his reply, Fleming suggested that safeguarding U.S. investors will require more than mandating issuers to make additional warning disclosures and “likely necessitates significant action focused on other securities market participants, including auditors, index providers, investment advisers, broker-dealers, and stock exchanges.”

“The PCAOB was created in the wake of the accounting scandals at Enron and other publicly-listed companies, and the goal was to help ensure the reliability of financial disclosures,” Fleming wrote. “This is a critical part of the fabric of investor protection in the U.S., and we should pursue remedial measures so that companies that want access to U.S. markets are not able to evade it.”

The PCAOB has for years sought to open up registered Chinese accounting firms to the inspections process. The audit industry watchdog has reached cooperative agreements with other audit regulators around the world but remains at an impasse with China, which has barred U.S. audit inspectors over fears of revealing state secrets.

That means that today, an investor who owns stock in a U.S.-listed Chinese company has no way to know if its books are properly reviewed by an independent auditor, depriving that investor of the same transparency that would be available for a U.S.-based company. The PCAOB has so far proven hesitant to invoke the so-called “nuclear option” of revoking the registrations of Chinese audit firms, which could lead to the delisting of their clients. But the board still asserts that the firms remain in violation of the Sarbanes-Oxley Act of 2002 as long as they are not open to PCAOB inspections.

The problem has received heightened attention recently following an accounting scandal at Luckin Coffee, a Chinese competitor with Starbucks that recently admitted to fabricating hundreds of millions of dollars in 2019 sales. Following the scandal, the SEC and PCAOB issued a joint statement in late April warning of the risks of investing in U.S.-listed Chinese companies.

(See Regulators Warn Americans About Risks of Investing in Chinese Companies in the April 24, 2020, edition of Accounting & Compliance Alert.)

Van Hollen and Kennedy last year introduced S. 945, the Holding Foreign Companies Accountable Act, which would amend Sarbanes-Oxley to bar a foreign company from listing on U.S. stock exchanges if the PCAOB is unable to inspect its auditor for three straight years. The measure would also require foreign issuers to make new disclosures to the SEC on issues related to foreign governments that prevent PCAOB inspectors from reviewing the work of their auditors.

“As we continue to experience the economic fallout and market volatility caused by the COVID-19 pandemic, the need to protect main street investors is all the more important,” Van Hollen said in a May 5 statement to Accounting and Compliance Alert. “All publicly listed companies should be held to the same reporting standards. My bipartisan bill would ensure that.”

The House Financial Services Committee in June 2019 held a hearing on the House version of the Holding Foreign Companies Accountable Act, where it was met with Republican criticism for being too drastic. Rep. Ann Wagner of Missouri questioned what the implications of the blanket trading prohibitions would be for investors in hundreds of companies, who own shares either directly or through mutual funds.

(See At Hearing, China Audit Inspection Bill Faces Scrutiny in the June 21, 2019, edition of Accounting & Compliance Alert.)

The SEC’s Investor Advisory Committee (IAC) is slated to discuss the issue during its upcoming May 21 meeting. During a panel on investor protection issues related to stock indexes, the panel “will include a discussion of the risks to U.S. investors from the inclusion of Chinese companies in popular indexes,” Fleming wrote. He added that he would work with IAC members to develop any needed recommendations.

“A growing number of Americans invest in funds rather than individual securities, and they can be exposed to more risk than they may realize from the inclusion of high-risk, low-accountability companies in an index,” Fleming wrote.

Van Hollen said he was “glad to see that the SEC will be addressing this issue at their upcoming meeting, and I hope to work together to fix this problem.”

 

This article originally appeared in the May 06, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.

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