In response to U.S. President Trump’s June 4 Memorandum calling for “firm, orderly action to end the Chinese practice of flouting American transparency requirements without negatively affecting American investors and financial markets”, the President’s Working Group on Financial Markets (PWG) on August 6, 2020, released a report (“Report”) making five recommendations. These recommendations are designed to address risks to investors in U.S. financial markets allegedly posed by the Chinese government’s failure to allow audit firms that are registered with the Public Company Accounting Oversight Board (PCAOB) to comply with U.S. securities laws and investor protection requirements. The SEC staff are preparing rules following recommendations made in the Report. Unless the regulatory conflicts between the U.S. and China in this area are resolved in the short term, the market may witness a wholesale de-listing of PRC issuers from U.S. exchanges by the end of next year.
- Enhanced Listing Standards for Access to Audit Work Papers.
The Report recommends enhancing the listing standards of U.S. exchanges, to require as a condition to initial and continued exchange listing:
- PCAOB access to work papers of the principal audit firm for the audit of the listed company; or
- For companies that are unable to satisfy the standard (a) as a result of governmental restrictions on access to audit work papers and practices in Non-Cooperating Jurisdictions (“NCJs”, including China), it would be required to engage an affiliated U.S.-member registered public accounting firm (“U.S. Firm”) to serve as the principal auditor of the listed company’s annual financial statements through a co-audit arrangement with the audit firm in an NCJ (“NCJ Firm”). Under PCAOB standards, a principal auditor is permitted to use the work and reports of other independent audit firms that have audited the financial statements of subsidiaries, divisions, branches, components or investments included in the listed company’s consolidated financial statements. The Report notes that additional rulemaking or standard setting would be needed to require the U.S. firm to supervise the work of the NCJ Firm, such that the latter’s work is performed under the U.S. firm’s guidance and control, and that PCAOB would be able to inspect the audit work and practices of the U.S. Firm, including the U.S. Firm’s quality controls with respect to its work on listed companies based in an NCJ. There remains, as the Report notes, the issue of whether NCJ governments would permit a U.S. firm to perform the work and retain the relevant work papers outside the NCJ.
To reduce market disruption, the new listing standards could provide for a transition period until January 1, 2022, for currently listed companies from NCJs to come into compliance. The new listing standards would apply immediately to new company listings once the necessary rulemakings and/or standard-setting are effective.
If an issuer violates, or fails to comply with, the enhanced listing standards, the exchange would initiate procedures for delisting the issuer or imposing trading suspensions. The SEC and the Financial Industry Regulatory Authority (“FINRA”) also have authority to suspend trading in a given security.
- Enhanced Issuer Disclosures.
The Report recommends requiring enhanced and prominent issuer disclosures of the risks of investing in NCJs, including issuing interpretive guidance to clarify these disclosure requirements to increase investor awareness, and more general awareness of the risks of investing in such companies.
- Enhanced Fund Disclosures.
The Report recommends reviewing the risk disclosures of registered funds that have exposures to issuers from NCJs to enhance the disclosures by these funds, including issuing interpretive guidance to clarify the disclosure requirements to increase investor awareness of the risks of investing in such funds.
- Greater Due Diligence of Indexes and Index Providers.
The Report recommends the SEC take action to encourage or require registered funds that track indexes to perform greater due diligence on an index and its index provider, prior to the selection of the index to implement a particular investment strategy or objective. In particular, due diligence should address whether the index construction takes into account any potential errors in index data if the information from issuers based in NCJs is unreliable or outdated or if less information about such companies is publicly available.
- Guidance for Investment Advisers.
The Report recommends the SEC issue guidance to investment advisers with respect to fiduciary obligations when considering investments in NCJs, including China.
Comparison with The Holding Foreign Companies Accountable Act
Before the release of the Report, several U.S. legislative proposals were designed to address the PCAOB’s lack of access to audit work papers. Most recently, S. 945, the Holding Foreign Companies Accountable (“HFCA”) Act was passed by the Senate on May 20, 2020. The U.S. House of Representatives recently included provisions, which are substantially similar to the HFCA Act, in the National Defence Authorization Act.
The PWG’s recommendations are informed by the HFCA Act. In particular, the first recommendation is similar to the trading prohibition provision under the HFCA Act which requires the SEC to prohibit the trading of the securities of listed companies, subject to certain transition periods, that retain an auditor whose reports cannot be inspected or investigated completely, as well as prohibit trading of such securities on an over-the-counter (“OTC”) market.
The differences between PWG’s first recommendation and the trading prohibition provision under the HFCA Act are:
- PWG recommends enhancing the listing standards of U.S. exchanges, which would apply to companies listed on specific exchanges and would mainly be enforced by such exchanges; while the HFCA Act, once becomes law, would apply to all the covered issuers listed on the U.S. capital markets and would be enforced by the SEC.
- PWG recommends a transition period until January 1, 2022, for currently listed companies and suggests applying the new listing standards immediately to new company listings once the necessary rulemakings and/or standard-setting are effective. The HFCA Act prohibits securities of a company from being listed on any of the U.S. securities exchanges or SEC regulated OTC markets if the company has failed to comply with the PCAOB audits for three years in a row (the year begins after the enactment of the HFCA Act), but it does not appear to impose any additional restrictions on new listings.
- The Report offers a co-audit arrangement that seems more flexible than the requirement under the HFCA Act. It is unclear if and how the co-audit between the U.S. Firm and NCJ Firm could work in practice as the arrangement will be subject to regulation and/or cooperation of the governments in NCJs such as China.
On August 8, 2020, when commenting on the Report, an official of China Securities Regulatory Commission (CSRC) mentioned that China has sent an updated proposal to PCAOB on August 4, 2020, in response to “the latest needs and concerns” of the U.S. China reiterates that it does not prohibit audit firms from providing audit work papers to overseas regulators but expects provision of audit work papers should be conducted through regulatory cooperation framework. However, the August 4 proposal has not been made publicly available.
A PCAOB Letter attached to the Report claims that China has refused to “cooperate meaningfully” with the PCAOB, and says China’s proposal dated April 3, 2020, does not accord with PCAOB’s core principles for access. It remains to be seen whether PCAOB or PWG will provide a response to China’s August 4 proposal.
Next Steps and Implications
On August 10, 2020, the SEC issued a statement that SEC staff are preparing proposals in response to the recommendations in the Report and the SEC welcomes the views of all market participants and members of the public. The SEC staff also stands ready to assist Congress with technical assistance in connection with any potential legislation regarding these matters.
Following the issuance of the Report, in a letter addressed to the board of directors of American universities and colleges, the U.S. State Department is asking colleges and universities to divest from Chinese holdings in their endowments, warning that, “Boards of U.S. university endowments would be prudent to divest from People’s Republic of China firms’ stocks in the likely outcome that enhanced listing standards lead to a wholesale de-listing of PRC firms from U.S. exchanges by the end of next year”.
As the Report notes, enhancing U.S. listing standards would not prohibit these companies (especially China-based issuers) from listing their securities on exchanges outside the United States, including Hong Kong, Shanghai or London. U.S. investors could purchase such securities on foreign exchanges, even though these purchases may be subject to fewer transparency and investor protections than in the United States. Enhanced listing standards may also result in Chinese companies “going-private” and delisting from the U.S. exchanges, and then relisting in their home jurisdiction, which is often at the expense of existing U.S. shareholders and may result in a financial windfall to insiders.