President’s Working Group | China Accounting Blog | Paul Gillis

President’s Working Group

The President’s Working Group (PWG) issued its report on July 24, 2020. The report makes five recommendations for the SEC to implement. While the PWG says it has considered the Holding Foreign Companies Accountable Act (HFCAA), it proposes to solve the problem using rules instead of laws—with regulation, not legislation. In my view, the PWG’s proposed solution is both naďve and unworkable. 

The PWG proposes to ban companies from listing on U.S. exchanges after 2022 if the auditor of the company cannot be inspected. New IPOs’ auditors must be inspectable immediately. 

An exception is provided. If a foreign auditor cannot be inspected, it may appoint a U.S. member firm to serve as principal auditor. While existing PCAOB rules allow the U.S. member firm to use the work of foreign affiliates, the proposal requires that the U.S. member firm serve as principal auditor. Under this recommendation, because the U.S. Firm would be the principal auditor and would be required to maintain the work papers in the U.S., the PCAOB would have the ability to inspect the audit work and practices of the U.S. Firm. This is most easily understood with respect to the Big Four audit firms, which audit most U.S. listed Chinese companies by market capitalization. For local Chinese firms not affiliated with U.S. member firms, the solution would be more complicated, but there are few, if any, of these auditing U.S. listed companies. 

While I am sure that seemed an elegant solution to the PWG, why would China allow the U.S. firm to take documents that China considers to be state secrets outside of China? Serving as principal auditor would require the U.S. firm to spend time in China, and why would China allow a foreign accounting firm to practice in China without local licenses? The report anticipates this objection, observing: 

Importantly, this recommendation would require the government of a non-compliant jurisdiction (NCJ) to permit the U.S. Firm to perform the work and retain the relevant work papers outside of the NCJ. The PCAOB’s inspection process would follow its typical process. 

Furthermore, what compensation would the U.S. firm expect for taking on the liability of being the principal auditor? Would companies be willing to pay the additional audit fees? I expect U.S. firms will be reluctant to take on this liability, but they should expect political pressure from the administration to take on the business and assume the liability. I suspect the intent of this proposal is not to have the U.S. member firms of the Big Four involved, but rather to put additional pressure on China to allow inspections. The PWG indicates it is aware that China must agree to allowing the involvement of U.S. accounting firms. If China is to agree to that, why not inspections instead?

Former SEC Chief Accountant Lynn Turner suggests the proposal is a return to peer reviews that were used to monitor audit quality before the PCAOB. I think he is wrong. The proposal is for the U.S. firms to become principal auditors that can be inspected. The proposal retains PCAOB audits, it simply requires audits of Chinese companies to be conducted by U.S. based firms. The type of peer reviews that Turner suggests is another alternative to PCAOB inspections. 

Famous short-seller Carson Block made a proposal at a recent SEC roundtable on Emerging Markets.  Block’s proposal would have the U.S. member firms post collateral to cover the liabilities of its foreign affiliates.  Block clearly misunderstands the structure of the Big Four firms, where each country is individually owned by partners in that country.  It is more like a franchise operation than a typical MNC with a parent and subsidiaries. 

The PWG proposal would be implemented through changes to exchange rules,  which must be approved by the SEC. Although the PWG proposal claims the SEC could do this unilaterally, it proposes to do so through the exchanges, which could take considerable time to go through the public comment process. Unlike the HFCAA, the PWG proposal would be limited to companies listed on exchanges, and companies that trade over-the-counter would not be affected. That appears to mean that while companies may be kicked off exchanges, they can still trade OTC.  I do not believe that the exchanges should propose the PWG suggestion unless they obtain agreement from the U.S. member firms of the Big Four that they would be willing to serve as principal auditors on Chinese listings. 

One of the advantages of the PWG approach is that it should be easier to unwind than legislation since the SEC can act without congress. 

The PWG proposal also recommends enhanced disclosures for companies and funds that invest in them. It does not include my recommendation to repeal special breaks for foreign private issuers, such as the exemption from Reg FD. The proposal also suggests the SEC issue guidance on the fiduciary responsibility of investment advisors which recommend Chinese stocks. 

The way this is being done means it will not happen quickly. First the exchanges must draft a proposed rule, which will be challenging if it is not supported by the Big Four firms. Then the proposed rule is published in the federal register. Law requires the SEC to act on the proposed change in 45 days, or up to 90 days if deemed appropriate. The recent NASDAQ proposal on Chinese IPOS saw the period extended to 90 days. That means action is likely not to happen until after the election.  

The PWG proposal attaches a letter from the PCAOB. The PCAOB letter discusses a recent Chinese proposal with respect to inspections, which is also attached. The PCAOB says the latest China proposal is materially deficient. I find the PCAOB arguments uncompelling, but rather they seem an excuse for not doing a deal. 

First, the PCAOB says China is retaining the ability to block inspection of companies. While China says it has no intent to interfere with the PCAOB selection of audits to inspect, it proposes that the U.S. and China agree on the selection.  

Second, the China proposal implies limitations on the scope of inspections, indicating that the PCAOB and China need to reach consensus on this. 

Third, the China proposal does not address limitations on access to working papers experienced in trial inspections. 

Fourth, the Chinese have not committed to a schedule of inspections. 

Fifth, the US alleges the agreement on enforcement cooperation has not worked. Somewhat surprisingly, and in conflict with previous statements from the CSRC, the PCAOB says it has received no documents since 2015.

Responding to the PWG report, China’s Securities and Regulatory Commission (CSRC) reported that it sent to the PCAOB on August 4 a new proposal that respects the needs of the U.S. side. A copy of the proposal has not been made available. 

In my view, it is unrealistic for the U.S. to expect China to simply concede all of its concerns over national security, whether they are valid concerns or not. Instead, I think that U.S. regulators should negotiate the terms of what happens if China does block an inspection or unreasonably restrict the inspection. I expect that the consequence should be to immediately suspend trading in the affected company. But refusing to negotiate an inspection deal because of fear China will not allow unfettered inspection is letting the perfect get in the way of the good. 

On the other hand, I do not see that the Trump administration can make a deal, given the many fronts of the cold war with China.  This particular plan seems designed to fail, given its need for China to agree and for the U.S. Big Four to act against their own interests. Delisting Chinese stocks is a scorched earth tactic that will hurt Americans more than Chinese. 

While I don’t expect a Biden administration to go soft on China, I do think it may be possible for talented diplomats to reach an umbrella settlement to the many outstanding China issues, including PCAOB inspections. But it is likely that either the PWG recommendations or some version of the HFCAA is put into effect before year end. But delisting appears to happen no earlier than 2022.

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