In mid-September, officials from the Public Company Accounting Oversight Board (PCAOB), a nonprofit corporation established by Congress and overseen by the U.S. Securities and Exchange Commission (SEC), arrived in Hong Kong to begin inspecting the auditors of some 250 Chinese companies with shares listed on U.S. stock exchanges. If successfully carried to completion, these inspections would mark the first time authorities in Beijing have provided U.S. regulators such extensive access to the audit papers of Chinese firms. The PCAOB’s Hong Kong sojourn was made possible by an unprecedented deal in which the China Securities Regulatory Commission (CSRC) and China’s Ministry of Finance (MOF) agreed to a detailed framework under which investigations could take place. While this statement of protocol (SOP) appears to be a significant breakthrough, whether the agreement can withstand political pressures on both sides remains uncertain.
Q1: What lies at the heart of the U.S.-China dispute over audit papers?
A1: The Sarbanes-Oxley Act of 2002, passed by Congress in response to the Enron accounting scandal, requires all auditors retained by companies with U.S.-listed shares to grant the newly created PCAOB freedom to inspect audit “work papers” created in the process of auditing those U.S.-listed firms’ financial statements. This oversight requirement extends to auditors with branches in foreign jurisdictions—including those based in China and Hong Kong, where most U.S.-listed Chinese firms retain their primary auditors. In a 2009 letter, the CSRC expressed its opposition to the PCAOB’s attempts at “unilateral” cross-border inspections of Chinese firms. This impasse persisted through more than a decade of bilateral talks over expanded U.S. access. As of April 2020, the CSRC had shared the audit papers of just 14 Chinese companies with the PCAOB—and only ever on a bespoke basis. The PCAOB currently lists China and Hong Kong as the only foreign jurisdictions where it lacks “necessary access to conduct oversight” thanks to Beijing’s longstanding refusal to allow the board to conduct its inspections.
In May 2020, following reports of widespread fraud at Nasdaq-listed Chinese-domiciled Luckin Coffee, the Senate passed the Holding Foreign Companies Accountable Act (HFCAA). The act threatened to expel Chinese firms from U.S. exchanges unless authorities in Beijing granted the PCAOB freedom to inspect those firms’ audit papers. President Trump signed the bill into law in December 2020. In March 2022, the SEC provisionally identified a tranche of five companies—including tech giant Baidu—as “covered issuers,” meaning they had retained an auditor with branches in foreign jurisdictions (i.e. China or Hong Kong) where the PCAOB lacked the ability to fully conduct investigations. Under the HFCAA, any firm that remains a “Commission-Identified Issuer” for three years in a row will have its securities barred from trading on U.S. exchanges. The March 2022 identifications started the clock, in effect signaling that absent a deal, many of China’s most prominent companies could see their U.S. shares removed by 2024. The SEC currently classifies more than 160 U.S.-listed Chinese issuers—well over half of the total group—as “Commission-Identified Issuers.”
Q2: How have Chinese firms tried to shield themselves from regulatory pressure?
A2: In the months leading up to the September provisional agreement, U.S.-listed Chinese firms took a variety of measures to insulate themselves from the risk that negotiations between the SEC and CSRC might collapse. In July, Alibaba announced plans to change its primary listing from New York to Hong Kong, although New York continues to account for the bulk of trading volume in its shares. Firms that satisfy Hong Kong’s high regulatory standards have flocked to so-called homecoming listings. A smattering of firms have issued shares on less prominent foreign exchanges, such as Singapore, London, and Zurich. Chinese regulators have helped facilitate these moves by building out capital market infrastructures linking China’s domestic exchanges with bourses overseas. Meanwhile, some issuers have pinned their hopes on legal workarounds, notably by switching to U.S.-based primary auditors. Whether authorities in Beijing and Washington would allow such workarounds in the absence of a broader cooperative framework remains to be seen.
Q3: How did each side frame the recent agreement?
A3: On August 26, SEC chair Gary Gensler announced that the PCAOB had signed a joint SOP with the CSRC and the MOF, in which Chinese authorities committed for the first time to grant a sufficient degree of access for the PCAOB to begin its investigations of Chinese auditors. According to the SEC’s fact sheet on the SOP, the text of which has not been made public, Beijing has committed to grant the PCAOB freedom to choose which firms to investigate and interview and the ability to take testimony from personnel in those firms. The Chinese side also agreed to refrain completely from redacting parts of documents reviewed. The U.S. side accepted, as it has in other jurisdictions, that certain items categorized as “restricted data” would be viewable only “in camera,” in which case U.S. inspectors would forgo access to physical or digital facsimiles. Negotiations had reportedly been in a deadlock for months over the U.S. refusal to let Chinese authorities redact material they considered sensitive.
In its public comments, the CSRC explained that “audit work papers generally do not contain state secrets, individual privacy, companies’ vast user data,” and other forms of highly sensitive information. It further stressed that documents requested by the PCAOB in its investigations “will be obtained by and transferred through Chinese regulators” and that Chinese authorities would “take part in and assist in” interviews conducted during the inspections—details that appear in tension with official statements from the U.S. side. The CSRC also claimed that only audit firms, and not the listed companies themselves, would be subject to foreign investigation—whereas the SEC states that under the agreement the PCAOB can “onward share” any information received during its inspections to the SEC, which in turn could use such data “for all SEC purposes,” including enforcement actions against U.S.-listed firms.
Q4: What factors might cause the deal to collapse?
A4: While commending the SOP as an “important” step, Gensler cautioned that “the proof will be in the pudding.” During recent congressional testimony, he noted that PCAOB investigators bound for Hong Kong could take up to 10 weeks to complete their work, and implied that any delays caused by Chinese counterparts on the ground would make it harder to avoid a second consecutive “identification” of U.S.-listed Chinese firms in early 2023. Congress has even introduced a bill to accelerate the timeline laid out in the HFCAA. If passed, the law would pull forward implementation by a year, effectively requiring the SEC to ban trading in securities of firms named as “Commission-Identified Issuers” for two consecutive years instead of the original three. Although Congress has yet to advance this acceleration proposal, it serves as both an additional point of leverage for the United States and a reminder that Congress may independently choose to raise the pressure on U.S.-listed Chinese companies if it feels that U.S. regulators have failed to take a firm enough stance in pursuing their statutory mandate.
Of perhaps greater concern are the apparent contradictions between U.S. and Chinese descriptions of the SOP agreement. Washington owes much of its bargaining power in the negotiations to a keen desire on the part of Chinese companies to continue listing in the United States, where they can access the world’s deepest and most liquid capital markets and raise funds in dollars at some distance from Beijing’s supervision. By increasing the risk of forced delistings, the HFCAA threatens to permanently shut Chinese firms off from such privileges. But while the CSRC states that “keeping Chinese companies listed on the U.S. markets is an all-win arrangement,” other powerful regulators in Beijing, especially party-led organizations such as the Cyberspace Administration of China, may judge the national security risks to outweigh the economic benefits. Moreover, each side’s contradictory understandings of the negotiated terms may prove insurmountable. In August 2022, five large state-owned enterprises listed in the United States opted to voluntarily remove their shares from the New York Stock Exchange, in apparent hopes of removing themselves from U.S. regulatory scrutiny. PCAOB chair Erica Williams pointedly responded to the voluntary delistings, asserting that the body enjoys full “retrospective” authority to inspect audit papers and that it will “need to have complete access … no loopholes, no exceptions.” The fate of the provisional deal will hinge on whether Beijing proves willing and able to meet such high expectations over the coming months.
Matthew P. Goodman is senior vice president with the Economics Program at the Center for Strategic and International Studies in Washington, D.C.
This article was researched and drafted by CSIS Economics Program research intern Joseph Vaughan.
Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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