On August 6, 2020, President Trump’s Working Group on Financial Markets issued a report containing five recommendations designed to protect US investors from significant risks in Chinese companies. The most significant recommendation is that the SEC adopt rules that would require companies seeking a listing on a US stock exchange to have prior to such listing, and that would require already listed companies to have by January 1, 2022, either:
- an audit conducted by an audit firm subject to inspection by the Public Company Accounting Oversight Board (PCAOB); or
- a co-audit performed by a US auditing firm that has access to the company’s audit work papers and is subject to PCAOB inspection.
Any such rules would have a direct effect on Chinese companies listed or seeking to be listed on a US stock exchange, because China does not allow the PCAOB to inspect Chinese audit firms.
The Working Group’s report and recommendations arrive in the midst of growing tensions between the US and China generally and increasing focus on China’s unwillingness to allow PCAOB inspections of audit firms in particular. In May 2020, the US Senate unanimously passed a bill that would require a company to be delisted from a US stock exchange if its auditor could not be inspected by the PCAOB for three years. Nasdaq then proposed additional listing requirements that would allow Nasdaq to take into account whether a company’s auditor is subject to PCAOB inspection in evaluating whether to list or delist a company. In June 2020, President Trump asked the Working Group to examine certain risks to investors in US financial markets posed by the inability of the PCAOB to inspect audit firms that audited companies with operations in China. The five recommendations were issued by the Working Group in response to this request.
In the 18-month period ended May 31, 2020, 17 PCAOB-registered firms in mainland China and Hong Kong signed audit reports for 195 public companies with a combined global market capitalization (on US and non-US stock exchanges) of approximately US$1.7 trillion. The ten largest of these companies have a combined market capitalization of US$1.3 trillion. In the worst-case scenario, the recommendations could lead to the adoption of regulations that result in the delisting of all of these companies.
However, at this time, it is not possible to predict exactly what will happen next. The SEC, NYSE and Nasdaq clearly have the authority to adopt listing standards that would require certain kinds of audits or co-audits, and the President’s Working Group that issued the recommendations includes the Chairman of the SEC. However, it is uncertain when they will adopt the related rules and what the rules will exactly say. Also, there is uncertainty as to whether the rules would apply to newly listing companies without a transition period, and what transition period will be adopted. If the NYSE or Nasdaq seek to amend their listing standards in response to this report, in the normal course it would take two months or more for rules to be drafted, subject to a public comment period, and then approved. It would take even longer if first the SEC has to go through a rulemaking and then, when that is done, the NYSE/Nasdaq have to implement the SEC rules.
It is also not clear how the co-audit alternative would work or whether a US auditor performing a co-audit of the Chinese company would have access to the work papers, which the PCAOB could review. Also, if the co-audit alternative is designed to be a way to get around Chinese regulations, China could then adopt new regulations applicable to Chinese companies or to US auditors auditing Chinese companies.
It appears clear that if new regulations are adopted as recommended by the report, then such regulations, combined with the other developments over the past few months related to listing requirements as well as the overall rhetoric between the governments, (1) could potentially lead more Chinese companies currently listed in the US to seek a dual listing in Hong Kong or elsewhere and (2) could potentially lead some companies considering listing in the US to instead list in Hong Kong, China or London.
The President’s Working Group on Financial Markets, which is chaired by the US Secretary of the Treasury and includes the Chairmen of the SEC, the CFTC and the Federal Reserve, published the following five recommendations.
(1) Enhanced listing standards for access to audit work papers
The SEC and/or the NYSE and Nasdaq should enhance the listing standards of US stock exchanges to require as a condition to initial and continued stock exchange listing PCAOB access to work papers of the principal audit firm for the audit of the listed company. If the PCAOB cannot access such work papers as a result of governmental restrictions on access to audit work papers, companies may satisfy this standard by providing a co-audit from an audit firm with comparable resources and experience where the PCAOB determines it has sufficient access to audit work papers and practices to conduct an appropriate inspection of the co-audit firm.
To reduce market disruption, the new listing standards could provide for a transition period until January 1, 2022 for currently listed companies to come into compliance. After this transition period, if currently listed companies are unable to meet the enhanced listing standard (or co-audit requirement), then they would become subject to stock exchange rules and processes that could lead to possible delisting if not cured. For new listings, however, there would be no transition period. The listing standards would apply immediately to new listings once the necessary rulemakings and/or standard-setting are effective.
If a company cannot meet the new standard because its auditor is not subject to PCAOB inspection, the company would be required to engage an affiliated US-member registered public accounting firm (the “US Firm”) to serve as the principal auditor of the listed company’s annual financial statements through a co-audit arrangement with the local audit firm (the “Local Firm”). Under PCAOB standards, the principal auditor is permitted to use the work and reports of other independent audit firms that have audited the financial statements of one or more subsidiaries, divisions, branches, components or investments included in the consolidated financial statements. Rulemaking or standard-setting by the PCAOB, SEC or both would be needed to require the US Firm to supervise the work of the Local Firm, such that the Local Firm’s work is performed under the US Firm’s guidance and control. The US Firm would be required to include in its work papers documentation of audit evidence sufficient to support the audit conclusions. Under this recommendation, because the US Firm would be the principal auditor and would be required to maintain the work papers in the US, the PCAOB would have the ability to inspect the audit work and practices of the US Firm, including the US Firm’s quality controls with respect to its work on listed companies. Importantly, this recommendation would require the local government to permit the US Firm to perform the work and retain the relevant work papers in the US.
(2) Enhanced issuer disclosures
The SEC and/or NYSE and Nasdaq should adopt a disclosure requirement or listing standard that requires enhanced and prominent issuer disclosures of the risks of investing in companies from countries that do not allow PCAOB inspections of auditors, 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.
(3) Enhanced fund disclosures
The SEC should issue interpretive guidance to clarify investment companies’ (funds’) disclosure obligations regarding investments in emerging markets, including with respect to PCAOB inspection and enforcement limitations with respect to issuers based in China. In addition, such guidance could promote enhanced disclosure regarding limitations on a fund adviser’s ability to oversee an index provider’s due diligence process over index data prior to its use in index computation, construction and/or rebalancing. The disclosure could further acknowledge that the rights and remedies associated with investments in a fund that tracks an index comprised of foreign securities, particularly emerging market securities, may be different from those of a fund that tracks an index of domestic securities.
(4) Greater due diligence of indexes and index providers
The SEC should 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. This enhanced due diligence should take into account the index provider’s process for index construction, including with respect to index rebalances. In particular, due diligence should address whether the process takes into account any potential errors in index data, index computation and/or index construction if the information from issuers based in jurisdictions that prohibit PCAOB inspections, including China, is unreliable or outdated or if less information about such companies is publicly available due to differences in regulatory, accounting, auditing and financial recordkeeping standards. It should also take into account the potential effects of such differences on the fund’s performance.
(5) Guidance for investment advisers
The SEC should encourage investment advisers to focus on their duties of loyalty and care when considering emerging market investments, including in China. With respect to investments in China, an investment adviser should consider differences in local regulatory, accounting, auditing and financial recordkeeping standards and the effects of those differences on the ability to accurately select investments that meet the client’s investment objectives and goals. Accordingly, investment advisers that are recommending investments in these jurisdictions may want to consider, as part of their reasonable investigation, whether there are limitations on the quality or availability of financial information with respect to these investments, as well as possible limitations on investors’ legal remedies in such jurisdictions.
The President’s Working Group’s Report can be accessed here.