Can the “co-audit” concept untangle PCAOB inspection impasse?
On August 7th, the President's Working Group on Financial Markets weighed in on the dangers that investing in Chinese companies posed to U.S. investors. This report is the latest salvo following the passage of Senate's Holding Foreign Companies Accountable Act in May and an SEC roundtable on the risks of investing in emerging markets in July.
The “Report on Protecting United States Investors from Significant Risks from Chinese Companies” appeared on its face to be an escalation of efforts to restrict Chinese companies from accessing the U.S. capital markets. The report recommends the SEC use its existing regulatory authority to delist all companies from “Non-Cooperating Jurisdictions” whose governments prohibit the Public Company Accounting Oversight Board (PCAOB) from gaining access to working papers as part of the auditor inspection process. The SEC would immediately prohibit non-compliant companies from listing on the U.S. stock markets and give existing public companies until January of 2022 to come into compliance or have their shares delisted from U.S. exchanges.
The recommendations appear draconian; they would cast uncertainty on the tradability of Chinese equities currently held by U.S. retail and institutional investors with a market value of approximately $1.7 trillion. The report notes that mass delisting could have adverse consequences since Chinese corporate insiders could have the opportunity to engineer "going private" transactions that would buy out American shareholders at discounted valuations. Corporate managers and private equity sponsors could then relist the companies on exchanges in Asia or elsewhere at a significant profit. These exchanges in Hong Kong, Shanghai, or London have diminished levels of transparency and investor protections. Still, they would remain investable by American investors and be eligible for inclusion in emerging markets and global index funds held as passive investments.
The recommendations of the working group, which was co-chaired by the Secretary of the Treasury, Chairman of the Federal Reserve, and Chairman of the SEC, among other heavyweights, reflect deep frustration with the inability of regulators to conduct inspections of auditors based in China and investigations into cases of accounting malfeasance by Chinese companies. While the PCAOB insists on having unfettered access to the working papers that provide supporting evidence for auditor opinions, the Chinese government has taken the position that submitting these documents to foreign government authorities constitutes a potential violation of state secrets laws. According to the SEC and PCAOB, their ability to access relevant information has deteriorated even further since the new Article 177 of China’s securities law came into effect in March of 2020. The law states that "Overseas security regulatory agencies shall not directly conduct investigation and evidence collection activities within the territory of the People's Republic of China.”
The China Securities Regulatory Commission (CSRC) has made several public statements in recent months, indicating their willingness to strengthen cooperative agreements with U.S. regulators. On Saturday, the CSRC noted that it had sent an updated proposal for joint PCAOB inspections “based on the latest needs and ideas of the U.S. side” on August 4th and claimed that it had "never prevented audit firms from providing work papers to overseas regulators." Given the conflicting statements by the two sides, it is hard to evaluate if negotiations can be productive.
Are “Co-Audits” a Path Forward?
The working group introduces the concept of a “co-audit” as a potential solution to the audit inspection impasse. Interestingly, this idea resembles a suggestion made by Carson Block of the activist short-selling firm Muddy Waters at the recent SEC roundtable. He suggested that the SEC require U.S. firms to assume legal liability for the audits performed by their China-based member firms, on the theory that they have leased their brands to these firms to instill investor confidence and thus bear responsibility when these audits go wrong.
Under the scheme proposed by the working group, companies whose China-based auditors cannot comply with PCAOB audit inspections could hire the affiliated U.S. firm to serve as the principal auditor through a co-auditing arrangement. This approach would effectively collapse the legal structure used to "ring-fence" liability within the local member firms and place all the audit work done by the Chinese member firm under the "guidance and control" of the U.S. firm.
While this approach would appear to address some of the regulators' most pressing concerns, there are several open questions:
- Working Papers – The arrangement would require that the U.S. firm be permitted to retain the relevant working papers outside of China and available for inspection by the PCAOB. Sharing these papers would appear to place both the Chinese issuer and the local audit firm at risk for violating the State Secrets Law unless Chinese government authorities approve. One potential workaround would be to have the local member firm "sanitize" the working papers to remove information that might be construed as sensitive under Chinese laws.
- Cost Escalation – It remains to be seen if the Big Four audit firms will be receptive to the proposed "co-audit" model, given that it would place responsibility for audit quality, liability, and compliance with two conflicting regulatory systems squarely at the doorstep of the U.S. mothership. At a minimum, one would expect that the duplication of effort and legal scrutiny required to sanitize working papers would result in meaningfully higher fees. Depending on the extent of such additional costs, the U.S. may face further competitive disadvantages relative to Asia's capital markets.
But in a stormy landscape, even feeble gleams are cheering. Up to this point, American investors who wanted exposure to Chinese growth companies faced two unappealing choices. They could accept a lower level of market oversight and a total lack of recourse when things went awry. Or they could see their existing portfolio of investments rendered illiquid through mass delisting. While there are many remaining obstacles to be overcome, the willingness to engage in creative thinking and discuss potential cooperation is encouraging.