Friday, September 04, 2020

Former SEC and PCAOB officials ponder delisting Chinese companies that defy audit inspections

By Amanda Maine, J.D.

A recent webinar hosted by the Council of Institutional Investors (CII) featured former PCAOB and SEC officials, as well as industry representatives who discussed the recommendations put forth by the President's Working Group on Financial Markets (PWG) on protecting U.S. investors from significant risks from Chinese companies. The panel discussed at length the PWG’s recommendation that would delist Chinese companies on U.S. exchanges if they do not allow PCAOB access to work papers of the principal audit firm for inspection by PCAOB staff. The participants also addressed similar legislation that has passed the Senate and other recommendations made by the PWG.

Allow inspections or delist. The PWG’s first recommendation would require, as a condition to initial and continued exchange listing in the U.S., PCAOB access to work papers of the principal audit firm for the audit of the listed company. The recommendation provides that companies unable to satisfy this standard as a result of governmental restrictions on access to audit work papers and practices in jurisdictions like China may satisfy this standard by providing a "co-audit" from an audit firm with comparable resources and experience, as determined by the PCAOB.

The PWG’s delisting recommendation is similar to the requirement in legislation sponsored by Sens. John Kennedy (R-La) and Chris Van Hollen (D-Md) that would prohibit securities of a company from being listed on any of the U.S. securities exchanges if the company has failed to comply with PCAOB audits for three years in a row. Unlike the PWG’s recommendation, S. 945, the Holding Foreign Companies Accountable Act, does not provide a "co-audit" workaround for companies. S. 945 passed the Senate by unanimous consent on May 20, although it has yet to be taken up in the House.

Lynn Turner, who served as SEC chief accountant from July 1998 to August 2001 and is now a senior advisor at Hemming Morse LLP, said that he does not oppose S. 945, although he would prefer that the issue of inspections in non-cooperating jurisdictions be focused on auditors rather than issuers. He said that he does not support the PWG recommendation on delisting companies, citing the "co-audit" provision in particular. Calling the co-audit proposal a "cop-out" and "dead on arrival," Turner said that a U.S. firm would never want to subject itself to the liability for what its Chinese affiliate did without access to its work papers, which the Sarbanes-Oxley Act requires and is not being complied with by the Chinese firms anyway.

Dan Goelzer, a founding member of the PCAOB in October 2002 who served as acting Chairman of the PCAOB from August 2009 through January 2011 as well as general counsel to the SEC from 1983 to 1990, agreed with Turner’s characterization of the co-audit provision. This approach is not workable, Goelzer said, because Chinese firms are unlikely to let their work papers be retained in the U.S. due to Chinese government restrictions. If they actually agreed to that, they might as well agree to PCAOB inspections in the first place, Goelzer remarked.

Goelzer gave a brief history of his experience at the PCAOB and negotiating with China on allowing PCAOB inspectors access to Chinese auditors. He noted that during his tenure at the PCAOB, inspections in foreign jurisdictions was not a uniquely Chinese problem and that the Board conducted long negotiations with many jurisdictions to gain access for its inspections staff, including with the European Union and Switzerland. According to Goelzer, the Board took a three-fold approach to China. First, solve the problem with other jurisdictions, leaving China as an outlier. Second, highlight the PCAOB’s transparency by publishing lists of where the staff is allowed to inspect so investors are aware of jurisdictions that do not allow inspections. And third, in 2010, the PCAOB stopped registering new firms where inspections were not allowed.

CII General Counsel Jeff Mahoney asked Goelzer about deregistering the audit firms themselves as a way to deal with the issue of uninspected audits. Goelzer said it was considered but ultimately determined that it was not a solution to the problem. For one, the process would be slow and uncertain. You can’t just wave a wand and deregister an audit firm, Goelzer explained. It is a slow process that involves trying to inspect a firm, the firm’s non-cooperation with inspections, and a referral to the PCAOB’s Enforcement Division, which can take at least three years. Goelzer added that, even if a firm is deregistered, you’re just left with issuers that have an unregistered auditor.

While proposals like those made by the PWG and S. 945 may be painful solutions which would result in investors paying a financial price, as well as the U.S. financial markets since Chinese companies will start raising capital outside the U.S., it is not feasible to have a regulatory requirement and not do anything to enforce compliance, Goelzer said.

Shaswat K. Das, counsel at King & Spaulding who served as an associate director at the PCAOB where he negotiated numerous bilateral agreements with foreign regulators, also spoke of his experience at the Board. This included negotiating an agreement with Chinese authorities on cross-border enforcement cooperation in 2013. Das said that the staff felt that it had been making progress with China on cross-border issues, but it eventually deteriorated. Regarding the 2013 agreement, Das said that China’s cooperation was inconsistent and did not adhere to the agreement. This culminated in discussions in 2015, which participants hoped would be a precursor to an agreement on cross-border inspections, but it eventually fell through. Das was particularly critical of language used by the China Securities Regulatory Commission (CSRC), which he described as accommodating on its face but unworkable in practice.

Das said he is not in favor of delisting Chinese companies on U.S. exchanges that do not comply with PCAOB inspections, instead preferring the approach taken by Nasdaq, which is proposing enhanced listing standards rather than a wholesale delisting requirement imposed by the government. Like Turner and Goelzer, Das expressed disapproval of the "co-audit" provision of the PWG’s recommendation. Calling it "flawed and unworkable," he echoed the sentiments of his fellow panelists that U.S. firms would never take on the responsibility envisioned by the co-audit proposal.

Gordon Seymour, of Glass Lewis who served as PCAOB general counsel from 2007 to 2018, also expressed concerns shared by his PCAOB compatriots about the co-audit provision of the PWG provision, which he called the most significant difference between the two delisting proposals.

Seymour also noted differences in timing and process between the two proposals. On its face, the PWG recommendation has an earlier deadline (January 2022 for currently listed companies) than S. 945, which would require the automatic delisting after three years of non-inspection. However, he advised that the PWG proposal would require at least two significant rulemakings that can be very time-consuming. In addition, past rulemakings by the SEC imposing changes on listing standards have been overturned, which is another possibility, Seymour said. PCAOB rulemaking on the "co-audit" regime would probably require multiple rounds of notice and comment rulemaking for the PCAOB’s proposal and then a separate notice and comment period before approval by the SEC, he added.

Other recommendations. Another recommendation of the PWG is requiring enhanced issuer disclosures of the risks of investing non-complying jurisdictions like China, including issuing interpretive guidance to clarify these disclosure requirements to increase investor awareness. Mahoney asked Kristen Malinconico, director of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness, if the Chamber would support additional SEC interpretive guidance that would increase the number of risk factors required to be disclosed by SEC registrants based in China. Malinconico responded that the Chamber supports principles-based disclosure and would generally be supportive of additional risk factor disclosure, as long as the information provided to investors is material. The SEC should resist the urge to stray into requiring disclosure in areas that are not material to investors, she said.

Malinconico added that the SEC should recognize that requiring additional disclosure also opens up a company to litigation and that the Commission should be mindful of this. Regarding more guidance, Malinconico stressed that more guidance does not take the place of an agreement between governments. It is not optimal for the business community or auditors to substitute themselves for these intergovernmental agreements, she said.

Regarding the delisting proposals of the PWG and S. 945, Malinconico said that the Chamber has been clear that companies that cannot abide by U.S. securities laws or exchange listing standards should not be listed. However, she agreed that the co-audit recommendation by the PWG comes with many questions and concerns.