The Holding Foreign Companies Accountable Act (“HFCA”) was adopted on December 18, 2020, requiring both the SEC and the PCAOB to adopt rules and procedures implementing its provisions. The HFCA requires foreign-owned issuers to certify that the PCAOB has been able to audit specified reports and inspect their audit firm within the last three years. If the PCAOB is unable to inspect the company’s public accounting firm for three consecutive years, the company’s securities are banned from trading on a national exchange.
As part of the HFCA’s implementation, on November 5, 2021, the SEC approved PCAOB Rule 6100 establishing a framework for the PCAOB’s determination that it is unable to inspect or investigate completely registered public accounting firms located in foreign jurisdictions because of a position taken by an authority in that jurisdiction (see HERE.) On December 2, 2021, the SEC adopted amendments to finalize rules implementing the submission and disclosure requirements in the HFCA and published a sample letter that could be issued to China-based companies (see HERE.) In early 2022, the SEC began publishing a list of companies identified under the HFCA and providing notice to those companies.
In late December 2021 and early 2022, a slew of China-based companies delisted from U.S. Exchanges or announced an intention to do so, including many high-profile entities such as Didi Global, which had completed a $4.4 billion IPO just months earlier. Other companies have opted to change auditors to a firm located in the U.S. or elsewhere. Amid the turmoil, on August 26, 2022, the PCAOB and the China Securities Regulatory Commission and Ministry of Finance signed a Statement of Protocol reaching a tentative deal to allow the PCAOB to fully inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong.
Despite the Statement of Protocol, there remains a large degree of skepticism as to whether implementation and practice will satisfy the requirements of the Sarbanes-Oxley Act of 2002 (“SOX”) and related PCAOB standards. In announcing the deal, PCAOB Chair Erica Williams reiterated that skepticism, noting that while on paper the Protocol meets all the standards, “the real test will be whether the words agreed to on paper translate into complete access in practice.”
Likewise, in his testimony before the Senate Committee on Banking, Housing and Urban Affairs on September 15, 2022, SEC Chair Gary Gensler echoed the concern, stating, “[T]he proof will be in the pudding. This agreement will be meaningful only if the PCAOB actually can inspect and investigate completely audit firms in China. If the PCAOB cannot, roughly 200 Chinese-based issuers will face prohibitions on trading of their securities in the U.S. if they continue to use those audit firms.”
In the first blog in this series, I discussed the final SEC rules implementing the HFCA and gave important background information (see HERE). In this blog, I will discuss the PCAOB Statement of Protocol reached with China officials. Finally, in a third blog in the series, I will delve into the sample comment letter to China-based issuers, which provides important disclosure guidance.
SOX mandates that the PCAOB inspect registered public accounting firms in both the United States and in foreign jurisdictions and investigate potential statutory, rule, and professional standards violations committed by such firms and their associated persons. The PCAOB realized early on that certain aspects of these mandates raised concerns for non-U.S. firms, including potential conflicts with local laws. To address these concerns, the PCAOB worked with international counterparts to develop arrangements and working practices to allow the PCAOB and foreign regulators to achieve their respective requirements.
To ensure that cooperation with foreign regulators maintained the spirit and requirements imposed by SOX, any arrangement with a foreign regulator must allow the PCAOB to: (i) conduct inspections and investigations in accordance with SOX; (ii) select the audit work and potential violations to be examined; and (iii) access firm personnel, audit work papers and other information and documents deemed relevant by the PCAOB.
Although most countries cooperate, not all regulators have despite repeated efforts. Over the years, the PCAOB has maintained a “Denied Access List” which identifies the jurisdictions where the PCAOB cannot conduct inspections because foreign authorities have denied access, and the auditors from those jurisdictions issue audit reports filed with the SEC for U.S.-listed foreign public companies. As of today, the PCAOB can conduct inspections everywhere it needs to do so except in mainland China and Hong Kong. Against this backdrop, Congress enacted the HFCA requiring the PCAOB to determine whether it is unable to inspect or investigate completely a registered public accounting firm that is located in a foreign jurisdiction because it is denied access by one or more authorities in that jurisdiction.
PCAOB – China Statement of Protocol
As the provisions of the HFCA have been implemented and the significant impact to China-based companies became a reality, on August 26, 2022, the PCAOB signed a Statement of Protocol with the China Securities Regulatory Commission and the Ministry of Finance.
The Statement of Protocol grants the PCAOB complete access to the audit work papers, audit personnel, and other information it needs to inspect and investigate any firm we choose, with no loopholes and no exceptions. In particular, the Protocol provides that:
- The PCAOB has sole discretion to select the firms, audit engagements and potential violations it inspects and investigates – without consultation with, nor input from, Chinese authorities.
- Procedures are in place for PCAOB inspectors and investigators to view complete audit work papers with all information included and for the PCAOB to retain information as needed.
- The PCAOB has direct access to interview and take testimony from all personnel associated with the audits the PCAOB inspects or investigates.
The PCAOB expects to implement the new Protocol with inspections before the end of the year.
As discussed above, the U.S. regulators remain skeptical about China’s compliance with the new Protocol. Following announcement of the Protocol, on September 6, 2022, acting SEC Chief Accountant Paul Munter issued a statement warning auditors working with companies that have been identified under the HFCA. A slew of companies that have been identified by the SEC on the HFCA list have retained new audit firms inside the U.S. or elsewhere, but outside of China or Hong Kong. This practice continues despite the Protocol, because as noted, there is still concern about whether the Protocol will have the intended result.
Munter’s concern is that auditors that are not located in a company’s home jurisdiction (i.e., China or Hong Kong) will not understand local business practices, have access to management, speak the same language as management and the audit committee members, be able to complete site visits and inspections and otherwise will not be able to fulfill their duties to the extent required by the PCAOB. Moreover, in some instances a U.S. audit firm is assuming the role of lead auditor while a local firm performs the actual audit work. The arrangement may be set up where the company engages both firms or where the lead auditor hires subcontractors. Munter reminds practitioners that these arrangements are governed by the PCAOB’s professional responsibility rules and requires, among other things, that the lead auditor take on the responsibility of supervision, documentation and review.
Drilling down, Munter notes that these arrangements (i) place a responsibility on the lead auditor to determine whether it can serve as lead auditor and fulfill those responsibilities prior to accepting the engagement, (ii) place significant supervisory responsibilities, and the associated potential for liability, on the lead auditor that the issuer engages; and (iii) require that audit documentation must be retained by or be accessible to the retained lead auditor’s office that is issuing the audit report and must support the work performed by any other auditors involved, including auditors associated with other offices of the lead accounting firm, affiliated firms, or non-affiliated firms.
Also, an auditor taking over the engagement of a company on the HFCA list needs to communicate with the prior audit firm and access work papers among other information. Under these circumstances, the new audit firm should specifically inquire about: (i) the integrity of the company’s management; (ii) any disagreements with management that the predecessor firm may have had regarding accounting principles or other significant matters encountered during the previous audit(s); (iii) communications of matters between the predecessor firm and the company’s audit committee; (iv) the predecessor firm’s understanding of the nature of the company’s relationships and transactions with related parties and any significant unusual transactions; and (v) the predecessor auditor’s understanding as to the reasons for the change of auditors.
To the extent that either the company client or the prior audit firm impedes the process and communication, the new auditor may need to withdraw or decline the engagement.
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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