U.S. stock exchanges and the China problem

Despite a lot of sabre-rattling by regulators and lawmakers, investors keep losing money from Chinese frauds and Chinese companies continue to list on U.S. stock exchanges.

Despite all the rhetoric from U.S. regulators and lawmakers, hyped-up and potentially fraudulent Chinese companies are still applying to list on US stock exchanges, continuing the chronic exploitation of U.S. investors.

Source: The artist Badiucao 巴丢草 https://www.badiucao.com/

The Holding Foreign Company Accountability Act (HFCA) grants the Securities and Exchange Commission the ability to delist foreign companies that fail to comply with securities laws that require companies to be audited by a firm that can be inspected by U.S. audit regulator, the Public Company Accounting Oversight Board.

According to Paul Gillis of Peking University in a recent Bloomberg podcast: “China has a very expansive definition of state secrets such that basically any transaction with a state-owned enterprise in China is considered to be a state secret … for example, my mobile phone bill is technically a state secret.” Chinese audit firms have been using variations of this excuse for years to evade inspection by the PCAOB.

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The law says:

The Commission shall-- ``(A) identify each covered issuer that, with respect to the preparation of the audit report on the financial statement of the covered issuer that is included in a report described in paragraph (1)(A) filed by the covered issuer, retains a registered public accounting firm that has a branch or office that-- ``(i) is located in a foreign jurisdiction; and ``(ii) the Board is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction described in clause (i), as determined by the Board;

The SEC’s rule requires:

… the Commission to identify public companies that have retained a registered public accounting firm to issue an audit report where the firm has a branch or office that: (1) is located in a foreign jurisdiction, and (2) the Public Company Accounting Oversight Board (“PCAOB”) has determined that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction…

For 15 business days after this provisional identification, a registrant may email the SEC if it believes it has been incorrectly identified, providing evidence supporting its claim. After reviewing the information, the registrant will be notified whether the SEC will “conclusively identify” the registrant as a Commission-Identified Issuer... SEC will (potentially) impose an initial trading prohibition on a registrant as soon as practicable after.

The PCAOB recently issued Rule 6100, a guideline for how it will operate to handle audit firms it is unable to inspect. The PCAOB established this rule as a result of the HFCA, which mandated a response from the PCAOB and SEC regarding how they will evaluate the level of resistance from an audit firm and its client before moving towards delisting.  

In short, the PCAOB will tell the SEC when it is not able to inspect an audit performed by a firm that resists. The PCAOB will provide the SEC a list of the public companies audited by that firm. The SEC will review that list and send an inquiry to the companies to ask that they either verify compliance will occur or change auditors. If the company does not comply or respond to the SEC inquiry that they will change audit firms they face removal from U.S. based stock exchanges. The law went into effect December 18, 2020.

It is too soon to tell what it will take for the PCAOB to formally refer an audit firm and its clients to the SEC.

There’s nothing new about delisting companies or de-registration of audit firms. Delisting is part of the Securities Exchange Act of 1934 and successive updates. Registration/de-registration is a core activity of the PCAOB since its founding in 2002, based on the Sarbanes-Oxley law.

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However, HFCA seems duplicative of existing law and is reactive, enacted to feign focus on a chronically hot topic: Uncooperative Chinese audit firms that provide opinions for the Chinese companies listed on U.S. exchanges that have turned out to be frauds. The law has multiple blind spots companies can exploit to evade delisting, especially the Chinese companies. 

The HFCA focuses on China mainland, Hong Kong and Macau headquartered companies that use China-headquartered audit firms, including those headquartered in Hong Kong. The law is designed to address only companies with a specific business model. In fact, this business model is only a small slice of the entire pie of Chinese companies listed on U.S. stock exchanges and companies that use audit firms the PCAOB has been unable to inspect.