For over a decade, the PCAOB has been unable to fulfill its SOX mandate to inspect audit firms in “Non-Cooperating Jurisdictions,” or “NCJs,” including China. To address this issue, in May, the Senate passed the Holding Foreign Companies Accountable Act, which would amend SOX to impose certain requirements on public companies that are audited by a registered public accounting firm that the PCAOB is unable to inspect, and a version was subsequently passed by the House as an amendment to a defense funding bill. Around the same time, Nasdaq also proposed rule changes aimed at addressing similar issues in restricted markets, including new initial and continued listing standards. (See this PubCo post.) Now, the President’s Working Group on Financial Markets, which includes Treasury Secretary Steven T. Mnuchin, Fed Chair Jerome H. Powell, SEC Chair Jay Clayton and CFTC Chair Heath P. Tarbert, has issued a Report on Protecting United States Investors from Significant Risks from Chinese Companies. The Report makes five recommendations “designed to address risks to investors in U.S. financial markets posed by the Chinese government’s failure to allow audit firms that are registered with the Public Company Accounting Oversight Board (PCAOB) to comply with U.S. securities laws and investor protection requirements.” In this Statement, the SEC Chair Jay Clayton, Chief Accountant Sagar Teotia and the Directors of various SEC Divisions responded to the Report, indicating that Clayton had already “directed the SEC staff to prepare proposals in response to the report’s recommendations for consideration by the Commission and to provide assistance and guidance to investors and other market participants as may be necessary or appropriate. The SEC staff also stands ready to assist Congress with technical assistance in connection with any potential legislation regarding these matters.”


In April, SEC Chair Jay Clayton and other SEC and PCAOB officials issued a Statement discussing the risks and exposures of companies based, or with significant operations, in emerging markets, including China, for both U.S. domestic companies and foreign private issuers. Although the SEC is committed to high-quality disclosure standards, the statement read, its ability to enforce these standards in emerging markets is limited and is “significantly dependent on the actions of local authorities” and the constraints of “national policy considerations.” As a result, in many emerging markets, “there is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse, in comparison to U.S. domestic companies.” In addition, the environment in which the company operates could affect “whether the company has sufficient controls, processes and personnel to address its accounting or financial reporting issues.” The message was that, notwithstanding similarity in form and appearance between disclosures from U.S. domestic companies and disclosures from or related to emerging markets, disclosures from emerging markets may well differ in scope and quality and companies need to provide appropriate risk disclosure in that regard. (See this PubCo post.)

To be competitive and inspire the confidence of investors, the new Report observes, the U.S. capital markets depend on “rigorously enforced disclosure and corporate governance regulations that help to prevent fraud and mismanagement…. To this end, the ability of U.S. authorities to examine for compliance, investigate and bring enforcement actions to hold issuers and gatekeepers accountable is a key aspect of U.S. securities law.” One mechanism to help ensure that companies provide accurate financial statements that have been subject to high-quality audits is the SOX requirement that PCAOB-registered accounting firms that issue audit opinions for U.S.-listed companies submit to PCAOB inspection and produce audit work papers. Foreign accounting firms that issue audit reports for U.S.-listed foreign issuers are subject to SOX. However, “Chinese law prohibits audit firms operating in China and Hong Kong from releasing documentation of Chinese issuers that Chinese authorities deem sensitive to share without explicit government permission.” As a result, the PCAOB and SEC have been unable to access audit work papers of Chinese-based issuers listed on U.S. exchanges: “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 (U.S. and non-U.S. exchanges) of approximately $1.7 trillion. The 10 largest of these companies have a combined market capitalization of approximately $1.3 trillion.” Although this prohibition has long been in operation, in March 2020, a new law essentially codified the position, prohibiting foreign regulators from directly conducting investigations and evidence collection activities in the PRC and, without the approval of Chinese authorities, prohibiting any entity or individual from providing documents and materials related to securities business activities to foreign regulators.

The Working Group developed five recommendations designed to “protect investors by ensuring a level playing field for all companies listed on U. S. exchanges”:

“(1) Enhanced Listing Standards for Access to Audit Work Papers. Enhancing the listing standards of U.S. exchanges to require as a condition to initial and continued exchange listing:

(a) PCAOB access to work papers of the principal audit firm for the audit of the listed company; or

(b) Companies that are unable to satisfy the 1(a) standard as a result of governmental restrictions on access to audit work papers and practices in NCJs 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 from NCJs to come into compliance. The new listing standards would apply immediately to new company listings once the necessary rulemakings and/or standard-setting are effective.

(2) Enhanced Issuer Disclosures. Requiring enhanced and prominent issuer disclosures of the risks of investing in NCJs, 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. Reviewing the risk disclosures of registered funds that have exposures to issuers from NCJs to enhance the disclosures by these funds, including issuing interpretive guidance to clarify the disclosure requirements to increase investor awareness of the risks of investing in such funds.

(4) Greater Due Diligence of Indexes and Index Providers. Encouraging or requiring 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.

(5) Guidance for Investment Advisers. Issuing guidance to investment advisers with respect to fiduciary obligations when considering investments in NCJs, including China.”

With regard to the enhanced listing standards, if a company is unable to meet the requirement of PCAOB access to audit work papers of the principal audit firm, the Report recommends that the company be able to satisfy this standard with 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.” That is, the company would be required to engage an affiliated U.S.-member registered public accounting firm that would serve as the principal auditor of the company’s financials through a co-audit arrangement. While the PCAOB currently permits a principal auditor “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,” the “co-audit” concept would apparently require the U.S. firm to “supervise the work of the NCJ Firm, such that the NCJ Firm’s work is performed under the U.S. Firm’s guidance and control.” Accordingly, new SEC rulemaking or PCAOB standard-setting would be required. (The Report notes that new rulemaking may also be needed to address the language issue for the U.S. firm.)

In addition, the U.S. accounting firm “would be required to include in its work papers documentation of audit evidence sufficient to support the audit conclusions.” Because the U.S. audit firm would be the principal auditor and would be required to maintain the work papers in the U.S., the PCAOB would be able to inspect the audit work and practices of the U.S. accounting firm, including its quality controls with respect to its work on listed NCJ companies. However—and it’s a big however—this “recommendation would require the government of an NCJ to permit the U.S. Firm to perform the work and retain the relevant work papers outside of the NCJ.” So how workable is this work-around? The Chinese law prohibits direct investigations in the PRC by foreign regulators and providing documentation to foreign regulators. But will the PRC authorities permit the described co-audit process? Will U.S. audit firms be willing to accept liability as principal auditor through “supervision”?

The Report notes that the exchanges could either submit new rules proposals on their own initiative, following informal discussions with the SEC, that would add specific listing requirements applicable to companies that are “based in or have a significant portion of their audit services conducted by firms in NCJs,” or the SEC could mandate the listing standard changes, which the exchanges would need to implement through new rulemaking. In either case, SEC approval would ultimately be required. For initial listings, the new rules would apply on effectiveness; however, for continued listings, listed companies would have until January 1, 2022 to “come into compliance.” At that point, if not in compliance, the companies would become subject to the exchange rules and processes that could lead to possible de-listing if not cured. The Report notes that the “compliance periods can be as long as one year to eighteen months, though the period can be longer due to various appeals processes.” There is also an 8-K filing requirement applicable when a company is notified that it is not in compliance. (By comparison, the Holding Foreign Companies Accountable Act provides for delisting and trading prohibitions after the SEC determines that the company has had three consecutive “non-inspection years,” although there is no provision for “co-audits.”)

The Report also addresses policy issues that could arise out of a change in the listing standards, including the possibility that the change would drive NCJ companies to list securities on exchanges outside the United States, including on exchanges in Hong Kong, Shanghai or London, with the result that U.S. investors that still purchased the securities could have even fewer protections and even less transparency. Another potential consequence is that companies could “go private,” which, in light of the structure of some entities and their jurisdictions of organization, could leave U.S. investors with little say in the matter and little recourse if they opposed the transaction or disagreed on valuation.

The recommendations also include enhanced company disclosure requirements. Although the SEC’s current principles-based disclosure requirements would, in theory at least, elicit these types of disclosures, if material, a more specific rule or listing standard or disclosure requirement could be helpful. For NCJs, the relevant risk disclosures would relate to a company’s structure—apparently “variable interest entities” are widely used in certain business sectors in China that have prohibitions or restrictions on foreign investment—lack of enforcement mechanisms, PCAOB inspection limitations, and “the NCJ’s regulatory environment, which in general provides governmental authorities with significant discretion that can be used to influence how such issuers conduct their business operations.”

The SEC Statement invites any public views or other information for consideration by the staff as the staff develops the proposals in response to the Report to be submitted to [email protected] Submissions will be added to the comment page for the July Emerging Markets Roundtable and made publicly available.