After months of closed-door negotiations, the Public Company Accounting Oversight Board (PCAOB) announced on Friday that it has entered into a Statement of Protocol with the China Securities Regulatory Commission (CSRC) and the Ministry of Finance of the People’s Republic of China (PRC).¹ The Statement of Protocol creates a pathway for companies based in China and Hong Kong to remain listed on US exchanges past 2024, notwithstanding the Holding Foreign Companies Accountable Act (HFCAA) adopted in 2020.² Despite this milestone, there are at least three reasons why this agreement may not be as significant as the press reporting suggests.

Background

The HFCAA directs the US Securities and Exchange Commission (SEC) to prohibit trading of a registrant’s securities on any US securities exchange if, for three consecutive years, the company was identified as having used a registered public accounting firm that the PCAOB determined it was unable to inspect or investigate completely because of a position taken by the relevant foreign regulatory authority. In response to concerns related to the domestic legal regime around protection of state secrets and data privacy concerns, auditors in the PRC and Hong Kong for more than a decade have not given the PCAOB full access to their audit work papers, for example, by withholding or heavily redacting audit work papers and by restricting the PCAOB’s ability to select for inspection the audits of state-owned enterprises and companies in strategic industries. As a consequence, absent a change in the PCAOB’s ability to inspect PRC and Hong Kong auditors, the HFCAA would cause trading in the securities of PRC- and Hong Kong-based companies to cease on US exchanges by 2024.

The Statement of Protocol establishes a framework for the PCAOB to inspect and investigate registered public accounting firms in the PRC and Hong Kong, including all work papers related to audits of US-listed Chinese companies.

Three Reasons the PCAOB’s Agreement With China May Not Have Changed the Landscape

1. The Statement of Protocol Is Simply a First Step
   US officials’ statements surrounding the Statement of Protocol were unusually pointed in emphasizing that the jury is still out on whether the PRC and Hong Kong will indeed allow the PCAOB to inspect and investigate completely their PCAOB-registered public accounting firms. In particular, while PCAOB Chair Erica Williams stated that the Statement of Protocol afforded the PCAOB “complete access” to audit work papers, audit personnel and other information, she stated that “the real test will be whether the words agreed to on paper translate into complete access in practice.” Similarly, SEC Chair Gary Gensler stated: “The proof will be in the pudding.” The CSRC also issued tempered remarks, characterizing the Statement of Protocol as a “first step.”³
   The agreement will be tested soon. Chair Gensler stated that “inspectors must be on the ground by mid-September if their work has any chance to be successfully completed by the end of this year”—in time for the annual determination to be made by the PCAOB when it reassesses whether the positions taken by PRC authorities have again prevented the PCAOB from completely inspecting and investigating audit firms in the PRC and Hong Kong. The PCAOB’s annual determination in 2022 would be especially significant if Congress were to pass the accelerating legislation referenced below, because it could trigger delistings as early as 2023. 
   From the perspective of US regulators, it will be incumbent upon PRC authorities to comply in all respects with the requirements of US law and the new Statement of Protocol—and to avoid creating inspection obstacles similar to those in the past. Were such obstacles to occur, there is a significant risk that US regulators would view them as undermining the principles behind the Statement of Protocol. 
2. The Statement of Protocol Will Have Limited Application, as Chinese Issuers Have Already Been Leaving US Markets
   Under the threat of delisting from the HFCAA, issuers based in the PRC and Hong Kong already have begun voluntarily delisting from US exchanges. For example, earlier this month, five of China’s largest state-owned companies announced plans to delist from US exchanges. In addition, Alibaba announced plans to seek a primary listing in Hong Kong, signaling an abandonment of the US markets among a sizable portion of the total market value at risk of delisting.⁴ This creates a possibility that the PRC and Hong Kong will become more permissive with respect to the PCAOB’s inspections, given that the companies with the most sensitive data have already opted to delist from US exchanges.
   However, while these moves might alleviate some of the PRC’s historic concerns around audit inspections, the PCAOB’s inspection authority is retroactive, and audits of these large issuers could still be subject to PCAOB inspection. If this were to occur, it could set the stage for an even more demanding test of the PRC’s willingness to completely abide by the terms of the Statement of Protocol.
3. Congress Continues to Take a Hard Line on China
   Both the HFCAA and pending accelerating legislation⁵ are the product of a group of legislators who have called on the Biden Administration to take a harder line on China, both with respect to securities regulation and in other areas. Some of the HFCAA’s proponents responded to the announcement of the Statement of Protocol by urging the SEC and the PCAOB to continue to enforce the HFCAA rigorously, even if it were to result in delistings. For example, Senator Marco Rubio “urged the PCAOB to accept nothing less than full compliance to the agreement” and expressed plans to continue working with the PCAOB to ensure full enforcement of the HFCAA.⁶ Senator John Kennedy stated: “We’ve got the regulatory hammer, and we will use it without flinching.”⁷ Senator Kennedy also called on Congress to pass his Accelerating Holding Foreign Companies Accountable Act without delay—as noted above, that act would cause PRC and Hong Kong companies whose auditors had not been subject to PCAOB inspection to be delisted by 2023 rather than 2024, further reducing the window for comprehensive resolution.⁸

The risk of delisting PRC- and Hong Kong-based companies from US exchanges is still present, despite the Statement of Protocol. Challenges similarly persist for auditors that are, or utilize audit firms that are, based in the PRC and Hong Kong. Aside from navigating the PCAOB’s upcoming inspections, audit firms could face other risks as well, such as renewed scrutiny around the use of other auditors and accounting service providers, including compliance with the applicable PCAOB auditing standards and consent requirements in Section 106 of the Sarbanes-Oxley Act. It will be critical to monitor developments around the inspection of PRC- and Hong Kong-based audit firms in the coming months.