US and Chinese regulators sign landmark agreement on inspection of Chinese audit work
On 26 August 2022, the US Public Company Accounting Oversight Board (PCAOB) and the PRC China Securities Regulatory Commission (CSRC) and Ministry of Finance (MoF) signed a Statement of Protocol that would allow US regulators access to audits of Chinese companies listed on the US stock exchanges.
Introduction
This marks a landmark agreement between US and Chinese regulators on a longstanding impasse dating back to the 2012 US administrative proceedings against the China-affiliates of the five largest accounting firms. Those proceedings, and the subsequent decade-long stalemate, stemmed from China's concerns over allowing regulators from other jurisdictions, including those from Hong Kong, to inspect Chinese company audits.
Background
This issue, stemming from PRC regulations1 on preservation of "state secrets" and restrictions on transmission of audit working papers, has long hindered Hong Kong auditors when dealing with requests for documentation. These restrictions were considered in the Standard Water case (in 2012), in which a Hong Kong auditor faced requests from the Securities and Futures Commission (SFC – the lead securities regulator in Hong Kong) to provide its audit working papers held in Mainland China. The High Court (of Hong Kong) held that these Mainland Chinese provisions (together with other relevant Chinese regulations) do not impose a "blanket" prohibition on cross-border transmission of audit working papers especially in the absence of evidence showing that they might contain "state secrets". According to this case, if prior approval from PRC authorities is required for transmission of working papers out of Mainland China, it should be the auditor's obligation to obtain such approval.
In practice, requiring auditors to provide evidence showing "state secrets" or obtaining any written indication from PRC authorities can be a difficult task. The MoF issued further provisional regulations2 providing more specific requirements for retaining audit working papers in Mainland China. However, the regulations continue to pose a compliance conundrum for Hong Kong firms which are expected to comply with both local and Mainland laws and regulations. This is especially the case when Hong Kong audit firms face regulatory requests compelling disclosure of the audit working papers which may physically be retained in Mainland China pursuant to Mainland Chinese regulations.
In a welcome move towards increased cross-border co-operation, Hong Kong regulators (e.g. the SFC) have in recent years entered into Memoranda of Understanding (MoU) with the relevant PRC authorities. Most notably as regards auditors, the Hong Kong Financial Reporting Council (FRC) signed a MoU with its PRC-counterpart (the Supervision and Evaluation Bureau of the MoF) in 2019 to provide mutual assistance in their regulatory roles. In December 2020, the FRC obtained its first batch of PRC working papers directly from the MoF. Since then, in June and August 2021, the FRC has completed two investigations using working papers obtained under the MoU. At the time of writing, it is understood that Hong Kong regulators continue to make use of their regulatory cooperation channels with the PRC authorities to facilitate cross-border transfer of working papers.
Update
The Statement of Protocol between the PCAOB, CSRC and MoF is the latest development in this space that is likely to further impact Hong Kong audit firms' compliance efforts. The scope of the Statement is intended to cover audit work carried out in Mainland China, and the PCAOB is already preparing to have inspectors on the ground by mid-September to start conducting on-site inspections, starting with the audits of Alibaba and Yum China. The choice of Hong Kong as the venue for the first inspections makes a lot of sense given (for example) the gradual easing of Covid-19 travel and social distancing restrictions in the city and that Hong Kong is not (for this purpose) "offshore". This also highlights Hong Kong's unique role as a facilitator between Mainland China and the rest of the world.
Nevertheless, regulators and commentators on both sides remain cautious as to how, in practice, this co-operation is to be implemented. For now, details are light as to the criteria to be met for the inspection process and how the success of an inspection will be verified.
We expect further developments and clarity on this as the PCAOB begin their investigative work in the fourth quarter of 2022. Watch this space.
1Such as the PRC's Provisions on Strengthening Confidentiality and Archives Administration in Overseas Issuance and Listing of Securities (No. 29 [2009])
2Namely the Notice on the Transitional Policy Issues Concerning Delegating the Approval Power for the Overseas Accounting Firms' Temporary Provision of Auditing Services in Chinese Mainland (No. 25 [2013]) and the Notice on Issuing the Interim Provisions on Accounting Firms' Provision of Auditing Services (No. 9 [2015])
This article is intended to give general information only. It is not a complete statement of the law and does not constitute legal advice. It is not intended to be relied upon or to be a substitute for legal advice in relation to particular circumstances.