I am in Washington for the meeting of the Standing Advisory Group of the PCAOB, of which I am a member. This morning PCAOB chairman James Doty reported on PCAOB activities. He said this about China:
China, in particular, has taken considerable attention. We continue to discuss our need for a protocol to inspect PCAOB-registered firms in mainland China and Hong Kong. I am mindful that we cannot wait forever. Meanwhile, though, I am optimistic that we will soon be able to announce a protocol to exchange documents and other information necessary to enforcement investigations and disciplinary proceedings.
This would be an important start that, I believe, reflects the Chinese authorities’ understanding that investors in both our countries need to have confidence that allegations of fraud will be properly investigated. It would be an acknowledgement that access to relevant documents is fundamental to effective investigations. Access to documents will also, of course, be necessary to carry out an effective inspection regime.
The implications of this “protocol”, if concluded, may be significant. An agreement to exchange documents would presumably mean that accounting firms will be permitted to send audit working papers outside of China and to give them to foreign regulators. That would seem to settle the cases against the accounting firms by the SEC in the US and the SFC in Hong Kong. While I understand the negotiations by the SEC and the PCAOB have been handled separately, I expect any agreement applies to both and will be extended to SFC in Hong Kong as well.
I expect the agreement will be announced as part of the Strategic and Economic Dialogue between the U.S. and China scheduled to take place in early July. Once the SEC gets the requested working papers, I expect it will dismiss the case against the firms. That removes the most urgent risk that the accounting firms might lose the right to practice. Accordingly, this agreement likely removes the risk that U.S. listed Chinese companies will be delisted.
For the PCAOB, the agreement is a painful compromise. There is no deal allowing for inspections. But the protocol might allow working papers to be shipped to the PCAOB in the U.S. for inspection, presumably after being redacted for state secrets. That is a poor substitute for on the ground inspections. I believe that the PCAOB is facing significant political pressure to accept this deal.
I believe that the protocol will make it very difficult for the PCAOB to negotiate joint inspections. While they still have the power to deregister the firms they cannot inspect, I think that the political consequences of doing so are too high, so they have lost the only leverage they had. Instead, the PCAOB is likely to have to swallow inspections by mail.