The U.S.-China Audit Oversight Dispute: Causes, Solutions, and Implications for Hong Kong

• Author: Robin Hui Huang
• Pages: 151-199

The U.S.-China Audit Oversight Dispute:

Causes, Solutions, and Implications for Hong

Kong

R

OBIN

H

UI

H

UANG

*

The audit oversight regime in the United States demands inspection and

investigative power on all audit firms that provide service to listed

companies, including foreign audit firms.

1

This is not a new requirement

but has been in place since the enactment of Sarbanes-Oxley Act of 2002.

2

The extraterritorial power granted by the act is often in conflict with laws

and sovereignty of foreign jurisdictions. Demanding foreign audit firms to

turn over documentation produced during the auditing process can put the

firms into the vortex of this conflict, as domestic law in foreign jurisdictions

may forbid them to do so. This conflict of law has now grown into one of

the most serious disputes between U.S. and Chinese regulators, due to the

cross-listing of many Chinese issuers (known as Chinese Concept Stocks) on

the U.S. stock market.

3

In order to properly understand the conflict and the

rationale of all sides, this article will retrace the United States’ Public

Company Accounting Oversight Board regime (PCAOB) from its creation,

particularly in relation to its extraterritorial oversight power and

international inspection practice. Over the years, the U.S. watchdog has

resolved the foreign oversight issue with most jurisdictions, but the conflict

with China has only escalated. The audit oversight regime of China and its

restriction on audit working papers from outside access will then be

reviewed.

Throughout the years of unresolved audit oversight issues with China,

multiple Chinese stocks listed in the United States have collapsed, often

* Professor, Faculty of Law, Chinese University of Hong Kong; Adjunct Professor,

University of New South Wales, Sydney, Australia; Li Kashing Visiting Professor, McGill Law

School, Montreal, Canada; Honorary Professor, East China University of Political Science and

Law, Shanghai, China. This research project (Project Number: 2019.A4.056.19C) is funded by

the Public Policy Research Funding Scheme from the Policy Innovation and Co-ordination

Office of the Government of the Hong Kong Special Administrative Region. It also received

support from Direct Research Grant at Chinese University of Hong Kong. I thank Mr. Paul

Wai Ho Cheuk for his excellent research assistance.

1. See generally Sarbanes-Oxley Act of 2002 Pub. L. No. 111-203, 124 Stat. 745 (2002).

2. Id.

3. See, e.g., Sofia Horta e Costa, Two Accounting Scandals in China in One Week Burn Investors,

B

LOOMBERG

(April 8, 2020, 3:13 AM), https://www.bloomberg.com/news/articles/2020-04-08/

two-accounting-scandals-in-one-week-burn-investors-in-china-inc [https://perma.cc/F36Q-

6R77].

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because of fraudulent accounting practices.

4

The failure of these Chinese

companies resulted in great losses for U.S. investors, the very thing the

PCAOB is meant to prevent.

5

From lawsuits with Chinese auditing firms, to

a relatively calm midpoint in 2013 when a Memorandum of Understanding

was signed, by 2020 the U.S. regulators have lost their patience with the

obstacles China places in their audit document inspections. The United

States recently issued perhaps its sternest warning that may point towards a

potential consequence of all Chinese companies being delisted.

6

While the

U.S.-China dispute continues to escalate, the same audit oversight issues

with Hong Kong seem to have subsided. The Hong Kong market is actually

expecting more Initial Public Offerings (IPOs) of Chinese companies,

including those that will be “coming back” from U.S. listings.

7

It is crucial

to understand the rationale of the Chinese reaction towards the U.S.

regulators’ demand throughout the years. Revelation from the lawsuits

against audit firms and companies in the United States and Hong Kong will

shed light on how the conflict of law comes down to today’s most significant

confrontation. Lastly, alternative policy options at this juncture and how

regulators can act to refine policy to accommodate the reality of these

Chinese companies will bring about critical impact on the integrity and

performance of the U.S. and Hong Kong stock markets, as well as on the

bilateral relationship between the United States and China.

The handling of cross-border audit oversight is a significant issue as

financial markets trend towards more cross-listing and interconnection.

8

The U.S. financial market is highly internationalized, and there are indeed a

large number of foreign companies listed or cross-listed on the U.S.

exchanges.

9

As of the first quarter of 2020, of the more than 2,400 public

companies on the NYSE, 507 are non-U.S. companies.

10

They come from

forty-six countries and make up around 20 percent of all listed companies.

11

The largest source of foreign companies on NYSE is Canada with its 135

companies, followed by China ranking second with eighty companies, and

4. Id.

5. Id.

6. See Benjamin Bain & David Westin, SEC Chief Backs Bill to Delist China Firms Barring

Audit Reviews,

B

LOOMBERG

(June 2, 2020, 10:50 AM), https://www.bloomberg.com/news/

articles/2020-06-02/sec-chief-backs-bill-to-delist-china-firms-barring-audit-reviews [https://

perma.cc/8NBJ-P7ZF].

7. Kari Soo Lindberg, Flood of China Mega Listings Will Tighten Hong Kong Liquidity,

B

LOOMBERG

, (May 21, 2020, 10:17 PM), https://www.bloomberg.com/news/articles/2020-05-

21/landing-mega-china-ipos-will-shake-up-hong-kong-s-interest-rates [https://perma.cc/

R5AY-KJTJ].

8. Current List of All Non-U.S. Issuers 507 NYSE and NYSE American-Listed Non-U.S. Issuers

from 46 Countries (as of April 30, 2020),

NYSE

(Apr. 30, 2020), https://www.nyse.com/

publicdocs/nyse/data/CurListofallStocks.pdf [https://perma.cc/9Z79-BH64].

9. Id.

10. Id.

11. Id.

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2021] U.S.-CHINA AUDIT OVERSIGHT DISPUTE 153

Brazil in third with thirty-five companies.

12

There are also around 180

Chinese companies of various sizes on Nasdaq, including three heavy-sized

companies being constituent stocks of the Nasdaq 100 Index.

13

On the

Hong Kong market, Chinese companies constitute a much higher

proportion.

14

Throughout the years since the very first listing of a Chinese

state-owned-enterprise (SOE) in the 1990s,

15

the listing of Chinese

companies in Hong Kong has grown at a rapid rate and now constitutes 67.5

percent of the market capitalization of the Hong Kong stock exchange.

16

Chinese companies also have the most sought after stocks and contribute

79.6 percent of the total turnover value.

17

With the prevalence of listing and

trading across jurisdictions, especially that of the mega economies of the

United States and China, the oversight of these lists and trades becomes an

ever more critical task.

I. The Audit Oversight Regime in the United States and its

Extraterritorial Application

A. T

HE

S

ARBANES

-O

XLEY

A

CT AND THE

PCAOB O

VERSIGHT

R

EGIME

Listed companies are required to periodically report their financial

statements so that investors can obtain timely and crucial information about

the companies.

18

Independent examination of financial records and financial

statements by auditing firms is, therefore, an indispensable part of this

process to ensure that such information is fair and accurate and conforms to

the law and generally accepted accounting principles.

19

The conduct of

auditors themselves is thus held to their professional standards.

20

The

auditing standards in the United States have a long history of development,

beginning in the 1900s.

21

In 1917, the American Institute of Certified

Public Accountants (AICPA) first formed a special committee for

12. Id.

13. These statistics are out of a total of around 3,300 companies listed on Nasdaq, as of June

30, 2020. Quotes for NASDAQ-100 Index,

N

ASDAQ

, https://www.nasdaq.com/market-activity/

quotes/nasdaq-ndx-index [https://perma.cc/D77W-DD6D] (last visited Dec. 8, 2020).

14. HKEX Fact Book 2019,

HKEX

(Mar. 24, 2020), https://www.hkex.com.hk/-/media/

HKEX-Market/Market-Data/Statistics/Consolidated-Reports/HKEX-Fact-Book/HKEX-

Fact-Book-2019/FB_2019.pdf [https://perma.cc/27YC-RBAG].

15. Robin Hui Huang

,

Yiguoliangzhibeijing xia de xianggang yu neidi zhengquan jianguan hezuo

tizhi ( ) [The Prospect and Evolution of Securities

Regulatory Cooperation between Hong Kong and Mainland China Under the ‘One Country, Two

Systems’ Arrangement], 5

[J. C

OMPAR

. L.]

12 (2017).

16. HKEX Fact Book 2019, supra note 14.

17. Id.

18. Securities Exchange Act of 1934, 15 U.S.C. § 78(m) (2020).

19. See id.

20. See id.

21. Accounting Research Guide,

G

EO

. L.

(June 23, 2020), https://guides.ll.georgetown.edu/

accounting/auditing-standards [https://perma.cc/CN5G-WWFF].

THE INTERNATIONAL LAWYER

A TRIANNUAL PUBLICATION OF THE ABA/SECTION OF INTERNATIONAL LAW

PUBLISHED IN COOPERATION WITH

SMU DEDMAN SCHOOL OF LAW