U.S.-China Audit Deal Is Only Window Dressing

Anyone who has dealt with Chinese authorities knows that serious negotiation starts only after an agreement is signed. Hong Kong learned this lesson the hard way in the decades after the 1984 Sino-British Joint Declaration.

Now it’s America’s turn. This week Chinese authorities and the U.S. Public Companies Accounting Oversight Board struck a last-minute deal allowing American regulators to inspect the audit papers of Chinese companies in Hong Kong that are listed on U.S. stock exchanges.

Under the 2020 Holding Foreign Companies Accountable Act, the Securities and Exchange Commission has warned some 260 Chinese companies, collectively worth $1.3 trillion in market capitalization, that they will be delisted in the U.S. by 2024 if they don’t allow independent audits. In response, the Chinese government introduced tighter rules for companies listed overseas and encouraged Chinese businesses to upgrade their listing on Hong Kong’s stock exchange. New laws on data security and personal information make it almost impossible for many Chinese companies to maintain their listing status overseas without acting in breach of their legal obligations at home. Five Chinese state-owned companies recently announced they would voluntarily delist from the New York Stock Exchange.

The deal between Beijing and the PCAOB seems to have reassured the financial world. The Nasdaq Golden Dragon China Index, which tracks Chinese companies that trade in the U.S., surged on the news. But differences between the two sides soon emerged.

PCAOB insists that its audit inspections will be wholly independent of Chinese authorities, with no requirement for consent from the Chinese government. The China Securities Regulatory Commission insists that “audit work papers and other information that the U.S. regulator needs access to will be obtained by and transferred through Chinese regulators.” The CSRC also says that a Chinese regulator may “assist” in any interviews or testimonies Chinese personnel give during audit inspections.

Under the Chinese interpretation, the PCAOB would be able to inspect only information Chinese authorities have first screened. Officials may insist that data crucial for proper auditing and transparent governance amounts to state or trade secrets and therefore isn’t disclosable under Chinese law. It will be almost impossible to challenge these decisions within the Chinese system, even in Hong Kong. The definitions of state or trade secrets fall within the domain of the Hong Kong Committee on National Security, whose decisions are binding on the Hong Kong courts and not open to any challenge by private parties or overseas regulators. Even if the Hong Kong courts were dragged into a dispute, the U.S. side won’t be able to count on a level playing field given the overarching power Beijing has under the Hong Kong National Security Law.

That’s not all. We expect China will maintain that audit records containing sensitive personal information and national-security data must be destroyed after any audit in compliance with Chinese laws. The American side is likely to insist that it has the right to preserve all audit records as per international auditing standards.

All and all, the agreement looks to be little more than window dressing. It may allow Chinese companies to remain on U.S. stock exchanges, but there’s no reason to think they’ll be rigorously audited.

This may please some large institutional investors, but the signal to the Chinese Communist Party is that U.S. regulators, and by extension the Biden administration, are still unwilling to challenge the governance issues endemic to Chinese companies—despite the serious financial risks they pose to investors and shareholders in the Western financial system.

This article was originally published in the Wall Street Journal.