The U.S. securities regulator’s accounting arm said it obtained ‘complete access’ to companies it targeted under a landmark information-sharing agreement reached in August

Key Takeaways:

  • The PCAOB gave a positive review of its trial inspections of two China-based accountants under a landmark U.S.-China information sharing deal
  • The positive assessment eases the likelihood of forced de-listings for the group of more than 200 companies

By Doug Young

Perhaps it got lost in the flood of news about China’s sudden relaxation of its “zero Covid” policy. Or perhaps it was overshadowed by the Fed’s decision to raise interest rates by another 50 basis points. Or perhaps it was simply a case of the stock market axiom that says to “buy on the rumor and sell on the news.”

Whatever the reason, investor reaction was quite the opposite of what you might expect to a U.S. statement that was highly praiseworthy of the first inspections under a recently signed information-sharing agreement between the U.S. and Chinese securities regulators. We’ll look at the statement in more detail shortly. But its headline nicely sums things up, saying “PCAOB Secures Complete Access to Inspect, Investigate Chinese Firms for First Time in History.”

So, investors should have been breaking out the champagne, relieved by this latest sign that made it look increasingly unlikely that an impasse between the U.S. and China might lead to the forced de-listing of more than 200 U.S.-listed Chinese stocks. But just the opposite occurred, with nearly all major U.S.-listed Chinese stocks and related funds closing lower.

The iShares MSCI China ETF (MCHI.US) was representative of the group, dropping 2.2% on Thursday after the extremely positive assessment from the Public Company Accounting Oversight Board (PCAOB), the inspection arm of the U.S. Securities and Exchange Commission (SEC).

That would seem to reinforce the “buy on the rumor, sell on the news” explanation for the daily dip. In fact, the MSCI China ETF is still up 30% from a year-low in late October, shortly before reports began emerging that the PCAOB had wrapped up its trial inspections early and was heading back to the U.S. The team of more than 30 inspectors had been in Hong Kong working with the CSRC.

Before we go any further, it’s probably helpful to review the long road that brought us to this point. This particular issue dates back more than two decades to around the year 2000 when the first Chinese companies began listing in the U.S., mostly because the big majority were money-losing private companies that were ineligible to list in China.

But the SEC quickly discovered it couldn’t inspect the group’s China-based auditors due to a ban on such inspections by China. The SEC and CSRC reached two earlier information-sharing agreements in 2013 and 2016 to address the issue, but the SEC ultimately abandoned those after failing to get the information it wanted.

Frustrated at the lack of progress, the U.S. passed the Holding Foreign Companies Accountable Act (HFCAA) in late 2020, giving China three years to provide the access the SEC was seeking. Failure to do that could result in the forced de-listing of the more than 200 U.S. listed Chinese companies.

The two sides finally reached an agreement in August this year, and the PCAOB dispatched a team to Hong Kong to conduct some trial audits under the agreement’s framework. At the time of the deal’s signing, the SEC said it would provide a progress report on whether it was getting what it wanted from the deal in December.

Complete access

With all that background in mind, we’ll take a more detailed look at the PCAOB’s latest statement, which describes its work conducting audits with the CSRC in Hong Kong in September, October and November. While the statement was filled with praise for the cooperation during that trial period, it also provided some cautionary words about the future – reflecting a U.S. skepticism that has existed throughout the process due to the failure of the previous two deals.

“For the first time in history, the PCAOB has secured complete access to inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong,” PCAOB Chair Erica Williams said in the statement dated Thursday. “And this morning the Board voted to vacate the previous determinations to the contrary.”

The statement, together with an accompanying fact sheet, contain some interesting details that weren’t previously disclosed about the audit process. The team of more than 30 PCAOB inspectors focused on two auditors during its trip, KPMG’s Chinese affiliate KPMG Huazhen LLP in Mainland China, and PricewaterhouseCoopers in Hong Kong. It said the team inspected eight “engagements” involving those two auditors, and emphasized that neither the CSRC or the auditors were informed in advance that they would be targeted.

In another interesting detail, the PCAOB notes the U.S. and Chinese sides began cooperating as early as April this year, well before the deal was signed in August. It said that cooperation began after the PCAOB initiated investigations of two Chinese firms and one Hong Kong firm in March. It said it began issuing requests related to those three investigations around that time, and the CSRC began providing the requested access as early as April.

The PCAOB notes that it uncovered “numerous potential deficiencies” in its latest inspections, but added such results are common in its first-time inspections around the world. Last but not least, it added its assessment that China is fully complying with the agreement now, but it could reverse that view at any time if the Chinese regulator becomes less cooperative in the future.

Hong Kong investors seemed slightly more encouraged by the deal, with the Hang Seng China Enterprises Index opening up slightly in Friday trade, even as the broader Hang Seng Index moved in the opposite direction.

So, where do things go from here? The latest PCAOB statement certainly seems to show the de-listing threat is rapidly receding, which is likely to set off a wave of new U.S. listings by Chinese companies in 2023 following more than a year without any major new IPOs.

At the same time, the latest report should help U.S.-listed Chinese stocks to maintain their recent rally. Components of the iShares MSCI China ETF currently trade at an average price to earnings (P/E) ratio of 11 and a price to sales (P/S) ratio of 1.1. That’s well below the P/E of 18 and P/S of 3 for the SPDR S&P 500 ETF Trust, showing the Chinese stocks are still quite undervalued right now compared to their U.S. peers.

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