China’s Courts Give NEW Guidelines on Capital Markets Some Teeth†
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Since March, the U.S. House Committee on Oversight and Accountability has been conducting an inquiry as to whether the Public Company Accounting Oversight Board (“PCAOB”) is “empowered to ensure meaningful oversight of auditors of [China]-based firms”. The Committee should welcome a document recently released by China’s State Council that aims at improving the country’s capital markets by strengthening information disclosure, among other measures.
What matters most, however, is whether the document has real teeth. Interestingly, the Supreme People’s Court of China has taken steps that, if followed consistently by all courts in the country, can empower this document.
The PCAOB & China
Historically, the PCAOB, a nonprofit corporation established by the U.S. Congress to “oversee the audits of public companies in order to protect investors”, faced obstruction when it attempted to inspect and investigate PCAOB-registered public accounting firms headquartered in mainland China and Hong Kong. The obstruction was largely due to China’s legal restrictions on the disclosure of a broad range of sensitive information.
To address this problem, the Holding Foreign Companies Accountable Act (“HFCAA”) was enacted by Congress in 2020 to essentially allow a foreign company to be prohibited from trading on U.S. markets if the company’s financial statements are audited by an accounting firm which the PCAOB determines it has been unable to inspect or investigate completely for three (amended in 2023 to two) consecutive years.
“In late 2022, the PCAOB used this historic access to examine select Chinese companies’ audit documents.”
The enactment of the HFCAA prompted Chinese authorities to reach an agreement with the PCAOB, which, as a result, was allowed to inspect and investigate PCAOB-registered public accounting firms headquartered in mainland China and Hong Kong completely. In late 2022, the PCAOB used this historic access to examine select Chinese companies’ audit documents.
Following such inspection and investigation, in November 2023, the PCAOB imposed its first major sanctions (nearly USD 8 million) against three China-based firms and four individuals. Last month saw the PCAOB’s issuance of its latest settled disciplinary order related to China. The order was against three partners of a mainland China-based accounting firm for violations of PCAOB standards in connection with the firm’s audit of a U.S.-listed Chinese company that had reported inflated revenue and prepared suspect accounts. Specifically, the PCAOB found, inter alia, that these three individuals “failed to obtain sufficient appropriate audit evidence”, “failed to exercise due care and professional skepticism”, and/or failed to provide appropriate audit supervision.
China’s NEW Guidelines on Capital Markets
To address various problems prevailing in China’s capital markets, including related auditing practices, the State Council released in early April a document titled “Several Opinions on Strengthening Supervision to Prevent Risks and to Promote High-Quality Development of Capital Markets”.
The document has identified three key goals:
- form, in the next five years, the basics of “an overall framework for the high-quality development of capital markets”;
- establish, by 2035, the basics of “highly adaptable, competitive, and inclusive capital markets, whose investors’ legal rights and interests will be more effectively protected”; and
- establish, by the middle of the 21st century, “high-quality capital markets that are commensurate with a financial power”.
To accomplish these goals, the State Council has identified various tasks, including the exercise of “strict and continuous supervision of listed companies” by, for example, “strengthening information disclosure and corporate governance supervision” and “seriously rectifying violations of laws and regulations in key areas such as financial fraud and capital misappropriation”.
Court Case Empowering the Guidelines
Interestingly, prior to the State Council’s release of the above-mentioned guidelines on capital markets, the Supreme People’s Court had already taken steps that have the potential to empower the document.
“One of the steps taken by the top court was the designation of a case involving an accounting firm as a ‘reference case’ […].”
One of the steps taken by the top court was the designation of a case involving an accounting firm as a “reference case” included in a new database which Chinese judges “must” (必须) search for similar cases before rendering judgments to ensure uniform application of law (see China’s “One Website, Two Databases” Approach to Judicial Transparency, Reform, & Consistency).
The reference case concerns a lawsuit brought by nearly 100 investors against (1) a listed Chinese company for providing, during the company’s asset reorganization process, information that contained “false records and major omissions” and (2) an accounting firm for failing to verify the company’s information. The investors alleged that they were misguided by the information and suffered investment losses. In March 2023, the High People’s Court of Chongqing Municipality ruled in favor of these investors, deciding that they should be compensated for their investment losses totaling RMB 12.8 million.
The court also found that the accounting firm failed to follow various audit standards to verify the company’s information and, as a result, the firm should bear “10% joint and several liability” for the investors’ losses. Because this case is designated as a “reference case”, the following principle is available to guide Chinese courts’ adjudication of similar subsequent cases:
[Where] an accounting firm failed to maintain necessary professional prudence and failed to design and implement appropriate audit procedures to verify the financial reports of a listed company, resulting in false records in the audit reports issued, the firm should bear, in accordance with law, corresponding joint and several liability for investors’ losses. The proportion of the joint and several liability should be determined by comprehensively [considering] various factors, including the accounting firm’s degree of fault and the extent that [the firm’s failure] contributed to the investors’ losses.
If followed consistently, this reference case will help empower the State Council’s new guidelines on capital markets. More importantly, the significance of these guidelines is likely to lead to the Supreme People’s Court’s designation of more reference cases of this type. Consequently, there will be a more comprehensive set of principles to not only guide Chinese courts in cases related to capital markets but also to hold auditors and companies audited by these auditors accountable—a fundamental goal that PCAOB and the U.S. House Committee on Oversight and Accountability seek to accomplish.
- The citation of this article is: Dr. Mei Gechlik, China’s Courts Give NEW Guideline on Capital Markets Some Teeth, SINOTALKS.COM®, In Brief No. 43, Apr. 24, 2024, https://sinotalks.com/inbrief/202404-english-capital-markets.
The original, English version of this article was edited by Nathan Harpainter. The information and views set out in this article are the responsibility of the author and do not necessarily reflect the work or views of SINOTALKS®. ↩︎
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