In June 2019, Senator Marco Rubio introduced a new bill called the Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges (“EQUITABLE”) Act (“the Act”) to heighten oversight of foreign companies listed on U.S. stock exchanges. Among other things, the EQUITABLE Act requires U.S. stock exchanges to de-list all foreign companies that fail to comply with federal regulations on the audits of their financial statements. This post will first set out the backgrounds of this new bill, and then analyze the applicable scope of the Act.Background: Conflict of Regulation on Cross-Border Auditing
The EQUITABLE Act was introduced to solve a longstanding conflict between U.S. regulators and their foreign counterparts. While U.S. regulators require foreign auditors to provide their work papers in connection with the audits conducted for U.S. public companies, some non-U.S. laws prohibit the auditors from producing such information for reasons of state security and data privacy. The conflict with Chinese regulators raises a special concern both because a significant number of U.S. public companies operate their main business in China, and because regulators on both sides failed to establish a satisfactory cooperation scheme.
Companies like Alibaba and JD.com have their operating companies based in China and their holding companies listed on U.S. stock exchanges; therefore, they are governed by both U.S. laws and Chinese laws. Under the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (the “PCAOB”) shall inspect the public accounting firms in connection with their performance of audits and issuance of audit reports for public companies listed in the United States, including those companies that have their major business operations in foreign jurisdictions. But under Chinese Accounting Law, auditors must archive and preserve their audit workpapers, and Chinese Archive Law provides that all private archives that (i) are valuable for the state and the public to preserve, or (ii) are classified as confidential (“Restricted Private Archives”) may not be transported out of the country without pre-approval by relevant Chinese regulators. Because the audit workpapers may arguably fall within the scope of Restricted Private Archives, Chinese auditors must seek pre-approval by local regulators before they can comply with the PCAOB’s inspection requirements.
As a result, auditors for China-based and U.S.-listed companies are required by U.S. laws to provide audit workpapers to the PCAOB for inspection, but are prohibited by Chinese laws to do so when the audit workpapers are determined to be Restricted Private Archives. In practice, Chinese regulators rarely grant such approval, and therefore the Chinese auditors have to comply with local laws and regulations and refrain from providing their audit workpapers to the PCAOB for inspections. After several rounds of diplomatic negotiation, regulators on both sides agreed to a Memorandum of Understanding (the “MOU”), establishing a cooperative mechanism where the PCAOB may request Chinese regulators to collect auditing records of Chinese accounting firms for inspection. But the MOU was still unsatisfactory for both parties: on the one hand, the MOU only gives the PCAOB access to censored audit workpapers and does not permit it to conduct routine onsite inspections of the Chinese auditors; on the other hand, Chinese regulators refuse to surrender their discretion in determining Restricted Private Archives and have strong sovereignty concerns over the PCAOB’s extraterritorial enforcement of law.
Against this background, Senator Rubio introduced the EQUITABLE Act. Rather than continuing the negotiation with Chinese regulators for a cooperative program of law enforcement, the Act would punish the Chinese issuers whose auditor fails to comply with U.S. laws in disregard of conflicting Chinese laws. The Act requires the PCAOB to publish a list of issuers that use a covered foreign accounting firm, prohibits any new listing by an issuer for which a covered foreign accounting firm serves as financial statement auditor, and prohibits any listing by a foreign issuer that has been using a covered foreign accounting firm for three consecutive years since the enactment. Thus, if Congress passes the Act, a U.S. issuer would face delisting if it continues to use a covered foreign accounting firm for three consecutive years, a condition which nearly all Chinese firms listed on U.S. exchanges would satisfy, as discussed below.Scope: Covered Foreign Accounting Firms
At the heart of the Act’s new regulatory scheme is the identification of “covered foreign accounting firm.” A covered foreign accounting firm is defined as “a foreign public accounting firm that [the PCAOB] is unable to inspect or investigate under the Sarbanes-Oxley Act of 2002 because of a position taken by an authority outside of the United States.” There are two prongs that an accounting firm must satisfy to fall within this definition: first, the firm must be a foreign public accounting firm regulated by the Sarbanes-Oxley Act; second, the PCAOB must be unable to inspect or investigate such firm because of a “position” taken by a foreign authority.
The first condition is straightforward under the Sarbanes-Oxley Act. A public accounting firm is “foreign” if it is organized and operates under foreign laws; it is subject to the PCAOB’s regulation if it prepares an audit report for a U.S.-listed company. Even if a foreign firm does not directly issue an audit report for a listed company, it may still be treated as a foreign public accounting firm regulated by the PCAOB if another regulated firm relies upon such foreign firm’s material service in issuing an audit report so that such foreign firm “plays a substantial role” in the provision of the audit report. The PCAOB has further interpreted the “substantial role” threshold to mean that the foreign firm either provides no less than 20% of total engagement hours or fees, or performs the majority of the audit procedures for a division of the audited public company provided that such division constitutes no less than 20% of the total assets or revenues of the audited company. Because under Chinese law accounting firms that are not organized in China may not provide auditing services for China-based companies without business cooperation with local accounting firms, effectively all auditors for China-based companies like Alibaba satisfy the first condition of the “covered foreign accounting firm” test.
The second condition is much more ambiguous. What does “a position taken by a foreign authority” mean? Specifically, what is a “position”? Textually, it is possible to interpret “position” as a piece of legislation enacted by a foreign legislature, an order issued by a foreign court, a regulatory rule promulgated by a foreign government, or any combination of the aforementioned. Additionally, it is unclear when the PCAOB is deemed to be “unable to inspect or investigate.” In the case that the PCAOB has established cooperative arrangements with foreign regulators, it can be argued that the PCAOB’s inability to inspect or investigate is conditioned upon its failure to obtain recourse through such cooperative arrangement. Under such reading, the Act seems to require the PCAOB to seek foreign regulators’ cooperation first before it can identify a covered foreign accounting firm. On the other hand, the PCAOB can claim that the cooperative arrangements are non-binding in nature. The PCAOB needs these arrangements precisely because it is unable to inspect or investigate independently. Under this view, unless the PCAOB specifically allows a foreign accounting firm to meet production obligation through cooperative foreign regulators, every foreign accounting firm meets the inability requirement under the Act. Either way, the PCAOB has a strong case that the MOU only provides the PCAOB with limited access to the audit workpapers, and the PCAOB is still unable to inspect or investigate the audit work and practices of Chinese auditors on site because of the position taken by Chinese government.
In 2015, the SEC reached a settlement with the Chinese branches of the Big Four accounting firms on non-compliance with the PCAOB’s regulation, and the administrative proceeding against these firms was dismissed for four years. Now, four years have passed, and the conflict of regulation remains unresolved. The United States-China Economic and Security Review Commission endorsed the EQUITABLE Act proposal by recommending Congress to exclude Chinese companies from U.S. stock exchanges if the PCAOB continues to be denied access to the audit workpapers for these companies. On June 5, 2019, the bill was referred to the Committee on Banking, Housing, and Urban Affairs of the Senate, but no committee report has been issued. The EQUITABLE Act is tailored to cover all Chinese auditors that provide audit services for U.S.-listed companies. Nevertheless, we need more time to see whether this bill is a serious attempt by Congress to resolve the current stalemate with China on the regulation of cross-border auditing, or whether it is intended as one more weapon in the ongoing trade war.
 Jay Clayton, Wes Bricker & William D. Duhnke III, Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally: Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China, SEC (Dec. 7, 2018), https://www.sec.gov/news/public-statement/statement-vital-role-audit-quality-and-regulatory-access-audit-and-other#_ftnref18.
 See Sarbanes-Oxley Act of 2002 § 104, 106, 15 U.S.C. § 7214 (2010).
 See Kuaiji Fa (会计法) [Accounting Law] (promulgated by the Standing Comm. Nat’l People’s Cong., Jan. 21, 1985, effective May 1, 1985, amended Nov. 4, 2017, effective Nov. 5, 2017), art. 23 (China).
 See Dang’an Fa (档案法) [Archives Law] (promulgated by the Standing Comm. Nat’l People’s Cong., Sept. 5, 1987, effective Jan. 1, 1988, amended Nov. 7, 2016), art. 16, 18 (China); Dang’an Fa Shishi Banfa (档案法实施办法) [Measures for the Implementation of Archives Law] (promulgated by the Nat’l Archives Admin., Jun. 7, 1999, amended Mar. 1, 2017), art. 18 (China); Guanyu Jiaqiang zai Jingwai Faxing Zhengquan yu Shangshi Xiangguan Baomi he Dang’an Guanli Gongzuo de Guiding (关于加强在境外发行证券与上市相关保密和档案管理工作的规定) [Provisions on Strengthening the Confidentiality and Archives Management in Overseas Issuance and Listing of Securities] (promulgated by China Sec. Reg. Comm’n, Nat’l Admin. St. Secrets Protection & Nat’l Archives Admin., Oct. 20, 2009), art. 7 (China) (requiring Chinese accounting firms to seek pre-approvals by Chinese regulators before foreign regulators conduct inspections).
 See Pub. Co. Accounting Oversight Bd., Memorandum of Understanding on Enforcement Cooperation Between the Public Company Accounting Oversight Board of the United States and the China Securities Regulatory Commission and the Ministry of Finance of China (2013), https://pcaobus.org/International/Documents/MOU_China.pdf.
 See China Sec. Reg. Comm’n, Comment Letter on Rule Amendments Concerning the Timing of Certain Inspections of Non-U.S. Firms, and Other Issues Relating to Inspections of Non-U.S. Firms (Jan. 22, 2009), https://pcaobus.org/Rulemaking/Docket%20027/024_Csrc.pdf (“[U]nder the current Chinese laws and regulations, PCAOB is not allowed to perform any form of independent or joint on-site inspection in the Chinese territory.”).
 EQUITABLE Act, S. 1731, 116th Cong. (2019).
 See Sarbanes-Oxley Act of 2002 § 106, 15 U.S.C. § 7216 (2010).
 See id.
 See Pub. Co. Accounting Oversight Bd., Bylaws and Rules of the Public Company Accounting Oversight Board § 1001(p)(ii) (2019), https://pcaobus.org/Rules/Documents/PCAOB-Rules.pdf.
 See Kuaijishi Shiwusuo Congshi Zhongguo Neidi Qiye Jingwai Shangshi Shenji Yewu Zanxing Guiding (会计师事务所从事中国内地企业境外上市审计业务暂行规定) [Interim Provisions on Auditing Operations Conducted by Accounting Firms Concerning the Overseas Listing of Domestic Chinese Companies] (promulgated by Ministry of Fin., May 26, 2015, effective Jul. 1, 2015) (China).
 See 15 U.S.C. § 7216(f) (2010).
 See Clayton et al., supra note 1.
 See SEC Imposes Sanctions Against China-Based Members of Big Four Accounting Networks for Refusing to Produce Documents, SEC (Feb. 6, 2015), https://www.sec.gov/news/pressrelease/2015-25.html; BDO China Dahua CPA Co., Securities Exchange Act Release No. 74217, at 19–23 (Feb. 2, 2015).
 U.S.-China Econ. & Sec. Review Comm’n, 2019 Report to Congress 537 (2019).
 S.1731 – EQUITABLE Act, Congress.gov, https://www.congress.gov/bill/116th-congress/senate-bill/1731/committees (last visited Nov. 11, 2019).