25 May 2020

The Holding Foreign Companies Accountable Act and Delisting of US Listed Chinese Companies

By:Laura Luo, Matthew Dickerson

On May 21, 2020, the United States Senate passed the Holding Foreign Companies Accountable Act (the “Bill”) with unanimous consent. The Bill would, if it becomes law, apply to Chinese companies listed on U.S. securities exchanges and require them to comply with U.S. regulatory and audit standards and information sharing or face the likelihood of delisting, notwithstanding that to do so may result in a breach of Chinese law.

Shortly after the passage of the Bill, the US House of Representatives introduced its version of the Bill, which is expected to swiftly pass in the House (even before the end of this month) because of perceived broad support for the Bill.  If approved there, it would be passed to President Trump for his approval and signature, following which it would become law.

The content of the Bill

The Bill primarily amends the Sarbanes-Oxley Act of 2002 (“SOX”) to require certain issuers to disclose to the Securities and Exchange Commission (the “SEC”) information regarding foreign jurisdictions that prevent the Public Company Accounting Oversight Board (the “PCAOB”) from performing inspections under SOX. 

Specifically, the Bill requires the SEC to identify all reporting issuers whose auditor has an office in a foreign jurisdiction (the “Foreign Jurisdiction”); and whom the PCAOB is unable to inspect or investigate because the laws or rules of that Foreign Jurisdiction prohibit such inspection (each a “Non-Inspected Issuer”). The Bill also requires the SEC to require such reporting issuers to provide documents to the SEC to establish and confirm that it is not owned or controlled by a foreign government in the Foreign Jurisdiction.

The Bill further requires that, to the extent that the PCAOB has been unable to inspect a reporting issuers’ auditor for three (3) consecutive years, the SEC shall prohibit its stock from being traded on any national securities exchange (such as Nasdaq or the NYSE) or any over-the-counter markets in the United States. Reporting issuers can regain their ability to trade if they certify to the SEC that they have retained an auditor which the PCAOB has been able to inspect; but this is immediately revoked in the event of a subsequent recurrence of non-inspection, which would result in a new five (5) year period of trading prohibition. 

In addition, the Bill requires that reporting issuers must disclose, for every year of non-inspection, the percentage of shares of the issuer owned by any foreign government in its home jurisdiction, whether such foreign government has any controlling financial interests in the issuer, the names of any member of the board of the issuer (or any operating entity of the issuer) who is an official of the Chinese Communist Party, and whether the constitutional documents of the issuer contain any charter of the Chinese Communist Party.

Although the Bill is written to apply to all foreign countries, the sponsors of the Bill explicitly targeted China in proposing the Bill.  The Bill comes in the wake of long-running and intense criticism of a perceived lack of transparency by Chinese firms by U.S. regulators.

Some Ambiguity in the Bill?

Section 2 of the Bill amends Section 104 of SOX to add the requirement for the SEC to require each reporting issuer identified by the SEC as a Non-Inspected Issuer to submit to the SEC documentation that establishes that such issuer is not owned or controlled by a government entity in the Foreign Jurisdiction (the “New SOX Section 104(i)(2)(B)”).  This section seems to raise a few questions: 

• It is unclear what purpose the New SOX Section 104(i)(2)(B) serves, specifically, whether it effectively prohibits a Non-Inspected Issuer from being “owned or controlled” by a government entity in the Foreign Jurisdiction.  As it stands, a company listed or reporting in the U.S. with Chinese operations (each, a “U.S. Reporting Chinese Company”) is generally either a U.S. company or a “foreign private issuer,” which is defined under the U.S. securities rules, among other things, to exclude any issuer that is a foreign government. Nevertheless, the term “foreign private issuer” does not exclude a company that is “owned or controlled” by a foreign government. Therefore, it is unclear whether New SOX Section 104(i)(2)(B) would function as a prohibition of any foreign private issuer that is “owned or controlled,” which is undefined in the Bill, by a foreign government from being listed in the U.S.  It is also unclear what the consequences would be if a Non-Inspected Issuer fails to establish that it is not “owned or controlled” by a foreign government. In the practical sense, it is unclear whether existing listed companies that are deemed to be “owned or controlled” by the PRC government would be permitted to continue being listed in the U.S. if they are unable to conform to the requirements of New SOX Section 104(i)(2)(B). We note that the SEC is required to issue, within 90 days of enactment of the Bill into law, a rule establishing the manner and form in which an issuer makes the submission under New SOX Section 104(i)(2)(B). It may be that such SEC rules provide guidance and clarity on this uncertainty.

• Additionally, Section 3(b)(2) and (3) of the Bill requires that, during a non-inspection year, the Non-Inspected Issuer that is audited by an auditor in the Foreign Jurisdiction must disclose, among other things, the percentage of its shares owned by government entities in its home jurisdiction and whether government entities in the Foreign Jurisdiction have a controlling financial interest in such foreign reporting issuer. As such, there appears to be a tension between the New SOX Section 104(i)(2)(B) and Section 3(b) in the sense that foreign government ownership and control is a matter of disclosure under Section 3(b) as opposed to a prohibition under New SOX Section 104(i)(2)(B). 

Some Background

The Bill is the latest move in a longstanding tug of war between US and Chinese authorities regarding public disclosure obligations of Chinese firms listed on U.S. stock exchanges, with foreign auditors caught in the middle. In December 2012, SEC initiated administrative proceedings against the Chinese branches of the “big four” accounting firms for refusing to produce audit work papers and other documents related to China-based companies under investigation by the SEC for alleged accounting fraud against U.S. investors. In response, the PCAOB and the China Securities Regulatory Commission (the “CSRC”) signed a memorandum of understanding in 2013 (the “2013 MOU”) which attempted to establish a cooperative framework for the effective exchange of audit documents between each countries’ respective regulators in furtherance of their investigative duties. However, the 2013 MOU contained a number of exceptions which limited the PCAOB’s ability to obtain certain documents without Chinese regulatory approval. Since then, the PCAOB has been vocal in its complaint that Chinese cooperation has not been sufficient for it to obtain timely access to relevant documents and testimony necessary for the PCAOB to carry out its enforcement function. 

On December 7, 2018, the Chairmen of each of the SEC and the PCAOB issued a joint statement addressed to investors in US capital markets, emphasising the importance of transparent disclosure of financial statements as the bedrock of the U.S. and global capital markets system, and highlighting that information necessary for proper regulatory oversight for U.S. listed companies “does not always flow to U.S. capital markets regulators from foreign jurisdictions to the extent it should”. The statement noted that the PCAOB faced obstacles in inspecting the auditors’ work with respect to 224 U.S. listed companies, out of which 207 were audited by auditors in China (including Hong Kong) and Belgium for the period between mid-2017 and mid-2018. The joint statement specifically discussed that SEC and PCAOB faced “significant challenges in overseeing financial reporting for U.S.-listed companies whose operations are based in China”,  that Chinese law required the business books and records related to transactions and events occurring within China to be kept and maintained in China, and that “China also restricts the auditor’s documentation of work performed in China from being transferred out of China”. The joint letter threatened “remedial action” in the event that significant information barriers persist, and urged a political solution to the deadlock.

This led to the bill, titled Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges (EQUITABLE) Act, sponsored by U.S. Senator Marco Rubio (R-FL), being introduced to the US Senate in June 2019, although it did not pass its Committee stage.

On April 21, 2020, the Chairmen of the SEC and the PCAOB and other SEC officials issued another joint statement highlighting the importance of high-quality, reliable audited financial statements and re-emphasising PCAOB’s inability to inspect audit work papers in China.

On the China side, in addition to China’s state secrecy laws and regulations that prohibit the sharing of certain sensitive information (i.e. state secrets) with foreign parties, on March 1, 2020, the CSRC amended the Securities Law of the PRC with new provisions at Article 177. Article 177 provides that, without the approval of the securities regulatory authority under the State Council and various components of the State Council, no entity or individual in China may provide documents and/or materials relating to securities business activities overseas. Article 177 has obviously far-reaching consequences for Chinese issuers listed on U.S. securities exchanges (and their professional advisors) that are under investigation or inquiry by a US regulatory authority or even a securities exchange. These companies are caught between compliance with PRC law which prohibits them from certain information transfer and disclosure, and compliance with US law which requires them to disclose.

Conclusion

For a U.S. Reporting Chinese Company, its compliance dilemma is fundamentally rooted in the tension between the laws of China and the United States. Therefore, unless there is a reconciling and collaborative response at the regulatory level between the two countries, there does not seem to be an apparent path to compliance for a U.S. Reporting Chinese Company who wishes to maintain its U.S. listing status, except to remove itself from U.S. reporting requirements.  As such, we anticipate that the Bill, if passed into law, may prompt and accelerate a new wave of “going private” transactions by Chinese issuers listed in the US, keen to avoid the consequences of a lack of compliance in their respective jurisdictions. 


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