On May 21, 2020, the United States Senate passed the Holding Foreign Companies Accountable Act (the “Bill”) with unanimous consent. If it becomes law, the Bill would apply to Chinese companies, among others, listed on U.S. securities exchanges and require them to comply with U.S. regulatory and audit standards and information sharing, notwithstanding that to do so may result in a breach of Chinese law. The consequence of non-compliance would be a prohibition on the trading of the company’s securities on any national securities exchange or through any over-the-counter method in the United States.
Shortly after the passage of the Bill, the U.S. House of Representatives introduced its version of the Bill, which is expected to pass in the House because of perceived bipartisan 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 would effectively require all reporting issuers to retain auditors whose foreign offices are fully subject to inspection by the Public Company Accounting Oversight Board (“PCAOB”) or face a mandatory prohibition on the public trading of their securities. In addition, foreign issuers who cannot comply with the rule would be required to include additional disclosures in their SEC filings identifying ownership by foreign governmental entities, board members who are officials of the Chinese Communist Party, and other matters.
Specifically, the Bill would amend the Sarbanes-Oxley Act of 2002 (“SOX”) to require the Securities and Exchange Commission (“SEC”) to identify issuers (“non-compliant issuers”) filing reports under the Securities Exchange Act who retain a registered public accounting firm to prepare an audit report filed with the SEC, where the accounting firm has a foreign branch or office that cannot be fully inspected or investigated by the PCAOB because of a position taken by “an authority” in the foreign jurisdiction. The determination as to the ability of the PCAOB to inspect the auditor’s foreign office would be made by the PCAOB. Any issuer identified by the SEC would then be required to submit documentation to the SEC establishing that it is not owned or controlled by a governmental entity in the relevant foreign jurisdiction. As noted below, it is not clear in the Bill what would be the consequences if an issuer could not make this certification.
To the extent the PCAOB is unable to inspect the foreign office of a reporting issuer’s auditor for three consecutive years (referred to as “non-inspection years”), the Bill would require the SEC to prohibit the issuer’s securities from being traded on any national securities exchange (such as Nasdaq or the NYSE) or any over-the-counter market in the United States. The issuer could lift the ban by certifying to the SEC that it has retained a registered public accounting firm which the PCAOB has inspected to the satisfaction of the SEC.
However, any subsequent recurrence of a non-inspection year would result in an immediate re-imposition of the trading ban. This time, the issuer would not be able to rehabilitate itself for five years after the re-imposition of the ban.
In addition, the Bill imposes additional reporting requirements on foreignissuers who are identified as non-compliant. A “foreign issuer” is defined in existing regulations as any issuer which is a foreign government, a national of any foreign country or a corporation or other organization incorporated or organized under the laws of any foreign country. This would include so-called “foreign private issuers” as well as governmental issuers. Foreign issuers who are non-compliant would be required to disclose, for every year of non-inspection during which they were permitted to continue to trade, that they are non-compliant, the percentage of shares of the issuer owned by any government entity in its home jurisdiction, whether such governmental entities have a controlling financial interest 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 issuers whose auditors are located in any foreign jurisdiction, 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 SOX to add a new Section 104(i)(2)(B). The new provision would require each reporting issuer identified by the SEC as non-compliant to submit to the SEC documentation establishing that it is not “owned or controlled by a governmental entity” in the foreign jurisdiction. The terms are not defined, but it seems obvious that a state-owned entity listed in the U.S. could not make this certification.
The difficulty is that the Bill does not spell out what happens if an issuer cannot make this certification. The remainder of the Bill discusses the consequences—specifically, a prohibition on trading—that will follow if an issuer remains non-compliant for prescribed periods of time. It does not specify what happens if an issuer, regardless of its compliance or non-compliance with the PCAOB-related provisions of the Bill, is unable to certify it is not state-owned or controlled.
One possibility is that a state-owned or controlled issuer, by definition, could never comply with the requirements in the Bill. The proposed legislation itself does not connect the certification requirements in new SOX Section 104(i)(2)(B) with the provisions relating to prohibition on trading in new SOX Section 104(i)(3), but unless they are connected, there is no consequence for an issuer’s inability to make the required certification. This would lead necessarily to banning the public trading of the securities of all state-owned or controlled issuers, which would be a dramatic—and therefore unlikely—result of a drafting ambiguity.
The Bill is the latest move in a longstanding tug of war between U.S. and Chinese authorities regarding public disclosure obligations of Chinese firms listed on U.S. stock exchanges, with international and foreign accounting firms 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 U.S. 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 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 Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges (EQUITABLE) Act, sponsored by U.S. Senator Marco Rubio (R-FL) and introduced to the U.S. Senate in June 2019. The measure did not make it out of Committee.
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 extensive suite of state secrecy laws and regulations enacted between 2009 and 2014, that prohibit the sharing of certain sensitive information (i.e. state secrets) with foreign parties, and the Notice of the Chinese Ministry of Finance from July 1, 2015, providing that the scope of information sharing pursuant to any U.S. securities law investigation over a Chinese company must be agreed between Chinese and U.S. regulatory authorities, 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 U.S. 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 U.S. law which requires them to disclose such information.
The compliance dilemma facing companies reporting in the U.S., but with audited operations in China, is 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, which the CSRC has noted it is keen to pursue, 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. 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 U.S., or moving their listing to a Hong Kong securities exchange, in order to avoid the consequences of a lack of compliance in their respective jurisdictions.