In near lightning speed, Congress now has passed, and the President is expected to imminently sign into law, the Holding Foreign Companies Accountable Act (HFCAA), a bipartisan piece of legislation that, while applicable more broadly, is directed at the audit practices of Chinese companies, especially those owned or controlled by the Chinese government, and establishes a process to delist from US exchanges those companies that do not meet certain US audit standards.
This legislation follows on the heels of the Trump Administration’s action last week to bar US persons from investing in publicly traded securities of Chinese firms determined by the US government to be owned or controlled by the Chinese military. Unlike this more limited investment prohibition, which was established by Executive Order and can be revoked by the new Administration by executive action, the HFCAA is binding legislation that President-elect Biden would have no authority to waive. Thus, the legislation mandates the process for delisting and directs the US Securities and Exchange Commission (SEC), an independent agency, to implement the listing ban.
The HFCAA, which was first introduced in the Senate in May 2020, passed the Senate by unanimous consent that same month and was just passed in the US House of Representatives by voice vote on December 2, 2020. It now goes to President Trump’s desk to be signed into law.
Specifically, by its terms, the HFCAA establishes that an issuer’s securities will be banned from trading on US national securities exchanges in the event that, for three consecutive years, the issuer utilized a registered public accounting firm that has a branch or office located in a foreign jurisdiction that the US Public Company Accounting Oversight Board (PCAOB) is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction. Each year in which this occurs is referred to a “non-inspection” year.
The SEC has the authority to eliminate an initial ban if the issuer certifies that it has retained a registered public accounting firm that the PCAOB has inspected, but the SEC may also reinstitute the ban in the event the issuer experiences a subsequent non-inspection year. A reinstituted ban lasts for at least five years, after which the SEC may end the ban if the issuer certifies that it will retain a registered public accounting firm that the PCAOB is able to inspect.
The HFCAA also has important disclosure obligations for issuers that experience non-inspection years. Specifically, among other things, in each non-inspection year the foreign issuer would be required to disclose to the SEC:
- The percentage of the shares of the issuer owned by governmental entities in the foreign jurisdiction in which in the issuer is incorporated or organized;
- Whether governmental entities in the applicable foreign jurisdiction with respect to that registered public accounting firm have a controlling financial interest with respect to the issuer;
- The name of each official of the Chinese Communist Party who is a member of the board of directors of (1) the issuer, or (2) the operating entity with respect to the issuer; and
- Whether the issuer’s articles of incorporation (or equivalent organizing document) contains any charter of the Chinese Communist Party, including the text of any such charter.
The SEC is required to promulgate regulations implementing the HFCAA within 90 days of enactment.
The HFCAA in context
The HFCAA has enjoyed bipartisan support and little organized opposition since it was introduced in the Senate in May 2020. Its passage and impending enactment is the culmination of ongoing public debate in the United States on whether to delist from US exchanges Chinese companies—especially those owned or controlled by the Chinese government—with audit practices that do not meet US standards.
In December 2018, the SEC and the PCAOB, which oversees the auditing of public companies, issued a joint warning to investors about the challenges US regulators face when seeking to conduct oversight of US-listed companies whose operations are based in China and Hong Kong. Chinese law requires that records remain in China, and the Communist Party restricts access to typical accounting information on the grounds of national security and state secrecy.1 In February 2020, the SEC released a statement regarding the difficulties that US regulators face when auditing US-listed companies based in China, and said that US investors and the US capital markets have become generally more exposed to companies with significant operations in China.2
Thereafter, in February 2019, the US-China Economic and Security Review Commission identified 156 Chinese companies—including 11 state-owned enterprises—listed on three of the largest US exchanges with a combined market capitalization of $1.2 trillion.
Subsequently, in July 2020, the Presidential Working Group (PWG) on Financial Markets, at the direction of President Trump, completed its examination of measures to protect US investors and recommended policies consistent with those contained in the Senate and House versions of the HFCAA.3 The PWG was chaired by the US Secretary of the Treasury Steven Mnuchin, and included the Chairman of the Board of Governors of the Federal Reserve System Jerome Powell, the Chairman of the SEC Jay Clayton, and the Chairman of the US Commodity Futures Trading Commission Heath P. Tarbert. The PWG ultimately recommended Chinese companies be delisted beginning in 2022 unless US regulators can obtain access to their audits.
The American Securities Association, a securities advocacy group, also issued a report in August 2020 recommending that Chinese firms failing to comply with SEC audit requirements be forced to deregister within six months—a considerably shorter time frame than the three years set forth in HFCAA.
Potential impact of the HFCAA and what comes next
Under the HFCAA, as noted above, any foreign issuers would be delisted from US exchanges if, for three consecutive years, it utilizes a registered public accounting firm with an office or branch in its jurisdiction to conduct its audit and the issuer refuses inspection of the audit report based on the law of said jurisdiction. Additionally, for each “non-inspection year” identified by the SEC, the foreign issuer would be required to submit additional disclosures.
While covering all foreign issuers of securities traded on US exchanges, the HFCAA in fact is directed to Chinese companies listed on US exchanges that utilize auditing firms not subject to standards established by the PCAOB. For example, SEC Chairman Jay Clayton has stated that “[t]he [HFCAA] is a legislative attempt to get China to comply with the oversight requirements” and that "[t]he status quo is not acceptable.” 4
While some might view this measure as spillover into the financial sector of the ongoing US-Chinese economic and trade tensions, other observers have noted that it is hard to argue with the logic that firms listed on major US exchanges, which are afforded access to the most liquid capital markets in the world, should without exception be subject to transparent and robust audit disciplines compliant with western standards.
The SEC is required to promulgate implementing regulations within 90 days after enactment, and it is possible the SEC will attempt to push out proposed regulations before President Trump leaves office on January 20, 2021. Any such proposed regulations must go through a public comment period before final regulations are issued and implemented, however. Thus, it is also possible that the latter part of the rulemaking process would occur during the incoming Biden Administration.
As noted at the outset, the HFCAA mandates the delisting process and only affords the SEC the authority to establish rules to implement this process and provide the details of obligatory reporting by covered companies. Moreover, the SEC, as an independent agency, is not directly subject to oversight by the new Administration on its implementation of the HFCAA.
Nevertheless, there is the prospect that some greater flexibility can be injected into the delisting process. In this regard, US new outlets have recently reported that the SEC is also working on a separate proposal that would allow Chinese auditors to comply with the US inspection requirement without violating its own jurisdiction’s laws by permitting the companies to get a second review of their books by an accounting firm based in a country where auditors comply with PCAOB oversight.5 Such a rule would take weeks or months to finalize.
Moreover, it is possible that there could be some negotiations between the US and China over applicable accounting standards for Chinese issuers that meet PCAOB standards. Whether such negotiations occur, however, remains to be seen.