U.S. House of Representatives Passes the Holding Foreign Companies Accountable Act
On November 23, 2020, the Division of Corporation Finance published CF Disclosure Guidance: Topic No. 10, Disclosure Considerations for China-Based Issuers, which provides the Division's views regarding certain disclosure considerations for companies based in or with the majority of their operations in the People's Republic of China (PRC), referred to as China-based Issuers.
On December 2, 2020, the U.S. House of Representatives passed S.945, the Holding Foreign Companies Accountable Act, which was previously passed in the U.S. Senate by unanimous consent in May 2020. If signed into law by the President, this bill would, among other things, direct the U.S. Securities and Exchange Commission (SEC) to prohibit the securities of any publicly-traded company from being traded on any U.S. securities exchange or over-the-counter market if the Public Company Accounting and Oversight Board (PCAOB) has been unable to inspect the audit work of the company's auditor for three consecutive years. The specific disclosure and related requirements in this bill are discussed in greater detail in our previous Alert.
Over the past couple of years, the SEC and the PCAOB have continued to highlight issues and challenges faced in enforcing disclosure standards and inspecting the audit work and practices of PCAOB-registered accounting firms in emerging markets, including the PRC, and have taken a number of steps to address these issues. The foregoing efforts include, among other things:
- the SEC and PCAOB issued a series of public statements in December 2018 and 2019, and April 2020, describing, among other things, some of the challenges associated with U.S.-listed companies with operations in the PRC, including the PCAOB's inability to inspect the audit work and practices of PCAOB-registered audit firms in China, and disclosure considerations for companies with significant operations in emerging markets;1
- the SEC and PCAOB held a series of meetings with senior representatives from the four largest U.S. audit firms in November 2019, February 2020, and November 2020 to discuss audit firm efforts to enhance audit quality in emerging markets, including the PRC;2
- the SEC hosted an Emerging Markets Roundtable in July 2020 that brought together investors and other market participants, regulators, and industry experts to discuss the risks of investing in emerging markets, including the PRC;
- the President's Working Group on Financial Markets (PWG), of which SEC Chairman Jay Clayton is a member, released its Report on Protecting United States Investors from Significant Risks from Chinese Companies in August 2020 (PWG Report), which set forth five recommendations intended to address certain risks to investors in U.S. financial markets resulting from the PCAOB's inability to inspect the audit work and practices of PCAOB-registered audit firms in the PRC; and
- the SEC issued a statement in August 2020 responding to the PWG Report, in which, among other things, SEC Chairman Clayton directed the SEC staff to prepare proposals in response to the PWG Report's recommendations for consideration by the SEC.3
Against the backdrop of these efforts, the SEC's Division of Corporation Finance published new disclosure guidance relating to China-based Issuers. This guidance discusses certain risks associated with China-based Issuers and disclosure considerations for China-based Issuers. A summary of this guidance follows.
Risks Associated with China-based Issuers
The guidance discusses several risks associated with China-based Issuers, including:
- Risks Related to High-Quality and Reliable Financial Reporting. The guidance discusses risks related to certain actions taken by the U.S. executive and legislative branches in response to the restrictions on the PCAOB's ability to inspect audit work and practices of PCAOB-registered public accounting firms in China and on the PCAOB's ability to inspect audit work with respect to China-based Issuer audits by PCAOB-registered public accounting firms in Hong Kong.
As discussed above, S. 945, the Holding Foreign Companies Accountable Act, was passed by the U.S. Senate in May 2020, and by the U.S. House of Representatives on December 2, 2020. Assuming it is signed into law by the President, it could result in the delisting of companies that retain an auditor whose audit work and practices the PCAOB is unable to inspect for three consecutive years.4 It would also require new disclosures from these companies, such as the percentage of shares owned by governmental entities in the applicable foreign jurisdiction, whether governmental entities in the applicable foreign jurisdiction have a controlling financial interest in the company, and the names of any Chinese Communist Party officials who serve as a member of the board of directors of the company. Of note, some of the requirements in this bill will also require additional SEC rulemaking prior to implementation.
In August 2020, the PWG Report recommended, among other things, enhanced listing standards that would require, as a condition to initial and continued exchange listing in the United States, PCAOB access to work papers of the principal audit firm of a listed company.
If any of the foregoing legislative or executive actions were to become law or result in new rulemakings or proceedings (even with a transition period for currently listed issuers), then the Division advises that this "may have an adverse impact on trading prices of securities or terminate the trading of securities of China-based Issuers with PCAOB-registered public accounting firms in mainland China and Hong Kong."
- Risks Related to Information and Regulatory Oversight. The guidance discusses risks related to China-specific rules and regulations, in particular citing Article 177 of the PRC Securities Law (which became effective in March 2020), which limits U.S. regulators' ability to bring and enforce actions against China-based Issuers and their officers and directors. The guidance states that under Article 177, "no overseas securities regulator can directly conduct investigations or evidence collection activities within the PRC and no entity or individual in China may provide documents and information relating to securities business activities to overseas regulators without Chinese government approval." U.S. and PRC securities regulators have engaged in multiple rounds of negotiations trying to reach joint enforcement arrangements; however, no agreement has been reached to date. Given these limitations, the Division advises that U.S. investors in China-based Issuers "may not benefit from a regulatory environment that fosters effective enforcement of U.S. federal securities laws."
- Risks Related to a Company's Organizational Structure. The guidance discusses the limitations or prohibitions on foreign investment in Chinese companies operating in certain industries, and the practice by China-based Issuers of forming non-Chinese holding companies "that enter into contractual arrangements, intended to mimic direct ownership, with Chinese operating companies" (typically referred to as variable interest entities, or VIEs), to "circumvent these restrictions." The Division advises that there are several risks associated with the foregoing structure and the lack of direct control over the operating company.
- Risks Related to the Regulatory Environment. The guidance discusses risks related to the differences between the PRC's legal system and the legal system in the United States. The guidance states that these differences "may raise risks and uncertainties concerning the intent, effect, and enforcement of [PRC's] laws, rules, and regulations" and "[t]his lack of certainty may result in the inconsistent and unpredictable interpretation and enforcement of laws, rules, and regulations, which may change quickly."
- Risks Related to Shareholder Rights and Recourse. The guidance discusses risks related to the limitations on the ability of U.S. investors to make claims and enforce judgments in jurisdictions outside of the United States, in particular in those jurisdictions that 1) may not recognize or enforce U.S. judgments and 2) may have legal remedies that are significantly different from, and more difficult to pursue than, those available in the United States.
- Risks Related to Corporate Governance and Reporting Differences. The guidance discusses risks related to the jurisdiction of organization or incorporation of China-based Issuers (oftentimes outside of both the PRC and the United States, in places like the Cayman Islands or the British Virgin Islands), and the resulting differences in corporate law and corporate governance rules and practices in these jurisdictions. The Division states that these other jurisdictions may provide "fewer shareholder protections" such as fiduciary duties that directors owe to investors that might be narrower in scope or less developed than in U.S. jurisdictions, and, for those China-based Issuers that qualify as foreign private issuers, certain exemptions from U.S. exchange listing requirements and certain reporting requirements under the federal securities laws, including requirements relating to filing quarterly and current reports, Section 16 forms, as well as soliciting proxies and rules requiring insiders to comply with Regulation FD.
The guidance states that "China-based Issuers must fully disclose material risks related to their operations in China." Thus, in assessing material risks related to their operations in China, and their related disclosure obligations, the guidance provides a series of questions, reproduced in their entirety below, for consideration. These questions follow directly from the risks discussed above, and include questions relating to the limitations on PCAOB inspections, the use of the VIE structure, the PRC regulatory environment, differing shareholder rights and remedies, and status as a foreign private issuer, as follows:
- Does the company provide clear and prominent disclosure of PCAOB inspection limitations and lack of enforcement mechanisms, as well as the risks relating to the quality of the financial statements? For example, for China-based Issuers that engage audit firms based in China or Hong Kong, does the company caution investors about:
- the ongoing inability of the PCAOB to inspect the audit work of its outside audit firm?
- whether and how its audit committee has taken the lack of inspection into account in connection with the oversight of the outside audit firm and its procedures?
- the difficulty regulators such as the SEC and PCAOB may have in obtaining audit work papers from the company's auditors and the company and how that difficulty may impact the company and its shareholders?
- the possibility that SEC proceedings against the audit firm that the issuer employs (whether in connection with an audit of the issuer or other issuers operating in China) could result in the imposition of penalties against the audit firm, such as suspension of the auditor's ability to practice before the SEC?
- the possibility that legislative or other regulatory action in the United States may result in listing standards or other requirements that, if the company cannot meet, may result in delisting and adversely affect the company's liquidity or the trading price of the company's securities that are listed or traded in the United States?
- limits imposed by Chinese law on the ability of U.S. authorities, including the SEC, PCAOB, and the Department of Justice, to conduct investigations and bring actions, including Article 177?
- Does the company use VIEs in its organizational structure? If so, does the company include sufficient disclosure about the related party transactions in the VIE structure and caution investors about the risks associated with the VIE structure employed in China, including that:
- the VIE structure may be determined by Chinese authorities to be inconsistent with the laws and regulations of China, including those related to foreign investment in certain industries?
- the VIE structure may be disregarded by PRC tax authorities resulting in increased tax liabilities?
- the VIE structure may not be as effective as direct ownership in controlling entities organized in China, which often hold the licenses necessary to conduct the company's business in China?
- control over, and funds due from, the VIE may be jeopardized if the natural person or persons that hold the equity interest in the VIE breach the terms of the agreement?
- the VIE structure may result in unauthorized use of indicia of corporate power or authority, such as chops and seals?
- Does the company disclose risks relating to the regulatory environment in China, including risks related to a less developed legal system, which may result in inconsistent and unpredictable interpretation and enforcement of laws and regulations? For example, does the company caution investors that:
- evolving laws and regulations and inconsistent enforcement thereof could lead to failure to obtain or maintain licenses and permits to do business in China?
- intellectual property rights and protections may be insufficient for companies with material intellectual property in China?
- the increased global focus on environmental and social issues and China's potential adoption of more stringent standards in these areas may adversely impact the operations of China-based Issuers?
- non-citizen shareholders may experience unfavorable tax consequences, including for dividends payable and gains on sales of securities for China-based companies if determined to be a resident enterprise for PRC tax purposes?
- uncertainties in China's legal system could limit the enforcement of contractual arrangements?
- Chinese law restricts certain foreign investments in China and these laws continue to evolve?
- Chinese governmental authorities have significant discretion that can be used to influence how the company conducts its business operations?
- PRC law, and government control of currency conversion, may restrict the ability to transfer funds into or out of China?
- Does the company provide risk disclosure about differing shareholder rights and remedies in the company's country of organization and/or based on where a company's operations are located? For example, does the company caution investors about:
- the difficulties in effecting service of legal process, enforcing judgments obtained in U.S. courts, and bringing claims against the company or its directors and officers?
- the lack of shareholder rights and protections if the company is organized outside of the United States, particularly in jurisdictions where the law is less developed?
- If the company is a foreign private issuer, does it describe:
- corporate governance differences pursuant to Item 16G of Form 20-F?
- differences in reporting requirements between U.S. domestic issuers and foreign private issuers such as the frequency of financial reporting, the exemption from filing quarterly reports and proxy solicitation materials, and the exemption from Regulation FD?
What to Do Now?
China-based Issuers should review the Division's guidance carefully together with their existing risk factor, governance, and other disclosures in order to determine whether, and to what extent, additional disclosures may be required. As one example, in the guidance, the Division suggested one possible approach to disclosure relating to status as a foreign private issuer would be to provide a table comparing the differences in corporate governance practices to domestic issuers and to explain how those differences impact investors.
In addition, we are also closely monitoring the legislative developments with respect to S.945, the Holding Foreign Companies Accountable Act, including whether and when the President will sign this bill into law, and when the SEC will issue implementing regulations relating to these new requirements (if signed into law), as well as any new proposals that may be released by the SEC in response to the recommendations made in the PWG Report.
 See SEC Chairman Jay Clayton, SEC Chief Accountant Wes Bricker, and PCAOB Chairman 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 (Dec. 7, 2018), available here; SEC Chief Accountant Sagar Teotia, Statement in Connection with the 2019 AICPA Conference on Current SEC and PCAOB Developments (Dec. 9, 2019), available here; SEC Chief Accountant Sagar Teotia, Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19 (April 3, 2020), available here; and SEC Chairman Jay Clayton, PCAOB Chairman William D. Duhnke III, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, and SEC Division of Investment Management Director Dalia Blass, Emerging Market Investments Entail Significant Disclosure, Financial Reporting and Other Risks; Remedies are Limited (April 21, 2020), available here.
 See SEC Chairman Clayton, PCAOB Chairman Duhnke, and Members of SEC Staff Meet With Auditing Firm Representatives to Discuss Audit Quality in Emerging Economics and Markets (Nov. 4, 2019), available here; SEC Chairman Jay Clayton, SEC Division of Corporation Finance Director Bill Hinman, SEC Chief Accountant Sagar Teotia, and PCAOB Chairman William D. Duhnke III, Statement on Continued Dialogue with Audit Firm Representatives on Audit Quality in China and Other Emerging Markets; Coronavirus—Reporting Considerations and Potential Relief (Feb. 19, 2020), available here; and SEC Chairman Jay Clayton, SEC Chief Accountant Sagar Teotia, and PCAOB Chairman William D. Duhnke III, Statement on Third Meeting with Audit Firm Representatives Regarding Audit Quality in Emerging Markets and Recent Developments (Nov. 24, 2020), available here.
 See Chairman Jay Clayton, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, SEC Division of Trading and Markets Director Brett Redfearn, SEC Office of International Affairs Director Raquel Fox, and SEC Chief Accountant Sagar Teotia, Statement on SEC Response to the Report of the President’s Working Group on Financial Markets (Aug. 10, 2020), available here.
 See S. 945, Holding Foreign Companies Accountable Act, available here.