I. Background

The Holding Foreign Companies Accountable Act (“HFCAA”)¹, in December 2020 passed by the Congress and signed into law by then-president of the United States, Donald J. Trump, is one of the most influential measures in the U.S. economic competition with the People’s Republic of China (“PRC”). In theory, the HFCAA applies to all issuers that file reports with the U.S. Securities and Exchange Commission (“SEC”) that have filed financial statements audited by a registered public accounting firm with a branch or office in a foreign jurisdiction in which the Public Company Accounting Oversight Board (“PCAOB”) is unable to inspect or investigate the accounting firm completely because of a position taken by an authority in that foreign jurisdiction. However, it is clear from the HFCAA’s reference to the Chinese Communist Party², and by public statements of officials including one by the SEC’s Chair identifying Mainland China and Hong Kong as two jurisdictions that have historically failed to work with PCAOB to allow required inspections,³ that the HFCAA was primarily intended to pressure Mainland China and Hong Kong authorities to allow PCAOB inspections of accounting firms in Mainland China and Hong Kong. PCAOB is the authority established by the U.S. Sarbanes-Oxley Act of 2002, 20 years ago, to oversee the accounting firms that audit SEC reporting companies. All companies that have a class of securities listed on the New York Stock Exchange (“NYSE”) or Nasdaq, and some companies whose securities are traded on other U.S. securities markets, are SEC reporting companies.

The enactment of the HFCAA has raised tremendous concerns for Mainland China and Hong Kong-based issuers and their investors. This article focuses on the key impacts of the HFCAA on PRC-based, including Hong Kong-based, issuers and the recent developments between the two countries on the audit oversight.

II. Overview of the HFCAA

Among other things, HFCAA requires the SEC to identify SEC reporting companies that have filed financial statements audited by a registered public accounting firm with a branch or office in a foreign jurisdiction in which PCAOB has determined that it is unable to inspect or investigate the firm completely due to a position taken by an authority of the foreign jurisdiction (“Commission-Identified Issuers”).

Commission-Identified Issuers are subject to additional disclosure requirements. In addition, if an issuer remains a Commission-Identified Issuer for a period of three consecutive years, the SEC is required to prohibit its securities from trading on the NYSE, Nasdaq, and other U.S. securities markets, including U.S. over-the-counter markets. The first Commission-Identified Issuer was identified in 2022. Therefore, unless the dispute between U.S. and PRC authorities relating to the inspection of accounting firms is resolved, Commission-Identified Issuers may become subject to U.S. trading bans during 2024. Bills have been introduced with the U.S. Senate and House that would accelerate the trading bans by one year, to begin in 2023. However, the acceleration of the trading ban will occur only if the Senate and House bills are reconciled, and then passed into law. 

A. Commission-Identified Issuers

In December 2021, the SEC adopted the final amendments to the rules implementing the HFCAA⁴. In March 2022, the SEC began to identify Commission-Identified Issuers based on the identity and jurisdiction of the registered public accounting firm whose audit report was included in the issuer’s SEC annual report. The SEC will initially identify the issuer under the ‘provisional list of issuers identified under the HFCAA’ on its website⁵. Such provisionally identified issuers are granted a period of 15 business days to contact the SEC by email to dispute the identification with supporting documents and evidence. Those issuers who are unsuccessful in disputing the SEC’s determination will be moved to the ‘conclusive list’ and be deemed Commission-Identified Issuers. Since this process began in March 2022, over 160 companies have been put on the ‘preliminary’ or ‘conclusive’ list of Commission-Identified Issuers and are at risk of having their securities banned from trading in the U.S.

B. Submission requirements 

Once becoming a Commission-Identified Issuer, the SEC’s annual reporting forms require that, unless the issuer is owned or controlled by a foreign governmental entity, the issuer submit to the SEC electronically documentation that establishes that it is not owned or controlled by a governmental authority in the foreign jurisdiction⁶.

The issuer must submit the documentation through EDGAR on or before the due date of its annual report, and can submit the documentation together with the annual report, on Form 8-K or 6-K, as applicable, or via other appropriate methods⁷.

  C. Additional disclosure requirements

In addition, the SEC rules implementing Section 3 of HFCAA require a Commission-Identified Issuer to fulfill additional disclosure requirements in its annual reports⁸, including:

• that it is a Commission-Identified Issuer;
• the percentage of its shares owned by governmental entities in the foreign jurisdiction in which the issuer is incorporated or otherwise organized;
• whether governmental entities in the foreign jurisdiction with respect to the issuer’s audit firm have a controlling financial interest of the issuer;
• the name of each official of the Chinese Communist Party who is a member of the board of the issuer or its operating entity; and
• whether the articles of incorporation of the issuer (or equivalent constitutional document) contain any charter of the Chinese Communist Party, and the text of any such charter.

D. Trading Prohibition

The SEC will impose an initial trading prohibition on an issuer as soon as practical after it has been conclusively identified as a Commission-Identified Issuer for three consecutive years. The trading prohibition applies to both trading on a U.S. national securities exchange and any other trading method within the jurisdiction of the SEC to regulate (including the “over-the-counter” market)⁹. The SEC is expected to begin issuing trading bans in 2024, unless U.S. and PRC authorities settle their disagreements regarding auditor inspections, or unless the existing rules are amended or accelerated.

In 2021, the U.S. Senate passed a bill¹⁰ to shorten the period for a Commission-Identified Issuer to become subject to a U.S. trading ban from three years to two years and in 2022, the House of Representatives also passed a similar bill¹¹ containing a provision to accelerate the trading prohibition from three years to two years. If these bills are reconciled and signed into law, the abovementioned trading prohibition will begin to apply in 2023.

A Commission-Identified Issuer can remove the trading prohibition if it certifies to the SEC that it has retained an accounting firm that the SEC has inspected to its satisfaction. 

If an issuer is identified to be a Commission-Identified Issuer again after a trading prohibition is ended, the SEC will impose a subsequent trading prohibition of a minimum of five years. 

III. Imminent risk for PRC-based issuers

  A. Proposed acceleration of the trading prohibition

If the U.S. Senate and House reconcile their previously passed bills to accelerate the U.S. trading ban, Commission-Identified Issuers may become subject to U.S. trading bans as early as 2023.

B. Imminent delisting risk for PRC-based issuers

NYSE, Nasdaq and other U.S. national securities exchanges have broad authority to delist companies under their respective listing rules. Commission-Identified Issuers may be at risk of delisting even if they are not subject to an immediate U.S. trading ban.

IV. Recent developments

A. New Statement of Protocol Agreement

PCAOB and the securities regulatory authority, the PRC Securities Regulatory Commission (“CSRC”), have been negotiating the terms of an agreement to permit PCAOB to inspect and investigate audit firms in Mainland China and Hong Kong. Positive signals have been released by the regulators to resolve the audit oversight issue.

On August 26, 2022, it was announced by the SEC¹² and CSRC¹³ that PCAOB and CSRC and the Ministry of Finance of the PRC (“MOF”) signed a Statement of Protocol Agreement (“SOP”) which established a framework for PCAOB to inspect and investigate audit firms based in the PRC including Hong Kong.

While the exact provisions of the SOP are not published, both sides have issued press releases about what has been agreed between the regulators¹⁴. However, there seem to be discrepancies between the tones and statements from the U.S. side and the PRC side with respect to the SOP. The table below discusses the relevant statements released by both sides:

The SEC described the signing of the SOP as only the first step, and noted that the agreement will be meaningful only if PCAOB actually can inspect and investigate completely audit firms in China. If the PCAOB cannot, PRC-based issuers will face prohibitions on trading of their securities in the U.S. if they continue to use PRC-based audit firms. The CSRC, on the other side, emphasized that the signing is an important step. Going forward, both sides will arrange regular inspection and investigation of the accounting firms according to the SOP and assess the results of cooperation. CSRC expected to continuing push forward the collaboration with U.S. regulators and achieve positive outcome.

B. Inspection and investigation in Hong Kong

It is reported that in late September and October 2022, the PCAOB sent a team of U.S. inspectors to the Hong Kong offices of two big four accounting firms to review the audit records of U.S.-listed PRC-based companies.¹⁵ It was also reported that China also seemed to have sent around ten officials from CSRC and MOF to Hong Kong to join the audit inspection.¹⁶ The inspection was expected to continue for eight to ten weeks.¹⁷ However, the latest report revealed that the on-site inspection was completed ahead of schedule around November 4, 2022, and the U.S. inspectors had left Hong Kong and returned to the U.S.¹⁸

No official statement or comment has been made by either regulator with respect to the details and results of the audit inspection in Hong Kong. The PCAOB is expected to issue a final report for the inspection and make a decision on how they will proceed in the coming weeks¹⁹.

V. What’s next

We should expect to see the SEC will continue to impose more stringent supervision with respect to the audit quality of U.S.-listed issuers, whether targeting China or as a general approach. In particular, last month, the China branch of a leading accounting firm agreed to pay SEC USD20 million to settle charges that it failed to comply with fundamental U.S. auditing requirement in its component audits of U.S. issuers and its audits of PRC-based companies listed in U.S.²⁰ The fine was based on the finding that the accounting firm’s staff asked companies to select their own samples for testing and to prepare audit documentation purporting to show that the China arm of the big four had obtained and assessed the supporting evidence for certain clients’ accounting entries.

  We expect to see more information from the government agencies in both sides with respect to the result of the audit inspection by the end of this year. From a risk identification, and prevention management standpoint, PRC-based U.S. listed issuers should consider alternative capital markets option strategies as the countdown to the trading prohibition becomes near.