Capital Markets and M&A Client Alert
On May 20, 2020, the U.S. Senate passed S.945, the Holding Foreign Companies Accountable Act (“Bill”), which requires certain public companies to disclose whether they are owned or controlled by a foreign government, including the People’s Republic of China. It also prohibits securities of a company from being listed on any of the U.S. securities exchanges or SEC regulated "over-the the-counter"' markets if the company has failed to comply with the Public Company Accounting Oversight Board’s (“PCAOB”) audits for three years in a row.
While not stated explicitly, the Bill focuses on NYSE and NASDAQ-listed companies that conduct business in China. The Bill’s authors have stated the Bill is aimed at protecting American investors from foreign companies that have been operating on U.S. stock exchanges while violating SEC oversight. The passage of this Bill follows recent statements by both the SEC’s and the PCAOB’s Chairmen warning about disclosure, financial reporting and other risks of PRC companies, as well as the escalating trade tension between the U.S. and China.
The PCAOB is the principal U.S. regulator that oversees the audits of public companies and SEC-registered brokers and dealers. The PCAOB is required by U.S. law to conduct regular inspections of all registered public accounting firms, both domestic and foreign, that issue audit reports for listed companies in the U.S. or which file periodic reports with the SEC.
The laws in various countries, including but not limited to, national security and data protection laws, prohibit such cross-border flows of information from their domestic accounting firms to foreign regulators. For example, China’s new Securities Law that came into effect on March 1, 2020 provides that an overseas securities regulator may not directly conduct investigations and evidence gathering within China. Without the consent of China Securities Regulatory Commission (“CSRC”), no one may provide documents related to securities business to overseas. CSRC’s regulations also require auditor working papers produced within China during an overseas IPO remain in China.
Although China’s Ministry of Finance (MOF), CSRC and the PCAOB signed a Memorandum of Understanding in 2013 which establishes a cooperative framework for the production and exchange of audit documents relevant to investigations in both countries’ respective jurisdictions, the SEC and the PCAOB have been asserting that Chinese cooperation has not been sufficient for the PCAOB to obtain timely access to relevant documents and they still face significant challenges in overseeing the financial reporting for US-listed companies whose operations are based in China. China’s Luckin Coffee, for example, recently disclosed an internal investigation of its Chief Operating Officer’s financial misconduct, including the fabrication of sales totalling RMB 2.2 billion (US $310 million), which has increased the concerns over US-listed Chinese companies’ credibility in their financial reporting.
Such concerns, amid the current U.S.-China tensions from the trade war and U.S. national security concerns (see our alert on export controls regarding Huawei) to the COVID-19 outbreak, pushed the Senate to pass the Bill unanimously. Once the Bill becomes law, it would apply to all US-listed foreign companies, but it is clearly targeting China as home jurisdictions of other foreign private issuers listed on the US stock exchanges have not been identified by either the SEC or the PCAOB as raising concerns of the kind that they have raised previously regarding PRC companies.
II. Summary of the Bill
1. Trading prohibition after 3 years of non-inspections
The Bill defines a year as a “non-inspection year” if the audit report filed by a US-listed company with the SEC for that year was prepared by an accounting firm registered with the PCAOB that has a branch located in a foreign jurisdiction, and the PCAOB is unable to inspect or investigate the firm completely because of a position taken by such foreign jurisdiction.
If a US-listed company has 3 consecutive non-inspection years, the SEC will prohibit the company’s securities from being traded on a U.S. national securities exchange or an “over-the-counter” market subject to SEC regulation. The prohibition could be removed if the company certifies that it has retained an accounting firm that the PCAOB has inspected to the satisfaction of the SEC. If non-inspection recurs after the SEC ends a prohibition, the SEC will prohibit the company’s securities from being traded on a U.S. national securities exchange for at least 5 years. Such prohibition could only be removed if, after the end of the 5-year period, the company certifies that it has retained an accounting firm that the PCAOB is able to inspect.
2. Disclosure of relationship with governmental entities
a. Disclosure to the SEC
Where the SEC identifies a non-inspection, the SEC will require the identified issuer to submit documentation to establish that the issuer is not owned or controlled by a governmental entity in the foreign jurisdiction in which it is incorporated.
Within 90 days after the Bill becomes law, the SEC will issue rules to establish the manner and form for making the submission above.
b. Additional disclosure in Form 20-F and Form 10-K
A foreign issuer, during its non-inspection year, will disclose in each Form 20-F and Form 10-K that cover a non-inspection year:
III. SEC And PCAOB Chairmen’s Statements
The SEC and PCAOB Chairmen issued joint statements on December 7, 2018 and April 21, 2020, respectively, warning that the PCAOB’s inability to inspect audit work papers in China continues, and that investors should consider quality of financial reporting and other disclosure risk when investing in emerging markets, including China.
On May 4, 2020, the SEC announced that SEC staff will host a roundtable this summer to hear the views of investors, other market participants, regulators, and industry experts on how to raise investor awareness of the risks due to barriers to the PCAOB’s regulatory oversight in emerging markets, including China, and explore potential additional steps that can be taken to mitigate them. The SEC will post any public comments submitted to the roundtable on its website.
The Bill passed by the Senate must be passed by the House of Representatives and executed by the President before it becomes law. The SEC will then have 90 days to adopt regulations to implement the law, which regulations are expected to provide more clarification of the provisions under the Bill, including the criteria for a foreign issuer to certify itself as “not owned or controlled by a governmental entity” and the consequence of its failure to submit such certification.
Given the conflict between the laws of the U.S. and China on the cross-border flows of information related to securities and their issuers (unless the authorities of both countries resolve these conflicts in a timely fashion), we expect that compliance risks will be heightened for many PRC companies, particularly if the Bill is enacted into law. For those PRC companies concerned with the compliance risks and the associated negative impact on the share price, their boards of directors may consider whether privatizing with a view to listing elsewhere is in the best interests of their shareholders.