U.S.-listed Chinese companies face delisting risk under new U.S. law
Recently passed legislation will prohibit U.S. stock exchange listings by 2024 for companies whose auditors do not allow PCAOB inspections and require new disclosure of foreign government ownership.
Capping off a year of U.S. actions targeting Chinese companies, the U.S. Congress recently passed legislation directing the U.S. Securities and Exchange Commission (the “SEC”) to prohibit from trading, on a U.S. securities exchange or “over-the-counter,” the securities of SEC-reporting issuers whose financial statements have not been audited, for three consecutive years, by accounting firms subject to inspection by the U.S. Public Company Accounting Oversight Board (the “PCAOB”).
The Holding Foreign Companies Accountable Act (the “HFCA Act”) will also require non-U.S. issuers that use accounting firms not subject to PCAOB inspection to disclose ownership and control by non-U.S. governmental entities, and to identify Chinese Communist Party officials on their boards of directors.
President Trump is expected to sign the bill into law within the next few days.
Companies that are public in the United States are required to file audited financial statements with the SEC. Under the Sarbanes-Oxley Act of 2002 (“SOX”), the auditor of the financial statements filed with the SEC must be registered with the PCAOB, which means that the audit firm is subject to regular PCAOB inspections to assess the auditor’s compliance with applicable U.S. laws and professional standards in connection with its audits of public companies. Auditing firms that are based in China – including the local affiliates of the “Big Four” accounting firms – have to date refused to allow PCAOB inspections. The China-based auditors maintain that the production of audit papers would violate Chinese law as a potential disclosure of state secrets. The SEC and PCAOB have made accommodations for this situation, to enable listings of China-based issuers, under a 2013 Memorandum of Understanding with Chinese securities regulators. However, PCAOB access to the work papers of China-based auditors has remained restricted.
The new legislation amends SOX as follows:
- Identification of issuers – The SEC must identify any SEC-reporting company (an “identified issuer”) that files a report with the SEC containing audited financial statements prepared by a registered public accounting firm that has a branch or office located outside the United States, and that the PCAOB is unable to inspect or investigate completely because of a position taken by a non-U.S. authority (an “uninspected accounting firm”).
- Documentation of non-governmental control – The SEC must require each identified issuer to submit to the SEC documentation that establishes that the issuer is not owned or controlled by a governmental entity in the non-U.S. jurisdiction. The bill requires the SEC to adopt rules within 90 days establishing the manner and form in which an identified issuer must submit such documentation to the SEC.
- Prohibition on U.S. exchange trading – The SEC must prohibit from trading on a U.S. national securities exchange the securities of any identified issuer with three consecutive “non-inspection years,” which means the years after the HFCA Act’s enactment during which its SEC reports include audit reports prepared by an uninspected accounting firm.
- Prohibition on trading “through any other method” – The SEC must also prohibit the trading of the securities of an identified issuer “through any other method” within the SEC’s regulatory jurisdiction, including on the over-the-counter markets. The legislation is not clear as to whether this will cover the trading of securities of SEC-reporting issuers under other SEC rules, such as Regulation D.
- Removal of initial prohibition – The SEC can end an initial trading prohibition if the identified issuer certifies to the SEC that it has retained a registered public accounting firm that the PCAOB has inspected.
- Recurrence of prohibition – If the SEC ends an initial trading prohibition and the SEC later determines that the previously identified issuer has another non-inspection year, the SEC must impose another trading prohibition. After five years, the SEC can end the prohibition if the issuer certifies to the SEC that it will retain a registered public accounting firm that the PCAOB is able to inspect.
- Ownership disclosure – In any year that an identified issuer used an uninspected accounting firm that has prepared an audit report, the identified issuer must disclose the following information in each SEC report that covers a non-inspection year:
- that an uninspected accounting firm has prepared an audit report for the identified issuer;
- the percentage of the identified issuer’s shares that are owned by governmental entities in the non-U.S. jurisdiction in which the identified issuer is incorporated or otherwise organized;
- whether these governmental entities have a controlling financial interest with respect to the identified issuer;
- the name of each official of the Chinese Communist Party who is a member of the board of directors of the identified issuer or the operating entity with respect to the identified issuer; and
- whether the articles of incorporation of the identified issuer (or equivalent organizing document) contains any charter of the Chinese Communist Party, including the text of any such charter.
The dispute between the SEC and China-based auditors has been a point of contention for a number of years. The issue seems to have come to a head this year, with:
- The SEC and PCAOB’s issuance of a February 2020 joint statement about the difficulties U.S. regulators face when auditing U.S.-listed companies based in China, and an April 2020 joint statement warning investors about investing in “emerging market” (i.e., Chinese) companies given the absence of PCAOB inspections of auditors.
- Nasdaq’s filing of several proposals with the SEC in May 2020 to add more conditions to its initial and continued listing rules for companies operating in “Restrictive Markets,” including requiring a minimum market value of unrestricted publicly held shares and the company to have at least one director or senior management member with U.S.-listed public company experience or training. The SEC has pushed back the date for its decision on the Nasdaq proposals to early February 2021.
- The Trump administration’s July 2020 report (the “Trump Report”) recommending more stringent U.S. exchange listing rules and heightened disclosure requirements for companies based in jurisdictions that do not cooperate with U.S. regulators, as well as enhanced disclosure and diligence requirements for funds. SEC Chair Jay Clayton has said that the SEC staff is working on proposals in response to the Trump Report.
- The SEC staff’s publication of guidance in November 2020 directing Chinese companies to look closely at their disclosure in certain areas, including whether there is clear and prominent disclosure of restrictions on the PCAOB’s ability to inspect the company’s audit firm.
While the HFCA Act is certain to spur Chinese companies traded on the NYSE or Nasdaq to explore alternatives, the need for the SEC to engage in its rulemaking process and the three year delisting time frame in the legislation means that Chinese issuers will have until at least early 2024 to chart a course of action. It is possible that in that time frame a compromise on PCAOB audit access may be reached between the SEC and the Chinese auditing firms, or that the new Biden administration in the United States will affect enforcement of the HFCA Act. The provisions requiring disclosures of state ownership and Chinese Communist Party directors will, however, likely come into effect by mid-2021, as the SEC adopts new rules to implement HFCA.
Amidst these developments, many China-based companies with U.S. listings have recently explored or effected secondary listings and other transactions to facilitate smooth withdrawal from U.S. markets.
We will continue to monitor developments in this area and welcome any queries you may have about the legislation and your listing options.