Proposed US legislation targets US-listed Chinese companies
Following years of attempts by US regulators to inspect the papers of China-based audit firms, the US Senate recently approved legislation with far-reaching consequences for certain non-US, SEC-reporting issuers. If it becomes law, the Holding Foreign Companies Accountable Act would prohibit from trading on a US securities exchange or trading “over-the-counter” the securities of issuers that have used, for three consecutive years, non-US accounting firms whose work papers are not available for inspection by the US Public Company Accounting Oversight Board (the “PCAOB”). The bill would also require these issuers to disclose ownership and control by non-US governmental entities, and to identify Chinese Communist Party officials on their boards of directors. The US House of Representatives has not yet taken action on the bill.
Companies that are public in the United States are required to file audited financial statements with the US Securities and Exchange Commission (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 US laws and professional standards in connection with its audits of public companies.
China-based audit firms – including the Chinese branches of the “Big Four” accounting firms – have long refused to allow PCAOB inspections, arguing that the production of audit papers would violate Chinese law, because of the potential disclosure of state secrets discussed in the audits. In 2012, the SEC filed an action against the Chinese branches of several audit firms for refusing to produce work papers, resulting in an administrative order barring the branches from auditing companies listed on US exchanges for six months. The matter was settled after the China Securities Regulatory Commission provided copies of the audit firms’ work papers to the SEC. In 2013, the PCAOB negotiated a Memorandum of Understanding with Chinese securities regulators allowing the PCAOB to obtain audit work papers of China-based audit firms. In 2013, both the SEC and PCAOB Chairs noted that “progress has been slow and satisfactory resolution remains uncertain.”
In early 2020, a number of China-based US-listed companies were alleged to have engaged in fraudulent activity, and in some cases, the allegations were followed by SEC enforcement, private lawsuits and delistings. In April 2020, the SEC and PCAOB jointly issued a statement warning investors about investing in “emerging market” (i.e., Chinese) companies given the absence of PCAOB inspections, among other things. In May 2020, Nasdaq proposed new listing rules that may affect China-based issuers, and proposed to apply additional and more stringent listing criteria to an applicant or listed company based on the qualifications of the company’s auditor (including the PCAOB’s inability to inspect the work of the auditor).
The new legislation would amend SOX as follows:
Identification of issuers
Documentation of non-governmental control
Three-year prohibition on US exchange trading
Three-year prohibition on trading “through any other method”
The SEC must also prohibit for three years 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 would cover the trading of securities of SEC-reporting issuers under other SEC rules, such as Rule 144A or Regulation D.
Removal of initial prohibition
The SEC can end an initial three-year 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 prohibition can be ended if the identified issuer provides satisfactory certification to the SEC that it will retain a registered public accounting firm that the PCAOB is able to inspect.
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-US 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.
Market participants have predictably been alarmed by the legislation, as a significant number of China-based issuers would be affected. Although drafted to regulate both over-the-counter and on-exchange trading, the legislation in its current form would only apply to existing SEC registrants. How it would apply to US IPOs remains unclear.
The US House of Representations has not yet taken action on the bill, and the language could therefore differ in any version that is finally approved by the House and signed by the President into law.
We will continue to monitor developments in this area and welcome any queries you may have about the legislation and your listing options.