SEC guidance directs China-based companies to take a close look at their disclosures
Disclosure should include lack of PCAOB inspection of auditors, corporate governance differences, limited shareholder rights, Chinese regulatory risk
Following a series of U.S. actions this year targeting China-based companies, the staff of the U.S. Securities and Exchange Commission (the “SEC”) recently issued guidance directing these companies to look closely at their disclosure in certain areas, including whether there is clear and prominent disclosure of restrictions on the Public Company Accounting Oversight Board’s (“PCAOB”) ability to inspect the company’s audit firm.
CF Disclosure Guidance: Topic No. 10 (Disclosure Considerations for China-Based Issuers) (the “Guidance”) directs SEC-reporting China-based companies to consider the following questions in assessing their risks and related disclosure obligations:
- Restrictions on PCAOB inspection of auditors – 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? China-based accounting firms that audit U.S.-listed companies have long refused to allow the PCAOB to inspect their work papers, as is required by the U.S. Sarbanes-Oxley Act. These firms, which include the Chinese branches of the “Big Four” accounting firms, have argued that the production of audit papers would violate Chinese law prohibiting anyone from providing documents and materials related to securities business activities to overseas regulators.
- Use of variable interest entities (“VIE”) structures – Does the company use VIEs in its organizational structure? These structures are commonly used to circumvent Chinese regulations limiting or prohibiting foreign investment in Chinese companies operating in certain industries. If VIEs are used, 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? For example, exerting control through contractual arrangements may be less effective than direct equity ownership, and a company may incur substantial costs to enforce the terms of the arrangements, including those relating to the distribution of funds among the entities.
- Chinese regulatory environment – 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?
- Shareholder rights – 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, bringing claims against the company or its directors and officers, and the lack of certain shareholder rights and protections?
- Disclosure of differences – If the company is a foreign private issuer, does it describe the differences in corporate governance and SEC reporting requirements compared to a U.S. domestic issuer?
While the SEC has been concerned about China-based companies for many years, the interest seems to have come to a head this year, which saw the following developments:
- Holding Foreign Companies Accountable Act – In May 2020, the U.S. Senate passed the Holding Foreign Companies Accountable Act (the “HFCA Act”), which would prohibit from trading on a U.S. securities exchange or trading “over-the-counter” the securities of issuers that have used, for three consecutive years, non-U.S. accounting firms whose work papers are not available for inspection by PCAOB. The bill would also require these issuers to disclose ownership and control by non-U.S. governmental entities, and to identify Chinese Communist Party officials on their boards of directors. The U.S. House of Representatives has not yet taken action on the bill.
- Nasdaq proposals – In May 2020, Nasdaq filed several proposals with the SEC to amend its listing rules to make it more difficult for China-based companies to list or remain listed on Nasdaq. Unlike the HFCA Act, the proposed amendments would not expressly impose PCAOB inspection of the auditor as a condition of listing. Instead, Nasdaq would require companies in “restricted markets” (i.e., markets that limit regulatory information sharing) to have at least one member of senior management, a director or an outside consultant that has general familiarity regarding the reporting requirements of a U.S.-listed public company, and allow Nasdaq to impose certain requirements (such as a higher offering minimum) on offerings by such companies to ensure a sufficient investor base and public float. However, one proposal would allow Nasdaq to deny listing or continued listing or impose additional listing standards at its discretion if Nasdaq has concerns relating to the audit of a potential or existing listed company (whether or not in a restricted market). The SEC has extended the time period for reviewing these proposals and has not indicated when it will make a decision on them.
- Trump administration report – In July 2020, the Trump administration issued a report recommending more stringent U.S. exchange listing rules and heightened disclosure requirements for companies based in jurisdictions that do not cooperate with US regulators, as well as enhanced disclosure and diligence requirements for investment funds. Current SEC Chairman Jay Clayton said he had directed the SEC staff to prepare proposals in response to the report’s recommendations.
- Executive order prohibiting U.S. investment – In November 2020, President Trump issued an Executive Order prohibiting, beginning on January 11, 2021, U.S. persons from engaging in any transactions in “publicly traded securities, or any securities that are derivative of, or are designed to provide investment exposure to such securities” of listed “Communist Chinese military compan[ies].”
Although the Guidance is not a SEC rulemaking intended to impose any new or additional disclosure obligations, and most of the suggested disclosure is already fairly standard for China-based issuers, it certainly signals strong SEC staff interest in the area. China-based companies should expect comment letters regarding the topics discussed in the Guidance if they are not addressed in their upcoming SEC disclosures.
It is not clear what will happen with the other actions under the administration of President-elect Biden. As the PCAOB inspection problem is longstanding, it is possible that the SEC, even under new leadership, may approve the Nasdaq proposals. News reports have also indicated that the SEC may be preparing a rule proposal requiring companies to use PCAOB-inspected auditors, to be published by the end of the year.
We will continue to monitor developments in this area and welcome any queries you may have about these developments and your listing options.