SEC takes first steps to put in force the Holding Foreign Companies Accountable Act
But disclosure requirements will not be triggered until SEC identifies affected companies, and SEC is not yet addressing the mandated trading prohibitions
The U.S. Securities and Exchange Commission (the “SEC” or “Commission”) has taken its first step towards implementing the Holding Foreign Companies Accountable Act (the “HFCA Act”), by adopting an interim final rule that will require certain SEC-reporting companies – mainly those based in China – to make specific disclosures regarding Chinese government control and influence over these companies. The SEC has not yet acted, however, on the HFCA Act provisions that would require trading prohibitions on the securities of these companies.
Further, while the rule becomes effective 30 days after Federal Register publication, its requirements are not triggered until the SEC identifies the affected issuers. A “Commission-Identified Issuer” is one that has retained, for the preparation of the audit report on its financial statements included in its Form 10-K, 20-F, 40-F, or N-CSR (the “annual report forms”), a registered public accounting firm that has a branch or office that is located in a foreign jurisdiction, and that the Public Company Accounting Oversight Board (“PCAOB”) has determined it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction (a “PCAOB-Identified Auditor”). The SEC has not yet made these identifications and has not indicated when it will do so.
The SEC is also requesting public comment on the disclosure rules as well as the trading prohibitions. Comments are due 30 days after the rule is published in the Federal Register.
Why are these disclosures being required?
The HFCA Act, which was adopted in late 2020, specifically directs the SEC to promulgate rules implementing its provisions.
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, potentially as a 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.
What is required by the interim rule?
The interim rule requires all Commission-Identified Issuers to submit supplemental documentation to the SEC, and many of those issuers will also be required to make further disclosures in their annual report forms.
- Submission requirement – A Commission-Identified Issuer must submit electronically to the SEC documentation that establishes that it is not owned or controlled by a governmental entity in the foreign jurisdiction. This documentation must be submitted on or before the Form 10-K, 20-F or 40-F is due. A company that is owned or controlled by a foreign governmental entity is not required to submit this documentation.
- Disclosure requirement – Further, if the Commission-Identified Issuer is a “foreign issuer” (i.e., a foreign government, foreign national or entity organized under laws of a foreign country), for every year that the issuer is identified as retaining a PCAOB-Identified Auditor for the preparation of the audit report on its financial statements included in its annual report forms (a “non-inspection year”), it must disclose:
- that, for the immediately preceding annual financial statement period, a registered public accounting firm that the PCAOB was unable to inspect or investigate completely, because of a position taken by an authority in the foreign jurisdiction, issued an audit report for the issuer;
- the percentage of its shares owned by governmental entities in the foreign jurisdiction in which the registrant is incorporated or otherwise organized;
- whether governmental entities in the foreign jurisdiction with respect to the PCAOB-Identified Auditor have a controlling financial interest with respect to the issuer;
- the name of each official of the Chinese Communist Party who is a member of the issuer’s board of directors or the operating entity with respect to the issuer; and
- whether the issuer’s articles of incorporation (or equivalent organizing document) contains any charter of the Chinese Communist Party, including the text of any such charter (together, the “HFCA Act disclosures”).
Preliminarily, the SEC’s view is that the terms “owned or controlled” and “owned” and “controlling financial interest” in the HFCA Act are intended to refer to a person’s or governmental entity’s ability to “control” the registrant as that term is used in the U.S. Securities Exchange Act of 1934 and its rules.
When must companies begin to comply with the rule?
The interim rule becomes effective 30 days after it is published in the Federal Register, but first the PCAOB must identify the accounting firms that it has been unable to inspect, and then the SEC will use that information to identify issuers that use these auditors. Until these identifications are made, companies are not required to comply with the interim rule’s submission or disclosure requirements.
Neither the PCAOB or the SEC has indicated when they will make these identifications. Although the SEC has already made a preliminary determination regarding the issuers likely to be affected (see “How many companies are expected to be affected?” below), it is also currently requesting public comment on the identification procedure, including with respect to whether the SEC should set a specific determination date and whether the list of issuers should be published on the SEC’s website. The SEC will issue appropriate notice once it has established the process by which it will begin to identify registrants.
How should companies make the required submission?
Currently, the SEC is not prescribing the type of documentation that can or should be submitted to the SEC to establish that a Commission-Identified Issuer is not owned or controlled by a governmental entity in the foreign jurisdiction, leaving it up to the issuer to determine how best to satisfy the requirement. The SEC is seeking comment as to whether it should issue more guidance on this point, including whether it should provide a non-exclusive list of appropriate documentation (such as a legal opinion or a statement or an officer/director certification).
The submission should be made electronically to the SEC on a supplemental basis, and the SEC is requesting comment as to whether the documentation should be made publicly available or retained by the SEC on a non-public basis, and/or whether the issuer should be allowed to request confidential treatment for some or all of the submission.
Commission-Identified Issuers that are owned or controlled by a foreign governmental entity will not be required to submit documentation to the SEC, although the SEC is seeking comment as to whether these issuers should be required to affirmatively state that they are owned of controlled by a foreign governmental entity.
What year(s) must the disclosures cover?
Once identified, an issuer will be required to comply with the submission requirement, and if applicable, the disclosure requirement, for each non-inspection year. For example, if an issuer is identified based on its Form 20-F filing made in 2022 for the fiscal year ended December 31, 2021 as being a Commission-Identified Issuer, then 2022 would be deemed a non-inspection year. The issuer would be required to comply with the submission and, if applicable, the disclosure requirements in its Form 20-F filing covering the fiscal year ended December 31, 2022, which is required to be filed in 2023.
Since the HFCA Act is intended to apply to non-inspection years after the legislation’s December 2020 enactment, the HFCA Act requirements will not apply to any fiscal year ending on or prior to December 31, 2020.
How must the disclosures be made?
Issuers should make the HFCA Act disclosures in their annual report forms, which in both Form 20-F and Form 10-K will be required in a new item entitled “Disclosure Regarding Foreign Jurisdictions that Prevent Inspections.”
The SEC has added an instruction in each of Form 20-F and Form 40-F to specify that the disclosure applies to annual reports, and not to registration statements, or the issuer’s proxy or information statement.
Does the interim rule require the delisting of Chinese companies?
Not yet. If a company is determined to be a Commission-Identified Issuer for three consecutive years, the HFCA directs the SEC to prohibit the securities of the registrant from being traded in the U.S. market. The SEC intends to address the implementation of these trading prohibitions separately from the interim rule, and is requesting public comment on how best to do so.
The SEC is still reviewing a proposal from the Nasdaq Stock Exchange that would impose additional listing criteria (such as a minimum market size/public float) on companies primarily operating in jurisdictions that do not provide the PCAOB with ability to inspect public accounting firms.
How many companies are expected to be affected?
Based upon a preliminary review of SEC-reporting issuers in calendar year 2020, the SEC has identified 273 registrants who could be deemed Commission-Identified Issuers. Nearly 80% of the potential Commission-Identified Issuer candidates are Form 20-F filers. Approximately 22% were incorporated in the United States while 78% were incorporated in foreign jurisdictions, including 4.8% who self-disclosed to be state-owned enterprises. The vast majority (nearly 90%) are listed on a U.S. national exchange.
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Although the SEC has not yet identified the issuers that will be affected by the interim rule, and, perhaps more importantly, its has not yet issued rules implementing the HFCA-mandated trading prohibitions, the issuance of the interim rule indicates that the SEC remains interested in addressing the PCAOB non-inspection problem. While it is possible that the PCAOB and the Chinese auditing firms may reach a compromise solution prior to the SEC adoption of any trading prohibitions, Chinese companies should, if they have not done so already, be exploring or effecting 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 interim rule, the HFCA Act and your listing options.