This article has been adapted from an original publication by Squire Patton Boggs.
On May 20, 2020, the US Senate unanimously passed S.945, the Holding Foreign Companies Accountable Act, as introduced by Senators John Kennedy (R-LA), and Chris Van Hollen (D-MD). Later that same day, Representative Brad Sherman (D-CA), introduced in the House of Representatives a bill identical to that passed by the Senate. The swift, unanimous passage of the act by the Senate sent shock waves through US-listed companies whose operations are based in China and those who plan to get listed on US exchanges in the future.
While the bill addresses certain companies with ties to any foreign jurisdiction, it clearly is designed to target Chinese companies. The purpose of the bill is to insulate investors from risk posed by the lack of complete visibility of audits of Chinese companies’ listed in the United States. Currently, the Public Company Accounting Oversight Board (PCAOB) faces obstacles to inspect audits of the Chinese Companies due to Chinese laws and regulations. If the bill is enacted in a form similar to the present versions, some Chinese companies will be forced to delist from US exchanges within three years unless the Chinese and US regulatory bodies reach an agreement to eliminate or significantly lessen difficulties presently stifling the PCAOB’s ability to inspect affected companies’ audits.
The proposal presents a dilemma for the Chinese companies listed on US exchanges insofar as they would be required to comply with directly conflicting laws.
Established by Congress in 2002 under the Sarbanes-Oxley Act of 2002, and subject to oversight by the Securities and Exchange Commission (SEC), the PCAOB oversees audits of public companies, brokers, and dealers, including audits of compliance reports. The PCAOB routinely inspects audits conducted by accounting firms based in the United States to ensure that audited financial statements are accurate and reliable, thus protecting investors and improving the reliability of corporate disclosure under the securities laws.
However, over the years the PCAOB has been unable to inspect audits of auditing firms based in Hong Kong and China, including affiliates of US based accounting firms, due to various Chinese laws and regulations, including the Chinese Accounting Law, State Secrecy Law, and Archive Law, which restrict auditors’ paperwork performed in China, and certain business books and records related to transactions and events occurring in China, from being transferred outside of China. In addition, the China Securities Regulatory Commission (CSRC) recently amended the Securities Law of the People’s Republic of China, including new provisions requiring sign-off from the securities regulatory authority before individuals or companies provide documents and/or materials relating to securities business activities overseas.
Under current laws, Chinese companies technically comply with the US securities exchanges’ requirement that audits be conducted by firms registered with the PCAOB, despite the fact that, in reality, the PCAOB remains blind to the audits.
This issue has survived a decade’s worth of unsuccessful cross-border regulatory negotiation between the United States and China, US Congressional and regulatory proposals, and calls for attention from investors and analysts alike. The PCAOB itself has highlighted the issue for years and continues publishing information and statistics regarding public companies to which it has no audit visibility. According to the PCAOB, the organization lacks access to inspect the audits of 188 public companies which account for a combined market capitalization of $1.9 trillion.
Over the past several weeks, however, pressure from all sides has ratcheted up resulting in the Senate’s unanimous passage of the bill. On May 4, 2020 the SEC announced an upcoming roundtable to discuss this particular issue, followed by President Trump stating during a May 14, 2020 interview with Fox Business that his administration was looking “very strongly” at requiring Chinese companies to comply with US accounting regulations. Nasdaq itself joined the fray when it issued two proposals in May which aim to increase investor confidence by expanding its scope of visibility into audits performed on companies listed on the exchange or applying to be listed. Senators Kennedy and Van Hollen subsequently introduced the proposal on May 20, 2020 which quickly passed without objection. Trump again mentioned that his administration is working on the issue during a news conference on China last Friday.
Notably, the legislation follows the recent implosion of Luckin Coffee, a China-based, would-be Starbucks competitor, which now faces potential delisting from Nasdaq after executives admitted to fabricating more than $300 million in revenue. Once valued at nearly $12.7 billion and now valued at less than $800 million, Luckin Coffee joins the growing list of Chinese companies listed on US exchanges that have combined to cause billions in losses to investors over the last several years, attributed by many to the lack of parity in audit visibility.
What the proposal does
The bill expands the enforcement ability of the SEC by charging the agency to take three primary actions:
- Identify companies that retain a registered public accounting firm which has a branch or office that is located in a foreign jurisdiction; and that the PCAOB is unable to inspect or investigate completely because of a position taken by a foreign jurisdiction.
- Require each identified company to certify to the SEC that that it is not owned or controlled by a governmental entity in a foreign jurisdiction.
- Prohibit the securities of the company from being traded on a national securities exchange or through any other method under the purview of the SEC, including through over-the counter trading, if the PCAOB remains unable to inspect the issuer for three consecutive years.
“Foreign” companies: The full name of the bill is “Holding Foreign Companies Accountable Act.” However, “Foreign Companies” can be misleading because, for example, the bill applies to all companies that file reports with the SEC and that retain a registered accounting firm with a branch or office located in China, and that the PCAOB is unable to inspect or investigate completely because of a position taken by China, which includes some US companies with operations based in China.
Ambiguity of the bill: First, it is unclear what consequence the companies that fail to certify that they are not owned or controlled by the Chinese government will face. Would they be forced to delist from exchanges immediately? Secondly and more importantly, what constitutes “owned or controlled by a foreign government” for purposes of the bill remains unknown at this point, but adoption of this same language by other government agencies can guide initial predictions of its ultimate scope. For example, the US Department of Defense (DoD) incorporates parallel language in requiring suppliers involved in government or defense-related contracts to make a similar disclosure. In its use of the phrase, DoD intends “effectively owned or controlled” to mean situations where a foreign government or any entity controlled by a foreign government “has the power, either directly or indirectly…to control the election, appointment, or tenure of the…officers or a majority of the…board of directors by any means, e.g., ownership, contract, or operation of law.”
The proposal still must pass a vote in the House of Representatives and then be signed by President Trump before it becomes law. If it is enacted in a form similar to the present versions, several Chinese companies may be forced to delist from US exchanges if the SEC determines that it has three consecutive non-inspection years.
In addition, if any of these companies is incorporated under the laws of China or any other foreign country and has a registered public accounting firm prepare an audit report during a non-inspection year, it must make additional disclosure, including the percentage of the shares of the company owned by the Chinese government or other governmental entities in the foreign jurisdiction in which the company is incorporated for such a non-inspection year.
We could see a wave of delisting of the Chinese companies from the US exchanges once the bill is signed into law.
The proposal presents a dilemma for the Chinese companies listed on US exchanges insofar as they will now be required to comply with directly conflicting laws: the relevant laws and regulations of China and those governing US securities. We hope that Chinese and US regulatory bodies can reach an agreement to resolve the issue of the PCAOB’s inability to inspect audits of Chinese companies, in an effort to both promote US-China collaboration and protect investors and the US capital markets. Otherwise, we could see a wave of delisting of the Chinese companies from the US exchanges once the bill is signed into law.
Given the fact that Rep. Sherman has already introduced an identical bill in the House, combined with the long history of bipartisan support for similar measures and the recent outspoken attention given by President Trump and the SEC, we anticipate that at least some form of the measures will indeed become law. If a bill passes in the House and receives President Trump’s approval, the SEC will then have 90 days to issue rules establishing the manner and form in which the applicable companies must submit certification that those companies have retained a registered public accounting firm that the PCAOB has inspected to the satisfaction of the SEC.
The proposal seeks to bridge the visibility gap by equipping the SEC with powerful enforcement mechanisms through which the SEC could cause the delisting of entities presently skirting audit inspections by the PCAOB, regardless of whether the entities intend to or not. Thinly veiled as applying to companies with ties to any foreign jurisdiction, the bill is a poignant and intentional effort to protect investors from risk and thwart influence within US exchange markets by the Chinese government by bringing parity to inspection transparency. We continue to carefully monitor the status of this legislation.
Charlotte Westfall is a partner at Squire Patton Boggs.
Fred A. Summer is senior counsel at Squire Patton Boggs.
Michael K. Weitzman is an associate at Squire Patton Boggs.