Holding Foreign Companies Accountable Act Expected to Make U.S. Exchanges Less Hospitable to Chinese Companies

On December 2, 2020, the U.S. House of Representatives passed, by unanimous vote, the Holding Foreign Companies Accountable Act (“HFCAA” or “Act”). Following enactment, foreign issuers, especially Chinese issuers, and their accounting firms will face greater pressure to make audit papers available for inspection within the next three years. Secondary listings in Hong Kong and China and delistings from U.S. exchanges could increase, as could opportunities for private equity funds to finance those delistings.

The House Bill is identical to the Senate Bill that passed unanimously on May 20, 2020. In light of the rare bipartisan consensus and other recent, swift actions taken by the Trump Administration to sign the Hong Kong Autonomy Act and the Uyghur Human Rights Policy Act into law, the HFCAA, another legislative measure targeting China (see our July 2020 alert), is expected to be signed into law this month.

Key Requirements

HFCAA will amend Section 104 of the Sarbanes-Oxley Act of 2002 (15 U.S.C. § 7214) by adding several key requirements, including:

• Identifying Issuers Not Currently Subject to PCAOB Inspection. The Securities and Exchange Commission (“SEC”) is required to identify issuers of SEC-registered securities (either publicly listed or traded over-the-counter) whose audited financial reports are prepared by an accounting firm that the Public Company Accounting Oversight Board (“PCAOB”) is unable to inspect due to restrictions imposed by an authority in the foreign jurisdiction where the audits are performed.
• Prohibition on Trading. If an identified issuer’s auditor cannot be inspected by the PCAOB for three consecutive years—starting from 2021 if the HFCAA is signed into law this month—the trading of that issuer’s securities on any U.S. national securities exchanges, as well as any over-the-counter trading in the United States, will be prohibited.
• Removal of Initial Prohibition. If the SEC imposes a trading prohibition on an issuer, that issuer has the opportunity to have the prohibition removed if it certifies that it has retained an accounting firm that the PCAOB can fully inspect. 
• Five-Year Ban upon Recurrence of Non-Inspection. If an issuer that had its initial prohibition removed later has a recurrence of a year during which the PCAOB is unable to inspect its audit papers, that issuer will be subject to a minimum five-year prohibition. 
• Disclosure of Government Ownership or Control. The identified issuers are subject to heightened disclosure requirements, including foreign government ownership or control, and the name of any official of the Chinese Communist Party (“CCP”) who sits on the board of the issuer. Issuers may look to the SEC to define what constitutes an “official” of the CCP for this purpose, because membership in the CCP in China is pervasive (there are over 90 million members), and the U.S. government has adopted a broad definition of “government official” where individuals are affiliated with state-owned enterprises.

The Act’s explicit purpose is to subject foreign issuers to the same accounting and audit oversight as listed U.S. companies. The primary impact of the HFCAA will be on foreign issuers whose audit papers cannot be inspected by the PCAOB due to restrictions under foreign law, particularly the over 200 Chinese companies currently listed on U.S. exchanges. More pressure will be put on these Chinese issuers, as well as their accounting firms, to make their financial records and audit papers available for inspection by the PCAOB within three years or face delisting.

Specific Target on China

The HFCAA is written to apply to any U.S.-listed company incorporated outside the United States.  Issuers not only in China and Hong Kong, but also Belgium and France, would trigger the HFCAA’s prohibitions because of local laws that prevent inspections by foreign agencies like the PCAOB (but PCAOB expects to enter or renew bilateral cooperative arrangements with Belgium and France to allow inspections).[1] However, the Act is widely understood as specifically targeting restrictions imposed by the Chinese government. This is made evident by the Act’s provisions that explicitly require disclosures of, for every year of non-inspection by the PCAOB, (i) the names of all officials of the Chinese Communist Party who sit on the board of an identified issuer and (ii) whether the articles of incorporation of a covered issuer contains any charter of the Chinese Communist Party. Moreover, the PCAOB has commented that “[o]nly in mainland China and Hong Kong . . . is the position of the Chinese authorities effectively an obstacle to inspection of all, or nearly all, registered firms in the jurisdiction.”[2]

Avoiding trading prohibition under the Act by permitting PCAOB inspection of audit papers could put Chinese companies at risk of violating Chinese laws, including China’s national security laws and the recently amended Chinese Securities Law, which, as of March of this year, includes a civil blocking statute that prohibits Chinese companies from providing records “relating to securities business activities” overseas without approval by the Chinese securities regulator (see our January 2020 alert).

Implementation by the SEC

The SEC will be charged with enforcing the HFCAA once it becomes federal law in the near future, and the SEC has already been at work. On June 2 and June 8, 2020, shortly after the Senate Bill was passed, the SEC published several NASDAQ rules to complement the Act, proposing, for example, “additional initial listing criteria for companies primarily operating in a jurisdiction that has secrecy laws, blocking statutes, national security laws or other laws or regulations restricting access to information by regulators of U.S.-listed companies.” Within 90 days of the HFCAA’s enactment, the SEC is required to issue rules concerning identified issuers’ disclosure of foreign government ownership and control.

After the President’s Working Group on Financial Markets published a report on August 6, 2020, which recommended the SEC to mandate that Chinese auditors share findings with the PCAOB, the SEC has been working on rules requiring Chinese companies to use auditors overseen by the PCAOB. The SEC is expected to take a measured approach to both enforce the HFCAA and protect the stability of the U.S. financial market. For example, the SEC is reportedly considering rules requiring accounting firms overseen by the PCAOB to validate their Chinese subsidiaries’ audit work, a potential compromise to HFCAA’s all-or-nothing requirements. The draft rules will likely be released in the near future, which we are monitoring.

Outlook for Chinese Companies

The imminent enactment of the HFCAA will almost certainly discourage new listings of China-based companies in the United States. It could also result in additional discounts to the trading prices of existing Chinese issuers as investors might factor in the delisting risk. In seeking to comply with the HFCAA, those issuers will likely face significant risks of liabilities under China’s blocking statutes and state secrecy laws. In case they have to eventually de-list in the United States, some issuers may consider going private, followed by re-listing in more friendly jurisdictions, such as Hong Kong and Shanghai. Many issuers will likely take a wait-and-see approach, as the law does not set out a timeline on its enforcement.  

[1] See Securities and Exchange Commission Release No. 34-88987; File No. SR-NASDAQ-2020-028 (June 2, 2020), pp 4-5.

[2] Id. note 9.