Chinese companies listed in the US are facing a range of serious regulatory challenges right now. Not only has the US government taken a hostile position toward China in general, but a series of actions – by the Trump administration, Congress and Nasdaq – over the summer may also soon force them to make some difficult decisions with respect to their US listings.
China-based accounting firms that audit US-listed companies have long refused to allow the PCAOB to inspect their work papers, as is required by the 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.
In May 2020 the US Senate passed the Holding Foreign Companies Accountable Act (HFCA Act), which would prohibit from US exchange or over-the-counter (OTC) trading the securities of issuers that have used, for three consecutive years, non-US accounting firms that do not permit PCAOB inspection. Shortly afterward, Nasdaq filed three rule proposals with the SEC that would impose more stringent standards on Chinese companies considering listing or already listed on the exchange.
Finally, the President’s Working Group on Financial Markets (PWGFM), a group that includes the secretary of the Treasury and the chairs of the SEC, Commodity Futures Trading Commission and Federal Reserve, in July issued a report recommending more stringent listing rules and heightened disclosure requirements for companies based in jurisdictions that do not co-operate with US regulators, as well as enhanced disclosure and diligence requirements for investment funds.
Among other things, the report recommends that the SEC adopt rules requiring the delisting by 2022 – and prohibiting, effective immediately, any new listings – of companies not audited by a firm that is subject to full inspection by the PCAOB. The exception is if such inspection is prohibited by law where the company is based and the company is ‘co-audited’ by a firm that is subject to full inspection by the PCAOB.
Jurisdictions that do not allow the PCAOB to inspect public accounting firms or otherwise do not co-operate with US regulators are deemed non-co-operating jurisdictions (NCJs). If the SEC acts on the recommendations, around 150 China-based firms currently listed on US exchanges will need to either obtain a co-audit from a firm that does subject itself to PCAOB inspection or face delisting.
In addition to the delisting recommendations and recommended restrictions on new listings, the report makes a number of further recommendations:
- Issuers: additional risk disclosures. Although the SEC’s principles-based disclosure rules already require such disclosures, the report recommends that issuers be required to make specific disclosures regarding the risk of investing in issuers from NCJs, as a listing condition and/or an additional SEC disclosure requirement
- Funds: additional risk disclosures. The report recommends that the SEC issue interpretive guidance to clarify investment companies’ disclosure obligations regarding investments in emerging markets, including with respect to PCAOB inspection and enforcement limitations
- Funds: enhanced due diligence of index providers. The report says the SEC should take steps to encourage or require SEC-registered mutual funds and ETFs that track indexes to perform greater due diligence on an index and its index provider prior to the selection of the index
- Funds: fiduciary obligation guidance. The SEC should issue guidance to investment advisers with respect to their fiduciary obligations when considering investments in NCJs, including China.
CONSIDERATIONS FOR COMPANIES
Although these developments are all only at the recommendation or proposal stage, US-listed companies that are in NCJs (which could include countries other than China) need to be thinking about:
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- When the changes could become effective
As there is little significant opposition to the changes in Congress or the SEC, these changes may reach a final stage quickly. The SEC has indicated that it will decide whether to approve the Nasdaq rule changes in September 2020, and chair Jay Clayton has already directed the SEC staff to prepare proposals in response to the PWGFM report’s recommendations.
The report recommends that, in order to reduce market disruption, the listing condition requirement should not apply to currently listed companies until January 1, 2022 but should apply immediately to new company listings. The US House of Representatives has yet to take action on the HFCA Act but could move at any time to do so.
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- Whether it will be possible to comply with the new requirements
The Nasdaq rule changes are most likely to be finalized earliest and are perhaps the least problematic for companies as they do not, as proposed, expressly impose PCAOB inspection of the auditor as a condition of listing. Instead, Nasdaq would require companies in ‘restricted markets’ – those 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 US-listed public company, and allow Nasdaq to impose requirements such as a higher-offering minimum on offerings by such companies to ensure a sufficient investor base and public float.
But one proposal would allow Nasdaq to deny listing or continued listing or impose additional listing standards in its discretion if the exchange has concerns relating to the audit of a potential or existing listed company, whether or not in a restricted market.
The PWGFM report recommends that US exchanges expressly require PCAOB inspection of the auditor as a condition of continued or initial listing, but also gives companies the option of engaging a co-auditor that is inspected by the PCAOB. Chinese authorities may, however, still find the co-auditor option a violation of the country’s law or may enact new legislation to prohibit it. Co-auditing would certainly be more costly, and it may be difficult for companies to find an audit firm willing to do a co-audit.
If adopted in the form passed by the Senate, the HFCA Act may be the most difficult to comply with, as it directs the SEC to prohibit from US exchange and OTC trading the securities of any company that has used for three consecutive years an auditor not inspected by the PCAOB, and the act does not expressly allow the option of a co-auditor. It also would require the company to make certain disclosures that would likely be unwelcome for Chinese companies, including the percentage of the shares owned by governmental entities and the name of each official of the Chinese Communist Party who is a member of its board of directors.
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- What current disclosures should be made
Although no new disclosure requirements regarding the risks of being in an NCJ have yet been imposed, the SEC’s principles-based disclosure rules already require these types of disclosures. Companies based in NCJs have generally been including these recent developments – the report, the HFCA Act and the Nasdaq proposals, if the company is Nasdaq-listed – in their SEC disclosures.
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- Whether to apply for a listing in another jurisdiction and/or delist pre-emptively
Some companies in NCJs have recently added secondary listings, with the most prominent examples being Alibaba and JD.com, both of which have added Hong Kong listings to their Nasdaq listings. Chinese companies are also considering other non-Asian listing venues as a replacement for their US listing. Chinese companies with US listings both with and without secondary listings should be considering whether to start the delisting and deregistration process voluntarily.
BROADER TENSIONS
These recent developments affecting China-based companies with US listings occur in the context of broader US-China tensions but are also driven by independent forces, such as several high-profile instances of alleged fraud relating to China-based companies, and a history of failed attempts to resolve the PCAOB inspection issue.
Irrespective of the results of the US election in November, these issues will almost certainly continue to raise challenges for China-based companies with US listings, as well as their investors, for the foreseeable future.
Jeffrey Cohen and Doug Davison are partners with Linklaters
