Impact of HFCAA on Chinese Public Companies
In December of last year, US lawmakers passed the Holding Foreign Companies Accountable Act (HFCAA). Originally introduced in the Senate in March 2019, this watershed legislation has the potential to shake up the global economy while simultaneously increasing transparency. The overarching aim of the HFCAA is to require publicly traded companies listed on U.S. stock exchanges to show that they are neither owned nor controlled by a foreign government, and prevent securities of foreign companies from being listed in the U.S. if they fail to comply with federal Public Company Accounting Oversight Board (PCAOB) audit standards.
Under this Act, foreign companies traded on any U.S. exchanges are required to have their auditors submit to inspection by the Public Company Accounting Oversight Board (PCAOB) in an effort to establish that they’re neither owned nor controlled by a foreign government. With a wealth of Chinese companies trading in the U.S., the legislation is likely to have a significant impact on Chinese companies and their accounting firms, as well as U.S. investors and the capital market, for years to come.
How the HFCAA works
The Act will amend Section 104 the Sarbanes-Oxley Act of 2002, the comprehensive legislation passed by Congress aimed at overseeing the conduct of public companies. Pursuant to the HFCAA, there will be a number of sizable changes.
• First, the Securities and Exchange Commission (SEC) will now be required to identify companies that are utilizing registered public accounting firms located outside the United States that are preventing audits from the PCAOB.
• Additionally, the SEC must prohibit securities trading of these public companies within U.S. markets following three consecutive years of non-inspection. Under the language of the bill, these companies will be prohibited from trading on either a national securities exchange or “through any other method that is within the jurisdiction of the Commission to regulate, including through the method of trading that is commonly referred to as the ‘over-the-counter’ trading of securities.” It should be noted that in the event an issuer receives a trading prohibition, then the issuer is allowed to have the prohibition overturned as long as it is able to retain an accounting firm that can be fully inspected by the PCAOB.
• Also, as part of the Act, there are disclosure requirements for non-inspection years for foreign issuers of securities that utilize firms to prepare audit reports. For instance, they will need to disclose the percentage of shares owned by foreign government entities. They will also need to disclose whether or not foreign government entities have “controlling financial interest with respect to the issue.”
• Finally, there are also disclosure requirements that specifically involve China. According to the Act, the names of each official of the Chinese Communist Party of the board of directors of either the issuer or “the operating entity with respect to the issuer” must be disclosed in their Form 10-K, Form 20-F, and shell company reports. Additionally, it must be disclosed if the issuer’s articles of incorporation (or “equivalent organizing document”) has “any charter of the Chinese Communist Party, including the text of any such charter.”
Potential impact of the HFCAA
While the HFCAA applies to any U.S.-listed company incorporated outside the United States, including Mainland China, Hong Kong, France, and Belgium, it is generally understood as explicitly targeting Chinese companies under the restrictions imposed by the Chinese government.
This Act could lead to an increase in the number Chinese and Hong Kong-based issuers being delisted from U.S. exchanges in the coming years. In fact, according to the list of public companies affected by obstacles to PCAOB inspections, there are more than 200 Chinese companies currently audited by CPA firms in mainland China and Hong Kong that would be negatively impacted. These companies, including popular stocks such as Alibaba Group Holding Ltd – ADR, Baidu Inc, JD.com Inc, and Nio Inc – ADR, could feel the brunt of this new legislation.
Note that the Big Four accounting firms in China are independent from the Big Four in the U.S. and do not meet the audit requirements of the PCAOB since they are under the China’s national security laws and the Chinese Securities Law, which prohibit Chinese companies from providing records “relating to securities business activities” overseas without approval by the Chinese securities regulator. Besides, the imminent enactment would certainly discourage new listing of Chinese companies in the U.S. as it could result in a discount on the trading prices as investors may factor in the potential de-listing risk.
However, it remains to be seen how the SEC implementation will roll out within 90 days of the HFCAA’s enactment, which could be greatly influenced by the new leadership of the SEC. According to Bloomberg, President-elect Joe Biden is expected to pick Gary Gensler to head the SEC.
Additionally, because of the three-year compliance timeline in the Act, Chinese companies may consider several options to mitigate the impending risks. The most likely one is to engage a reputable U.S.-based CPA firm, preferably one that has an established China Group, who understands both the Chinese business climate and the U.S. accounting rules, and most importantly obtain a clean compliance record with PCAOB. Yet, it’s also critical that companies consider other factors such as the investor and make sustainable long-term plan to maintain a legitimate and confident position in US capital markets.
If you have any questions
MGO’s SEC practice has a dedicated China Group experienced with Chinese IPOs, RTOs, M&A deals and the unique characteristics of SPAC acquisitions. To understand your options, and the path ahead, please feel free to reach out to us for a consultation.