The SEC recently adopted interim final amendments to several forms to implement the disclosure and submission requirements of the Holding Foreign Companies Accountable Act
April 5, 2021, the Securities and Exchange Commission (SEC) adopted interim final amendments to several forms to implement the disclosure and submission requirements of the Holding Foreign Companies Accountable Act (“HFCA”), a new rule designed to address the investment risks associated with China-based issuers. The rule, effective May 5, 2021, mandated under the HFCA requires certain foreign issuers (“Commission-Identified Issuers”) to make mandatory disclosures or risk delisting in the U.S.[1]
U.S. regulators have increased oversight over China-based issuers as U.S. investors exposures to companies based in or with the majority of their operations in China over the past several years have also increased. While other non-U.S. issuers feature additional risks, Issuers based in China can be particularly risky because the SEC has faced challenges in enforcing its disclosure requirements establishing that Issuers are not owned or controlled by a governmental entity, such as the Chinese Communist Party (“CCP”).
Risks of Investing in Chinese Issuers
As highlighted by the SEC’s new rule, there are additional risks in distributing, trading, or investing in Chinese issuers because the PCAOB has been unable to inspect or investigate accounting- or audit reports. In a report issued in November 2020, the SEC highlighted some of the potential risks associated with investments in China-based Issuers, including:
Risks Related to High-Quality and Reliable Financial Reporting: The SEC emphasized that one of the most significant risks results from current restrictions on the Public Company Accounting Oversight Board’s (PCAOB) ability to inspect audit work and practices of PCAOB-registered public accounting firms in China and on the PCAOB’s ability to inspect audit work with respect to China-based Issuer audits by PCAOB-registered public accounting firms in Hong Kong.
Risks Related to Access to Information and Regulatory Oversight: China has often restricted U.S. regulators’ access to information and limited regulators’ ability to investigate or pursue remedies with respect to China-based Issuers, generally citing state secrecy and national security laws, blocking statutes, or other laws or regulations. In addition, according to Article 177 of the PRC Securities Law, which became effective in March 2020, no overseas securities regulator can directly conduct investigations or evidence collection activities within the PRC and no entity or individual in China may provide documents and information relating to securities business activities to overseas regulators without Chinese government approval.
Risks Related to the Regulatory Environment: China’s legal system also raises risks and uncertainties concerning the intent, effect, and enforcement of its laws, rules, and regulations, including those that restrict the inflow and outflow of foreign capital or provide the Chinese government with significant authority to exert influence on a China-based Issuer’s ability to conduct business or raise capital. This lack of certainty may result in the inconsistent and unpredictable interpretation and enforcement of laws, rules, and regulations, which may change quickly.
Risks Related to a Chinese Holding Company Organizational Structure: Because current regulations in China limit or prohibit foreign investment in Chinese companies operating in certain industries, many China-based Issuers form non-Chinese holding companies that enter into contractual arrangements, intended to mimic direct ownership, with Chinese operating companies. Through these contractual arrangements, the China-based Issuer is generally able to consolidate the Chinese operating company, commonly referred to as a variable interest entity or VIE, in its financial statements, although whether the China-based Issuer maintains legal control of the Chinese operating company is a matter of Chinese law. According to the SEC, these China-based Issuer VIE structures pose risks to U.S. investors that are not present in other organizational structures; for instance, exerting control through contractual arrangements may be less effective than direct equity ownership, and a company may incur substantial costs to enforce the terms of the arrangement.
Risks Related to U.S. Enforcement: As noted by the SEC, federal securities law claims against China-based issuers, including their officers, directors, and agents, may be challenging for investors to pursue in U.S. courts. Even if an investor secures a judgment, the investor may still be unable to enforce it in China.
The SEC’s new Interim Rule aims to hold Commission-Identified Issuers accountable if they flout the disclosure requirements. Section 2 of the HFCA Act amended Section 104 of the Sarbanes-Oxley Act of 2002 to require the SEC to identify each “covered issuer” that has retained a registered public accounting firm to issue an audit report where that firm has a branch or office located in a foreign jurisdiction, and the PCAOB has determined that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction.
Section 3 of the HFCA Act provides that these Commission-Identified Issuers that are foreign issuers, as defined in Exchange Act Rule 3b-4, are subject to additional specified disclosure requirements, which include the percentage of shares owned by governmental entities in the foreign jurisdiction in which the issuer is incorporated or otherwise organized; whether governmental entities in the applicable foreign jurisdiction with respect to that registered public accounting firm 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 board of directors of the issuer or the operating entity with respect to the issuer; and whether the articles of incorporation (or equivalent organizing document) contains a charter of the CCP.
Registrants are required to make disclosures for each year during which the SEC has identified it as a Commission-Identified Issuer-s. Section 3 of the HFCA identifies Form 10-K and Form 20-F, as well as transition reports filed on these forms.
The interim final amendments become effective May 5, 2021, will apply to registrants that the Commission identifies as having filed an annual report on Forms 10-K, 20-F, 40-F or N-CSR with an audit report issued by a registered public accounting firm that is located in a foreign jurisdiction and that the PCAOB has determined it is unable to inspect or investigate completely because of a position taken by an authority in that jurisdiction. Before any registrant will have to comply with the interim final amendments, the Commission must implement a process for identifying such a registrant.
Consistent with the HFCA Act, the amendments will require any such identified registrant to submit documentation to the SEC (i) establishing that the registrant is not owned or controlled by a governmental entity in that foreign jurisdiction, and (ii) requires disclosure in a foreign issuer’s annual report regarding the audit arrangements of, and governmental influence on, such a registrant.
Key Takeaway
The HCFA has set a “marker” for investors that due to the lack of transparency regarding financial disclosures, investments in certain China-based issuers involve unique risks. More broadly, investors should be able to recognize the dangers inherent in investing in any company that is not current in their reporting filings and/or does not have financials certified by established reputable accounting firms. Transparency is essential when conducting due diligence, and investors should be wary of any investment opportunity that is not supported by sufficient disclosures, especially those relating to an Issuer’s financial condition and control factors.
If you have questions, please contact us
If you have any questions or if you would like to discuss these issues further, please contact Paul A. Lieberman or the Scarinci Hollenbeck attorney with whom you work, at (201) 896-4100.
[1] See, 15 U.S.C. 78a et seq.; SEC Rel. 34-91634/IC34227; see Fed. Register, Pub. L. No. 116-122, 134 Stat. 1063 (December 18, 2020).
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New Rules Addresses Investment Risks Linked to China-Based Issuers
The SEC recently adopted interim final amendments to several forms to implement the disclosure and submission requirements of the Holding Foreign Companies Accountable Act
April 5, 2021, the Securities and Exchange Commission (SEC) adopted interim final amendments to several forms to implement the disclosure and submission requirements of the Holding Foreign Companies Accountable Act (“HFCA”), a new rule designed to address the investment risks associated with China-based issuers. The rule, effective May 5, 2021, mandated under the HFCA requires certain foreign issuers (“Commission-Identified Issuers”) to make mandatory disclosures or risk delisting in the U.S.[1]
U.S. regulators have increased oversight over China-based issuers as U.S. investors exposures to companies based in or with the majority of their operations in China over the past several years have also increased. While other non-U.S. issuers feature additional risks, Issuers based in China can be particularly risky because the SEC has faced challenges in enforcing its disclosure requirements establishing that Issuers are not owned or controlled by a governmental entity, such as the Chinese Communist Party (“CCP”).
Risks of Investing in Chinese Issuers
As highlighted by the SEC’s new rule, there are additional risks in distributing, trading, or investing in Chinese issuers because the PCAOB has been unable to inspect or investigate accounting- or audit reports. In a report issued in November 2020, the SEC highlighted some of the potential risks associated with investments in China-based Issuers, including:
Risks Related to High-Quality and Reliable Financial Reporting: The SEC emphasized that one of the most significant risks results from current restrictions on the Public Company Accounting Oversight Board’s (PCAOB) ability to inspect audit work and practices of PCAOB-registered public accounting firms in China and on the PCAOB’s ability to inspect audit work with respect to China-based Issuer audits by PCAOB-registered public accounting firms in Hong Kong.
Risks Related to Access to Information and Regulatory Oversight: China has often restricted U.S. regulators’ access to information and limited regulators’ ability to investigate or pursue remedies with respect to China-based Issuers, generally citing state secrecy and national security laws, blocking statutes, or other laws or regulations. In addition, according to Article 177 of the PRC Securities Law, which became effective in March 2020, no overseas securities regulator can directly conduct investigations or evidence collection activities within the PRC and no entity or individual in China may provide documents and information relating to securities business activities to overseas regulators without Chinese government approval.
Risks Related to the Regulatory Environment: China’s legal system also raises risks and uncertainties concerning the intent, effect, and enforcement of its laws, rules, and regulations, including those that restrict the inflow and outflow of foreign capital or provide the Chinese government with significant authority to exert influence on a China-based Issuer’s ability to conduct business or raise capital. This lack of certainty may result in the inconsistent and unpredictable interpretation and enforcement of laws, rules, and regulations, which may change quickly.
Risks Related to a Chinese Holding Company Organizational Structure: Because current regulations in China limit or prohibit foreign investment in Chinese companies operating in certain industries, many China-based Issuers form non-Chinese holding companies that enter into contractual arrangements, intended to mimic direct ownership, with Chinese operating companies. Through these contractual arrangements, the China-based Issuer is generally able to consolidate the Chinese operating company, commonly referred to as a variable interest entity or VIE, in its financial statements, although whether the China-based Issuer maintains legal control of the Chinese operating company is a matter of Chinese law. According to the SEC, these China-based Issuer VIE structures pose risks to U.S. investors that are not present in other organizational structures; for instance, exerting control through contractual arrangements may be less effective than direct equity ownership, and a company may incur substantial costs to enforce the terms of the arrangement.
Risks Related to U.S. Enforcement: As noted by the SEC, federal securities law claims against China-based issuers, including their officers, directors, and agents, may be challenging for investors to pursue in U.S. courts. Even if an investor secures a judgment, the investor may still be unable to enforce it in China.
The SEC’s new Interim Rule aims to hold Commission-Identified Issuers accountable if they flout the disclosure requirements. Section 2 of the HFCA Act amended Section 104 of the Sarbanes-Oxley Act of 2002 to require the SEC to identify each “covered issuer” that has retained a registered public accounting firm to issue an audit report where that firm has a branch or office located in a foreign jurisdiction, and the PCAOB has determined that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction.
Section 3 of the HFCA Act provides that these Commission-Identified Issuers that are foreign issuers, as defined in Exchange Act Rule 3b-4, are subject to additional specified disclosure requirements, which include the percentage of shares owned by governmental entities in the foreign jurisdiction in which the issuer is incorporated or otherwise organized; whether governmental entities in the applicable foreign jurisdiction with respect to that registered public accounting firm 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 board of directors of the issuer or the operating entity with respect to the issuer; and whether the articles of incorporation (or equivalent organizing document) contains a charter of the CCP.
Registrants are required to make disclosures for each year during which the SEC has identified it as a Commission-Identified Issuer-s. Section 3 of the HFCA identifies Form 10-K and Form 20-F, as well as transition reports filed on these forms.
The interim final amendments become effective May 5, 2021, will apply to registrants that the Commission identifies as having filed an annual report on Forms 10-K, 20-F, 40-F or N-CSR with an audit report issued by a registered public accounting firm that is located in a foreign jurisdiction and that the PCAOB has determined it is unable to inspect or investigate completely because of a position taken by an authority in that jurisdiction. Before any registrant will have to comply with the interim final amendments, the Commission must implement a process for identifying such a registrant.
Consistent with the HFCA Act, the amendments will require any such identified registrant to submit documentation to the SEC (i) establishing that the registrant is not owned or controlled by a governmental entity in that foreign jurisdiction, and (ii) requires disclosure in a foreign issuer’s annual report regarding the audit arrangements of, and governmental influence on, such a registrant.
Key Takeaway
The HCFA has set a “marker” for investors that due to the lack of transparency regarding financial disclosures, investments in certain China-based issuers involve unique risks. More broadly, investors should be able to recognize the dangers inherent in investing in any company that is not current in their reporting filings and/or does not have financials certified by established reputable accounting firms. Transparency is essential when conducting due diligence, and investors should be wary of any investment opportunity that is not supported by sufficient disclosures, especially those relating to an Issuer’s financial condition and control factors.
If you have questions, please contact us
If you have any questions or if you would like to discuss these issues further, please contact Paul A. Lieberman or the Scarinci Hollenbeck attorney with whom you work, at (201) 896-4100.
[1] See, 15 U.S.C. 78a et seq.; SEC Rel. 34-91634/IC34227; see Fed. Register, Pub. L. No. 116-122, 134 Stat. 1063 (December 18, 2020).
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