New law aimed at US-listed Chinese companies may impact other public companies with Chinese operations

• Law intended to force China to permit PCAOB inspection of accounting offices located in China
• Clients of audit firms not adequately inspected may have to document ownership or control by foreign governmental entities
• Ongoing audit inspection problems may lead to US trading ban

On December 18, 2020, the Holding Foreign Companies Accountable Act became law.  The new law targets foreign public companies whose financial statements are audited by firms with branches or offices in a foreign country that the PCAOB cannot inspect or investigate “completely.” Historically, the PCAOB has noted inspection challenges with accounting offices located in China.  Some of the requirements of the new law, however, extend to all public companies and, depending on future SEC rulemaking, could result in the delisting of some US public companies.

Restrictions on PCAOB Inspections; Disclosure of Foreign Government Control

The new law requires the SEC to identify audit firms with foreign branches or offices that it cannot adequately inspect or investigate because of local governmental policy.  The SEC must then “identify” the issuers audited by any of those firms (a “non-inspection year,” in the terminology of the new law) and require those issuers to provide documentation establishing that they are not “owned or controlled” by a governmental entity in the relevant country. The law does not require the issuer to have any operations in that country, nor does the law expressly limit the documentation requirement to foreign issuers.

Instead, the law focuses on the PCAOB’s ability to inspect the foreign branch or office of the audit firm, rather than on the accuracy of the issuer’s financial statements.  Accordingly, even US companies with no foreign operations could – if they select a global audit firm with operations in a problematic foreign country – potentially find themselves required to document whether they are owned or controlled by a foreign government.

We anticipate that the SEC will try to use the rulemaking process to narrow the scope of the documentation requirement, but the SEC often struggles to do that when faced with a statutory mandate.

It is not clear what form the documentation of ownership and control will take, nor whether the documentation will be publicly available.

Potential Ban on US Trading

More significantly, the law requires the SEC to prohibit US trading of securities issued by companies with problematic audits three years in a row, including any trading in the over-the-counter market.  The trading ban is not limited to companies owned or controlled by foreign governments or even to foreign issuers.  It is unclear how far the ban on “trading” will extend or whether it will prohibit, for example, mundane transactions like direct sales between individuals or transfers by will or inheritance.

While the law is intended to force China to permit the PCAOB to inspect accounting offices located in China or risk having Chinese companies banned from trading in the US, it is possible that other public companies will be caught in the crossfire.  US companies with significant manufacturing operations in China, for example, may find themselves unable to engage any registered public accounting firm that can successfully avoid Chinese government limitations on PCAOB inspections.  In that case, it may have a “non-inspection year” and risk a future trading ban.

Because “non-inspection years” must start after the enactment date of December 18, 2020, no trading ban will likely occur until at least 2024.  A company can remove the ban by retaining a firm that the PCAOB has satisfactorily inspected.  Even after a company’s ban is lifted, it faces a minimum five-year ban if it later has another “non-inspection year.”  After that five-year period, the company can lift the ban by certifying that it will retain a firm that the PCAOB can inspect.

New Disclosures for Foreign Issuers

The law imposes a new disclosure requirement that will apply to foreign issuers but not domestic companies.  Foreign issuers that use an auditor that the PCAOB cannot adequately inspect must disclose in their annual reports:

• that the audit report was prepared by a firm that the PCAOB could not adequately inspect;
• the percentage of the company’s shares owned by governmental entities in the country imposing restrictions on inspection (a fact the company may not necessarily be in a position to determine);
• whether governmental entities in that country have a controlling interest in the company;
• the name of each “official of the Chinese Communist Party” that is a director of the company or its operating company; and
• whether the company’s organizational documents contain any charter of the Chinese Communist Party.

As SEC Chair Jay Clayton noted in a statement, the SEC was already working on similar disclosure requirements.  Although Clayton’s tenure as Chair ended last week, he indicated before his departure that the SEC staff would review the new legislation and develop a consolidated rule proposal for the SEC’s consideration.