16 August 202014 minute read

US moves forward on enhanced securities regulations focusing on Chinese companies

The momentum of US efforts to address the financial risks posed by emerging market companies, especially those in China, has not slowed.  Outlined below are key developments since the SEC’s July 9, 2020, Emerging Markets Roundtable, including issuance of a report by the President’s Working Group on Financial Markets (PWG) and legislation passed by the US House of Representatives.  Market participants should expect to see more US action on these securities-related issues in the coming months.

The PWG Report

On July 24, 2020, the PWG submitted to President Trump its Report on Protecting United States Investors from Significant Risks from Chinese Companies.  The Report addresses risks to investors in US financial markets posed by governments that refuse to allow the Public Company Accounting Oversight Board (PCAOB) to inspect audit firms registered with it as required by US securities laws.  The PWG identifies these governments as “Non-Cooperating Jurisdictions” (NCJs) and focuses on the Chinese government in particular.  The Report outlines relevant US authorities and public policy objectives, identifies the key challenges to complying with US laws and policy objectives when auditing Chinese and other NCJ companies and presents five recommendations to address them, including enhanced listing standards and disclosures, greater due diligence, and guidance for investment advisors.

The Report was prepared in response to the President’s Memorandum on Protecting United States Investors from Significant Risks from Chinese Companies and is the culmination of a two-month long process that included discussions with various regulators, exchanges, investors, and other experts, including discussions held during the all-day virtual Roundtable (see our prior alert). The PWG is chaired by US Treasury Secretary Steven Mnuchin; other members include the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the Securities and Exchange Commission (SEC), and the Chairman of the Commodity Futures Trading Commission.

The Report is generally consistent with the views expressed at the Roundtable and joint statements made by top-level SEC and PCAOB officials as well as recent bipartisan legislation passed by Congress.  The Report is significant because the PWG unanimously recommended to the President that the SEC take the steps outlined in the Report. As described in more detail below, we anticipate that these issues will be addressed by the President and the SEC in the near future.

The critical issue: inspection and investigation of audits in China

The Sarbanes-Oxley Act of 2002 was enacted to strengthen corporate governance standards. Its provisions included creation of the PCAOB to oversee the accounting profession by establishing auditing standards for public accounting firms, inspecting registered accounting firms to assess their compliance with those standards, and undertaking investigations and enforcement actions against firms that fail to comply with those standards. In addition to other requirements, any accounting firm, whether in the US or abroad, that prepares or issues an audit opinion with respect to any issuer of securities in the US is required to produce the underlying audit work papers related to that audit work at the request of the PCAOB or the SEC. However, certain jurisdictions, including China, do not currently permit the PCAOB to inspect their public accounting firms or provide sufficient access to inspect and investigate the audits of such issuers.

As a result, where an audit firm is based in an NCJ, including China, the PCAOB cannot fulfill its statutory mandate under Sarbanes-Oxley  to inspect audit firms, leaving investors in US capital markets potentially exposed to significant risks.

The Report stresses that for more than a decade, the PCAOB has been unable to inspect the audit work papers of audit firms based in China and that protocols established with Chinese regulators demonstrate “China’s refusal to cooperate meaningfully,” rendering those protocols ineffective.

The PWG recommendations

To address these challenges, the President issued the Memorandum, tasking the PWG with examining risks to investors in US financial markets posed by the inability of PCAOB-registered audit firms to comply with US securities laws.  In response, the PWG recommends to the President that the SEC take five actions.  The Report notes specifically that these recommendations are informed by the Holding Foreign Companies Accountable Act (HFCA Act), passed by unanimous consent in the Senate on May 20, 2020, which would require the SEC to prohibit trading of securities of companies that retain an auditor whose reports cannot be inspected or investigated completely by the PCAOB.

(1) Enhance listing standards for access to audit work papers.  Although the Report recognizes certain risks in doing so, it nonetheless recommends enhancing the initial and continued listing standards of US exchanges to require:

(a) PCAOB access to work papers of the principal audit firm for the audit of the listed company or

(b) if a company’s auditor cannot provide such access due to governmental restrictions and practices, the company must provide a co-audit from an audit firm with comparable resources and experience where the PCAOB determines it has sufficient access to audit work papers and practices to conduct an appropriate inspection of the co-audit firm.  The recommendation contemplates that the company would engage an affiliated US-member PCAOB registered accounting firm to serve as the principal auditor of the company’s financial statements through a co-audit arrangement with the NCJ audit firm.  The US audit firm would be the principal auditor.

To reduce market disruption, the Report proposes that the new listing standards provide a transition period until January 1, 2022 for currently listed NCJ companies to comply. The new listing standards would apply immediately to new company listings once necessary rulemakings and standards are effective.

In addition to the need for rulemaking to implement this recommendation, the Report notes that the proposal's viability will depend on whether the NCJ will permit the US audit firm to perform the work and retain the relevant work papers outside of the NCJ.  It is an open question whether NCJs, especially China, will permit such a process.

(2) Enhance issuer disclosures.  The Report recommends requiring prominent enhanced issuer disclosures of the risks of investing in NCJs, including issuing interpretive guidance to clarify these requirements to increase investor awareness and more general awareness of the risks of investing in such companies.  The Report identifies key risk disclosures such as a company’s variable interest entity structure, lack of enforcement mechanisms, PCAOB inspection limitations, and the NCJ’s regulatory environment, and recommends a more specific disclosure requirement that would highlight the risks of investing in an NCJ issuer.

(3) Enhance fund disclosures and due diligence.  The Report recommends that the SEC clarify the disclosure obligations of registered investment companies regarding investments in emerging markets. This would include reviewing the risk disclosures of registered funds that have exposures to NCJ issuers and issuing interpretive guidance to clarify the disclosure requirements to increase investor awareness of the risks of investing in such funds.  In particular, the Report recommends enhanced risk disclosures and due diligence by registered investment funds and their managers, as well as an enhanced fiduciary focus by investment advisers, when considering investments in emerging markets.  Enhanced risk disclosure might focus on issues unique to emerging markets including PCAOB limitations for auditors of NCJ issuers.  The Report envisions that the enhanced fiduciary focus of investment advisers would result in additional investigation into the risks and regulatory implications of investments in NCJ companies.  The Report also suggests that advisers provide enhanced disclosure regarding limitations on their ability to oversee an index provider’s due diligence process.

(4) Greater due diligence of indexes and index providers by registered funds.  The Report proposes encouraging or requiring registered funds that track indexes to perform greater due diligence on an index and its index provider prior to selecting the index to implement a particular investment strategy or objective.  The Report specifies that such due diligence should assess whether the index provider’s process considers potential errors that may occur if the information from NCJ companies is unreliable or outdated or if less information about such companies is publicly available.  The Report also states that the due diligence should take into account the potential effects of differences in regulatory, accounting, auditing, and financial recordkeeping on the fund’s performance, and suggests that index funds provide disclosure regarding their due diligence in their disclosure documents.  Noting that the SEC and other federal regulators, unlike their counterparts in jurisdictions such as the UK and EU, do not currently have the authority to regulate the activities of index providers directly, the Report suggests that this approach may indirectly encourage such index providers to consider factors such as transparency and quality of financial information more carefully when constructing their indexes.

(5) Guidance for investment advisers.  The Report recommends issuing guidance to investment advisers with respect to their fiduciary obligations when considering investments in NCJs.  In particular, the Report suggests that investment advisers recommending investments in NCJ companies might consider, as part of their “reasonable investigation,” any limitations on the quality or availability of financial information related to these investments as well as limitations on investor remedies in NCJs.

SEC response to the Report

On August 10, the SEC issued a statement responding to the Report.  It explained that SEC Chairman Jay Clayton has directed the SEC staff to prepare proposals for the SEC’s consideration that respond to the Report’s recommendations and noted that members of the public may submit comments during this preparation period.

New Congressional action

The US House of Representatives has acted on its version of the Senate’s HFCA Act, making it more likely that some form of legislation will be enacted.  On August 4, the House version of the bill was sent to the Senate as part of the proposed legislation that would authorize appropriations for national defense (House Bill).  With one exception, it is substantially the same as the HFCA Act and the companion bill, H.R. 7000, originally introduced in the House.

Section 1798 of the House Bill would amend Section 104 of the Sarbanes-Oxley Act to require disclosure regarding foreign jurisdictions that prevent PCAOB inspections and calls for trading prohibitions on the securities of “covered issuers” that have three consecutive “non-inspection years.”  A “covered issuer” for these purposes is an issuer of securities that is required to file reports under Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended (Exchange Act), and a “non-inspection year” is a year during which the SEC identifies the covered issuer as described below with respect to every such report filed by the covered issuer during that year, beginning after the date of enactment of a final bill.

Identification of certain covered issuers

The House Bill would require the SEC to identify each covered issuer that, with respect to the preparation of the audit report on the financial statement of such covered issuer that is included in a report filed under Exchange Act Section 13 or 15(d), retains a registered public accounting firm that has a branch, office, or affiliate that (i) is located in a foreign jurisdiction; (ii) performs more than one-third of the audit services for the audit report of the covered issuer; and (iii) the PCAOB is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction, as determined by the PCAOB.  The threshold of performing more than one-third of the audit services is a new provision that did not appear in either the HFCA Act or H.R. 7000 as introduced. 

Covered issuers also would be required to submit to the SEC documentation to determine whether they are owned or controlled by a governmental entity in the foreign jurisdiction. 

Trading prohibitions

If the SEC determines that a covered issuer has three consecutive non-inspection years, it will be required to prohibit the covered issuer’s securities from being traded on a national securities exchange or through any other method within the SEC’s regulatory jurisdiction, including through trading in the over-the-counter market.  The bill also provides a mechanism for the SEC to end the prohibition if the covered issuer meets certain conditions, with a renewed prohibition if the covered issuer again has a non-inspection year.  The second prohibition will last at least five years before the covered issuer is able to seek to regain trading privileges after certifying that it will retain a registered public accounting firm that the PCAOB is able to inspect and investigate.

Additional disclosure

Each covered issuer that is a foreign issuer and for which, during a non-inspection year, a registered public accounting firm identified by the SEC in accordance with the procedure described above has prepared an audit report, will be required to disclose in each covered form (for example a Form 10-K, Form 20-F or equivalent filing) filed by that issuer covering such non-inspection year:

  • that, during the period covered by the covered form, such registered public accounting firm has prepared an audit report for the issuer
  • the percentage of the issuer’s 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 of the issuer (or equivalent organizing document) contains any charter of the Chinese Communist Party, including the text of any such charter.

Rulemaking

After the enactment of final legislation, the SEC will have 90 days to issue rules implementing the legislation that are consistent with the SEC mandate, including the protection of investors and maintaining fair, orderly and efficient markets.

Next steps for Congress

The legislation has passed the House and, as noted above, has been referred to the Senate.  The Senate has already passed its own defense spending bill as well as the HFCA Act.  The conference committee for the defense spending bill will determine whether the provision is included, and if so, may further amend it.  After that, the House and Senate must vote on the final conference bill before it is sent to the President for signature.

What may come next

While the proposed legislation works its way through conference, we anticipate that the SEC will issue guidance relevant to these issues.  Throughout the Report, the PWG noted that the SEC has the ability to issue market guidance related to the recommendations.  While guidance would not have the same binding effect as a law or rule, the SEC could issue guidance more quickly even as it considers potential rules.  In addition, as noted in a prior alert, Nasdaq’s proposal to revise its listing standards, which addresses some of the matters referenced in the Report, is still under consideration by the SEC.  We anticipate that at least some of these recommendations will generate action from the SEC.

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While none of the actions described above currently have the force of law, the totality of statements and actions taken across the US government demonstrates a strong and consistent desire to take steps to reform the current legal and regulatory landscape for Chinese companies listed in the United States. 

 
For further information regarding how these developments will impact your company in the near future, please contact the authors or your DLA Piper relationship partner.

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