Per the Holding Foreign Companies Accountable Act, the US Securities and Exchange Commission has begun identifying public companies that retained audit firms that the Public Company Accounting Oversight Board has determined it cannot inspect completely due to a position taken by the authorities in a foreign jurisdiction.
In early March 2022, the Securities and Exchange Commission (SEC) began identifying public companies that retained a registered public accounting firm to issue an audit report where the firm has a branch or office located in a foreign jurisdiction and the Public Company Accounting Oversight Board (PCAOB) has determined that it is unable to inspect or investigate completely because of a position taken by the authorities in the foreign jurisdiction (Commission-Identified Issuer). Once identified, such companies will have 15 business days to contact the SEC to dispute their identification before the determination is deemed conclusive.
The identification of Commission-Identified Issuers is part of the SEC’s recently finalized rules to implement Sections 2 and 3 of the Holding Foreign Companies Accountable Act (HFCAA),[1] wherein Congress directed the SEC to prohibit a registrant’s securities from being listed on any US securities exchanges if the PCAOB determined that it was unable to inspect the auditor of the registrant’s financial statements for three consecutive years. The initial batch of public companies identified by the SEC had recently filed annual reports that included an audit report signed by an audit firm located in a foreign jurisdiction and that the PCAOB determined it was unable to inspect or investigate fully as discussed below.
The PCAOB was established by Congress through the Sarbanes-Oxley Act of 2002 (SOX) and was a direct response to the significant financial reporting frauds by certain public companies in the early 2000s. Accordingly, the PCAOB provides oversight of the audits of public companies listed on US exchanges and its authority includes the registration, inspection, and investigation of audit firms, including those located in foreign jurisdictions.
For the PCAOB to exercise its oversight of audit firms located outside the United States, it often enters into cooperative arrangements with foreign regulators and, in 2013, it entered into a Memorandum of Understanding (MOU) with Chinese regulatory authorities. However, since 2013, the PCAOB has repeatedly expressed concern that the cooperation necessary to conduct its full inspection and investigation of audit firms in China and Hong Kong was not sufficient. To address these concerns, in 2020, Congress enacted the HFCAA, which authorizes the PCAOB to determine whether it is unable to inspect or investigate registered public accounting firms located in foreign jurisdictions due to interference from a governmental entity in that jurisdiction. As a result of the HFCAA, the PCAOB adopted Rule 6100, which provides a framework for its assessment of such audit firms, and in December 2021, it released a report that identified the audit firms located in China and Hong Kong that it determined it could not fully investigate and inspect because of a position taken by authorities in those jurisdictions (PCAOB-Identified Audit Firms).[2]
Documentation Submission Requirement
As noted above, the SEC adopted final amendments to its rules to implement the HFCAA on December 2, 2021, which went into effect on January 10, 2022.[3] As part of the SEC’s finalized rules, it amended Form 10-K, Form 20-F, Form 40-F, and Form N-CSR to require that Commission-Identified Issuers provide additional disclosures that prove the company is not owned or controlled by a governmental authority in the foreign jurisdiction of the PCAOB-Identified Audit Firm. Each Commission-Identified Issuer should determine the appropriate documentation to submit in response to the requirement, based on their organizational structure and other registrant-specific factors. The terms “owned or controlled” refer to a governmental entity’s ability to “control” the registrant, as that term is used in the Securities Exchange Act of 1934, as amended (Exchange Act) and the rules thereunder.
Additional Disclosures Required for Foreign Issuers
In addition, a Commission-Identified Issuer that is a foreign issuer as defined by Exchange Act Rule 3b-4 must provide additional disclosures in its annual report for the year in which the SEC identifies it, which includes the following:[4]
Inline XBRL Tagging and Identification
As part of the finalized rules, the SEC also mandated that issuers use structured data tagging to assist the SEC’s identification of Commission-Identified Issuers. In this respect, annual report filings on Form 10-K, Form 20-F, and Form 40-F that are submitted with eXtensible Business Reporting Language (XBRL) presentations for any period ended after December 15, 2021 must data tag the (1) identity of the auditor (or auditors) who provided opinions related to the financial statements presented in the annual reports, (2) the location where the auditor’s report was issued, and (3) the PCAOB ID Number of the audit firm or branch that provided the opinion.
The SEC clarified that the additional inline XBRL data requirement was to aide its identification of Commission-Identified Issuers. The SEC also indicated that it would begin identifying issuers “as early as possible after the filing of an annual report and on a rolling basis” by evaluating through the use of inline XBRL whether the audit report included in the annual report was signed by a PCAOB-Identified Audit Firm.[5] In this respect, the adopting release does not contemplate the consideration of any other factors in identifying the Commission-Identified Issuers, and the SEC’s HFCAA website explicitly states that its role is solely to identify issuers that have used PCAOB-Identified Audit Firms.[6]
Trading Prohibition
The HFCAA amended Section 104(i)(3)(A) of SOX to require the SEC to impose a trading prohibition on a public company that has been identified as a Commission-Identified Issuer for three consecutive years. In accordance with amended Section 104(i)(3)(B) of SOX, the SEC will end the trading prohibition of a Commission-Identified Issuer if the issuer certifies that it has retained an audit firm that is not a PCAOB-Identified Audit Firm.
In the adopting release, the SEC emphasized its intention to maintain a “clear and transparent” process for identifying Commission-Identified Issuers and stated that it will impose the trading prohibition “as soon as practicable after the issuer has been determined to be a Commission-Identified Issuer for three consecutive years.”[7] Under the current rules, the earliest that a trading prohibition would apply would be in 2024.
Proposals to Accelerate the Trading Prohibition from Three Years to Two Years
There are multiple legislative actions in Congress that relate to the potential acceleration of the trading prohibition. On June 22, 2021, Senator John Kennedy of Louisiana introduced Senate Bill S. 2184, which would amend SOX to shorten the period under which a Commission-Identified Issuer may be delisted from three years to two years. The House of Representatives introduced companion legislation, HR 6285, on December 14, 2021, which provides the same acceleration of the trading prohibition. Finally, the House of Representatives also passed the America COMPETES Act of 2022, HR 4521, on February 4, 2022, which also includes a provision to accelerate the training prohibition from three years to two years.
Given that the proposal to accelerate the trading prohibition appears to have bipartisan support, it is likely that legislation will be enacted and, as such, trading prohibitions could begin to apply in 2023.
On the US side, it is likely that additional companies may be identified as Commission-Identified Issuers in the coming weeks and months. In this respect, annual reports for the fiscal year ended December 31, 2021 for public companies that qualify as foreign private issuers are due by May 2, 2022,[8] and it is expected that a number of issuers filing annual reports by that deadline may have used PCAOB-Identified Audit Firms. Currently, the remedy for public companies that have been identified as Commission-Identified Issuers is to engage an audit firm that satisfies the PCAOB inspection requirements and file financial statements that include an audit report signed by that firm; however, there may be additional changes that a company must make to its internal controls and processes to allow such firms to conduct audits.
On the China side, in response to the risks of foreign regulators accessing sensitive data of listed companies as a result of the HFCAA, the Cyberspace Administration of China (CAC) has recently announced cybersecurity review of certain Chinese internet and technology companies recently listed in the United States. It also subsequently updated its cybersecurity review regulation to require that Chinese companies holding the data of more than one million users must submit to cybersecurity review before seeking to go public overseas.
On the other hand, SEC’s Chinese counterpart, the Chinese Securities Regulatory Commission (CSRC), has made several public statements to deny the media reports that it will prohibit companies with variable interest entity (VIE) structures from listing abroad or discourage Chinese companies from choosing the United States as their offshore listing venue. Instead, the CSRC stated that it recognizes the importance of Chinese companies having access to the US capital markets and respects the PCAOB’s mandate to oversee the quality of audit works.
The CSRC has indicated that it remains in close discussions with the SEC and the PCAOB to work out a mutually satisfactory solution under the principle of “joint US-China audit inspection.” In the latest public statement, the CSRC mentioned that “positive progress” had been made in talks on regulatory cooperation with the US regulators. While PCAOB subsequently confirmed such discussion and certain unspecified progress, it also stated that full access to relevant audit information was “not negotiable” and that any potential resolution is “premature.”[9]
It remains to be seen whether the US and Chinese regulators will be able to resolve the audit issue in order to prevent the delisting of hundreds of China-based companies from US stock exchanges. China-based companies already listed or seeking a listing in the United States should carefully review their legal obligations under both US and Chinese law to comply with the respective disclosure and regulatory approval requirements. Investors with significant holdings of China-related assets exposed to the HFCAA are also well advised to closely monitor the regulatory developments in both countries.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Boston
Bryan S. Keighery
Carl A. Valenstein
Laurie A. Cerveny
Hong Kong
June Chan
Yile (Eli) Gao
William Ho
Louise Liu
Edwin Luk
Billy Wong
New York
Thomas P. Giblin, Jr.
Howard A. Kenny
Kimberly M. Reisler
Philadelphia
Justin W. Chairman
Ezra D. Church
James W. McKenzie, Jr.
Joanne R. Soslow
Pittsburgh
Celia A. Soehner
Princeton
David C. Schwartz
Shanghai
Matthew H. Lewis
Todd Liao
Silicon Valley
Albert Lung
Singapore
Bernard Lui*
Joo Khin Ng*
Washington, DC
Leland S. Benton
Erin E. Martin
*A director of Morgan Lewis Stamford LLC, a Singapore law corporation affiliated with Morgan, Lewis & Bockius LLP
[1] See Holding Foreign Companies Accountable Act Disclosure Adopting Release, Exchange Act Release No. 34-93701 (Dec. 2, 2021) (adopting release).
[2] See PCAOB Release No. 104-HFCAA-2021-001, (Dec. 16, 2021) and Appendix A and Appendix B therein for a complete discussion of the PCAOB’s analysis and determination with respect to the identified audit firms.
[3] See generally SEC Press Release, “SEC Adopts Amendments to Finalize Rules Related to the Holding Foreign Companies Accountable Act,” (Dec. 2, 2021).
[4] For example, if a registrant is identified as a Commission-Identified Issuer based on its annual report for the fiscal year ended December 31, 2021, it will be expected to comply with the updated disclosure requirements in the annual report for the fiscal year ended December 31, 2022.
[5] Supra note 1 at 70032.
[6] See www.sec.gov/hfcaa
[7] Supra note 1 at 70034. The trading prohibition order would be effective the fourth business day after it is published.
[8] A foreign private issuer has four calendar months after its fiscal year end to file its annual report, whereas a US public company has 60 to 90 days after its fiscal year end depending on its filer status.
[9] See Bain, Benjamin, “US Says Speculation of Deal on China Stock Listings is Premature,” Bloomberg (Mar. 24, 2022).