New Rules for Mandatory Trading Suspension of US-Listed Chinese Companies

Michael Levitt and Sarah Solum are partners and Jeremy Barr is counsel at Freshfields Bruckhaus Deringer LLP. This post is based on a Freshfields memorandum by Mr. Levitt, Ms. Solum, Mr. Barr, Calvin Lai, Arun Balasubramanian and Tracy Zhang. Related research from the Program on Corporate Governance includes Alibaba: A Case Study of Synthetic Control (discussed on the Forum here) by Jesse M. Fried and Ehud Kamar.

On December 2, 2021, the US Securities and Exchange Commission (SEC) issued new rules which further implement requirements and clarified the timing related to the potential mandatory trading suspension of Chinese companies listed on US stock exchanges beginning in 2024.

The SEC’s new rules were adopted pursuant to the Holding Foreign Companies Accountable Act, enacted by the US Congress in December 2020. This law requires the SEC to prohibit the trading of securities of companies on a US national securities exchange if the US PCAOB is not permitted for 3 consecutive years to inspect the audit work papers for such issuer’s auditor with a branch or office in a non-US jurisdiction because of a position taken by an authority in such non-US jurisdiction. China currently prohibits audit firms located in China and Hong Kong from providing the PCAOB access to audit work papers.

Identification of Companies

The new SEC rules provide that the SEC will identify companies (whose auditors cannot be inspected by the PCAOB) on a rolling basis promptly after submission of annual reports starting with annual reports for fiscal years beginning after December 18, 2020. Therefore, SEC determinations will begin for annual reports for the 2021 year which are due, for foreign private issuers with December 31 fiscal year ends, by April 30, 2022. These companies will be identified and listed on an SEC website—https://www.sec.gov/hfcaa—along with the number of consecutive years they have been on the list. Companies would have 15 business days to challenge (by email) inclusion on the list.

Under the rules, the SEC will impose a trading prohibition and issue an order prohibiting the trading of the securities on a US national securities exchange as soon as practicable after the issuer has been on the list for three consecutive years. The order will be effective on the 4th business day after being published. This means the earliest such orders would be issued after 2023 annual reports are filed in 2024. The SEC will issue a new order ending any trading prohibition if the issuer certifies to the SEC that it has retained an auditor that the PCAOB has inspected to the satisfaction of the SEC and files an annual report or an amended annual report containing an audit report signed by such firm. The new order would be effective the next business day after being published.

Disclosure Requirements

Once a company is on the list, the SEC’s rules will now require any company that is a foreign issuer to make specified disclosures in its annual report on 10-K or 20-F. These disclosures would be due at the earliest in the annual report for 2022 which, for foreign private issuers with December 31 fiscal year ends, would be due by April 30, 2023: The disclosures include:

  1. That the PCAOB was unable to inspect or investigate completely the issuer’s auditor;
  2. The percentage of shares of the issuer owned by governmental entities in the jurisdiction in which the issuer is organized;
  3. Whether governmental entities in the non-US jurisdiction of the auditor have a controlling financial interest in the company;
  4. The name of each Chinese Communist Party official who is a director of the company or the operating entity with respect to the company; and
  5. Whether the organizational documents of the company contain any charter of the Chinese Communist Party.

Due to the use by many Chinese companies of variable interest entity (VIE) structures, the SEC clarified that any company that uses a VIE or other structure that results in additional non-US entities being consolidated in the company’s financial statements must provide these disclosures both for itself and for its consolidated foreign operating entities. This clarification means, for example, that disclosure of the percentage of shares owned by governmental entities applies not just to the company itself (which may be a Cayman entity) but also for the company’s consolidated operating entities (which may be based in China).

Documentation Regarding Control by Non-US Governments

Once a company is on the list, the company must submit documentation to the SEC establishing that the company is not owned or controlled by a governmental entity in the relevant non-US jurisdiction of the auditor, either on a Form 8-K or 6-K, as part of an annual report, or using another appropriate method. Companies that are owned or controlled by a governmental entity do not need to submit any documentation.

This documentation must be submitted on or before the due date of the company’s annual report. As with the disclosure requirements, the submission would be due at the earliest in connection with the annual report for 2022 which, for foreign private issuers with December 31 fiscal year ends, would be due in April 2023.

The SEC rules do not specify exactly what documentation is required or sufficient to show the absence of governmental ownership or control. Also, the rules do not define “owned or controlled” but state that companies should look to the typical SEC definition of control—the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise. Once submitted, the documentation will become publicly available.

Going Forward

The new SEC rules, combined with new PCAOB rules approved by the SEC in November 2021, indicate that the US government is methodically preparing the appropriate machinery for the potential trading suspension of US listed Chinese companies in 2024. It is possible that the US Congress could accelerate the trading suspension requirement to 2023.

The SEC identified 273 companies who could be at risk due to its new rules. If a company’s shares or ADRs could no longer trade on the NYSE or Nasdaq, they would no longer benefit from the liquidity offered by the US stock exchanges. These shares / ADRs would likely begin to trade in the US on the OTC Bulletin Board, which has much less liquidity and less stringent governance requirements. This would make it much more difficult for investors to buy or sell shares in these companies, particularly large blocks of shares. Although it is possible the Chinese and US governments may reach a reconciliation on this topic, which we believe would be a good outcome, companies and their shareholders need to prepare as if there would be no reconciliation.

The rules could cause some US-listed Chinese companies to forego their US listing. Some US-listed Chinese companies have already established a dual listing in Hong Kong, or are considering such a listing, or may consider going private. Listing in Hong Kong may be accomplished as a primary listing or a secondary listing. Some US-listed Chinese companies may also consider listing on other stock exchanges in Shanghai, Shenzhen, London, Frankfurt, Amsterdam, or Singapore, among others, none of whom have raised issues regarding inspections of Chinese auditing firms.

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