Time Running Out Under the HFCAA

Cydney S. Posner is special counsel at Cooley LLP. This post is based on her Cooley memorandum.

In December 2020, the Holding Foreign Companies Accountable Act, co-sponsored by Senators John Kennedy, a Republican from Louisiana, and Chris Van Hollen, a Democrat from Maryland, was signed into law. The HFCAA amended SOX to prohibit trading on U.S. exchanges of public reporting companies audited by audit firms located in foreign jurisdictions that the PCAOB has been unable to inspect for three sequential years. (See this PubCo post.) The U.S.-China Economic and Security Review Commission reports that, as of March 31, 2022, Chinese companies listed on the three largest U.S. exchanges had a total market capitalization of $1.4 trillion. As a result, the trading prohibitions of the HFCAA, which could kick in in just a couple of years—or perhaps even sooner, if Congress speeds up the timeline—could have a substantial impact. According to SEC Chair Gary Gensler, “[w]e have a basic bargain in our securities regime, which came out of Congress on a bipartisan basis under the Sarbanes-Oxley Act of 2002. If you want to issue public securities in the U.S., the firms that audit your books have to be subject to inspection by the [PCAOB]….The Commission and the PCAOB will continue to work together to ensure that the auditors of foreign companies accessing U.S. capital markets play by our rules. We hope foreign governments will, working with the PCAOB, take action to make that possible.” But China and Hong Kong have not permitted PCAOB inspections, largely because of purported security concerns. Last week, in remarks to International Council of Securities Associations, YJ Fischer, Director of the SEC’s Office of International Affairs, addressed “recent regulatory developments related to the lack of US inspections of audits and investigations in China and Hong Kong, and the implications for continued trading of China-based issuers on US exchanges.” The main message: although there has been progress, “significant issues remain,” and reaching an agreement would be only “a first step.” In other words, there is still “a long way to go.”

According to Fischer, the inability of the PCAOB to conduct inspections in these countries “poses serious risks to US investors,” given the significant exposure of U.S. investors to China-based companies. The PCAOB reports that, “[i]n the thirteen month period ended December 31, 2021, 15 PCAOB-registered firms in mainland China and Hong Kong signed audit reports for 192 public companies with a combined global market capitalization (U.S. and non-U.S. exchanges) of approximately $1.7 trillion.” But, Fischer indicates, “the PCAOB has never been able to conduct audit inspections of firms in Mainland China, despite efforts dating back to 2007. In Hong Kong, the PCAOB has never been able to inspect any larger, network affiliates, and only inspected a few small firms before being blocked from inspecting all firms after 2010.” To conduct its inspection, the PCAOB must review the audit work papers and interview the firm’s engagement personnel. And in the event of possible violations of PCAOB standards or federal securities laws, the PCAOB “must be able to obtain the necessary work papers, documents, and information from firms and take testimony from audit firm personnel.” Moreover, she observes, the PCAOB must “obtain sufficient cooperation and agreement from Chinese authorities so that the PCAOB Board can make a determination that it can inspect and investigate completely in China and Hong Kong”—meaning it “must be able to access audit work papers from all, not some, China-based issuers and their registered public accounting firms, as well as conduct complete inspections and investigations in China and Hong Kong.”

The HFCAA requires the SEC to “identify” each public reporting company that has retained a registered public accounting firm to issue an audit report if that firm has a branch or office in a foreign jurisdiction and the PCAOB has been “unable to inspect or investigate [that firm] completely because of a position taken by an authority in the foreign jurisdiction.” In addition, once a public reporting company has been so “identified” by the SEC, the HFCAA imposes requirements on the company to submit certain documentation to the SEC establishing that it is not owned or controlled by a governmental entity in the foreign jurisdiction and to provide certain disclosures. The HFCAA prohibits trading on exchanges and other markets in the U.S. of companies that have been so “identified” for three sequential years. (See this PubCo post.) According to Fischer, the SEC had, as of May 20, 2022, ”conclusively identified 40 such issuers.” (That list is now over three times longer, containing some recognized names.) These issuers, she said, “may face potential trading prohibitions and, ultimately, delisting as soon as 2024.”

Fischer raised four key points:

  • First, she questioned the contention that audit work papers could not be produced because they contain national security materials. The PCAOB has conducted inspections in 50 other countries, and claims of national security “have not been an issue with other jurisdictions.” Audit inspections require an assessment of the auditor’s compliance with PCAOB and other regulatory and professional requirements. Selected issuer audit engagements are reviewed and various audit areas, such as revenue recognition, are examined. Importantly, she said, the PCAOB requests only “materials from the audit firm that support the auditor’s opinion on the financial statements or the internal controls of the issuer, or the quality controls of the accounting firm…. Sensitive information pertaining to national security—and by that I mean the ability for the state to cater to the protection and defense of its citizenry—should not be in auditor’s files.”
  • Second, she cautioned, “although there have been ongoing and productive discussions between US and Chinese authorities regarding audit inspections and investigations, significant issues remain and time is quickly running out.” She notes that, after the SEC adopted regulations in December 2021, “both houses of Congress passed legislation accelerating the HFCAA trading prohibition from three consecutive years to two consecutive years, which would place some companies in jeopardy of delisting as soon as 2023.” (According to Bloomberg, acceleration language is being debated in conference as part of a new trade and competition bill, H.R. 4521.) However, she notes, “this situation did not happen overnight. After more than a decade of confidence-building measures and pilots, the PCAOB still faces serious challenges relating to the absence of a workable cooperative agreement….”
  • Third—a point she wanted to emphasize—“even if US and Chinese authorities reach an agreement in the near future to commence PCAOB audit inspections and investigations in China and Hong Kong[,] such an agreement will only be the start towards satisfying the PCAOB’s statutory mandate.” While current discussions are “constructive,” it remains uncertain whether an agreement will be reached. But if there is an agreement, the PCAOB would still need to complete inspections and investigations, Fischer calculates, “by early November 2022.”
  • Fourth, China-based issuers that are deemed “too sensitive to comply” with PCAOB requirements could voluntarily delist “preemptively,” allowing other companies and audit firms to comply and thereby avoid potential trading prohibitions. According to Fischer,

“[f]or Chinese authorities, the audit inspection and investigation issues seem hard to solve. There have been disagreements over matters such as redactions, selection of the audit engagements and potential violations to be examined, and access to firm personnel, audit work papers, and other information. In 2016, the PCAOB started a pilot inspection of a China-based audit firm but it was prevented from completing it because Chinese authorities withheld or redacted information that the PCAOB needed. For more than 15 years, the PCAOB has been trying to access the necessary documents from China and Hong Kong-based audit firms. The PCAOB is only seeking access to audit firms that elected to register with the PCAOB, as well as the work papers of audits of issuers that have chosen to list on US capital markets. Yet, to date, every attempt to solve this problem has failed.”

Her suggestion—a decision she recognizes is for authorities in China—is that Chinese authorities consider whether to carve out some “China-based issuers that are simply ‘too sensitive to comply’ with the requirements for US listing and voluntarily delist those entities from US exchanges while bringing the remainder into compliance with PCAOB standards.” Whatever decision is made, the SEC has offered to work with Chinese authorities to ensure a smooth transition.

According to Reuters, the China Securities Regulatory Commission “said in a statement that negotiations were progressing smoothly overall, and it was inappropriate to disclose specific issues. ‘We’ve always maintained that the audit inspection issue should be solved by cooperation on the basis of equality. Our attitude has always been positive and constructive,’ the regulator said.”

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