The Holding Foreign Companies Accountable (HFCA) Act: A Critique

Several hundred Chinese companies with a total market capitalization of approximately $1 trillion are listed on U.S. exchanges. Until recently, China prevented the Public Company Accounting Oversight Board from inspecting the China-based auditors of these firms, as required by the 2002 Sarbanes-Oxley Act. In late 2020, then-President Donald Trump signed into law the Holding Foreign Companies Accountable Act which, as amended, requires the delisting of any firm whose auditors cannot be inspected by the PCAOB for two years in a row (the delisting rule).  In addition, the Act requires any China-based firm whose auditor cannot be inspected by the PCAOB to submit documentation and make certain disclosures related to their ties to the Chinese government and the Chinese Communist Party (the disclosure rules). In 2022, China began allowing PCAOB inspections, averting (at least for now) mass delistings.

In a recent paper, The Holding Foreign Companies Accountable (HFCA) Act: A Critique, we argue that the effect of the HFCA Act on U.S. investors is likely to be negative.  While China-based firms do pose unique risks to U.S. investors, the Act fails to mitigate—and may well exacerbate—these risks.

We first explain why the delisting rule, while well-intentioned, is more likely to harm than to help U.S. investors. If China continues to allow PCAOB inspections, the Act will generate at most a modest benefit. Periodic PCAOB inspections may well improve audit quality, which in turn could lead to higher-quality financial statements.  But audit inspections will not protect U.S. investors against fraud, which insiders can and do hide from auditors. Nor will audit inspections prevent massive expropriation via self-dealing transactions, which historically has afflicted China-based firms listed in the United States. As Ehud Kamar and one of us has explained, the location in China of insiders and their assets, and the firm and its assets, makes controllers of China-based firms essentially law-proof from the perspective of U.S. investors and regulators. China does not extradite its citizens to the United States, does not enforce U.S. judgments against Chinese residents or local entities, and makes document discovery and depositions extremely difficult if not impossible.

If, as we fear likely, China eventually prevents PCAOB inspections, the Act will harm U.S. investors by forcing value-destroying delistings. News of an impending delisting will cause stock prices to fall. The largest firms, especially those already are listed on another exchange (such as Hong Kong), will offer their U.S. investors shares tradable on the other exchange.  But many U.S. investors will sell their U.S.-traded shares at depressed prices rather than accept foreign-traded shares.  Smaller firms are likely to exit via a go-private at very depressed prices, as the law-proof insiders will engage in various manipulations to maximize their profits. 

We then turn to the Act’s disclosure rules. We explain that the rules, which generally come into effect only when China prevents PCAOB inspection of the audit firms, generate little useful information about the ties of China-based U.S.-listed firms to the Chinese party-state.

The purported objective of the rules is to expose the extent of these ties, which the drafters of the Act appear to believe put U.S. investors at risk.  But the disclosure rules are based on a parochial view of ownership and control, based on the U.S. model, that does not account for the idiosyncrasies of Chinese corporate governance. The rules focus on charter provisions, shareholders and board members, which are the most important indicia of control and ownership for U.S.-domiciled firms. But, as we demonstrate in our paper, the party-state may also exert control over a Chinese firm through (a) domestic PRC law as applied to subsidiaries and affiliates of the issuer; (b) CCP officers, members, and committees sprinkled throughout the issuer and its subsidiaries; and (c) general “fear governance.”

Moreover, it is not clear whether party-state influence is harmful or beneficial to foreign investors. While so far China has turned a blind eye to massive expropriation of U.S. investors by Chinese residents controlling relatively small U.S.-traded firms, recent changes in PRC law suggest it may wish to prevent such expropriation in the future, especially at a highly visible firm. If so, a firm’s connections to the Chinese party-state might strengthen enforcement and reduce the risk of misappropriation. It may also ease regulatory bottlenecks (such as licensing) and open new growth opportunities, thereby benefiting, not harming, investors.

Finally, the very design of these rules makes clear that Congress did not believe the disclosed information is material to investors. If Congress actually believed that the information required by the HFCA Act was material to investors, it would have required disclosure of this information at the IPO stage and then for as long as the firm remained publicly traded.  Between the enactment of the Act and late 2022 (when China permitted PCAOB inspections) dozens of China-based firms conducted an IPO in the US, without being required to disclose this information in their IPO prospectuses. Congress would also have required such disclosure even if the PCAOB is able to inspect audit firms, as the risk of the party-state’s meddling in a firm has little connection to whether the firm’s auditors are inspected.

The HFCA Act ostensibly was intended to better protect U.S. investors, but there is a substantial likelihood it will end up harming them through forced delistings. The core problem with China-based firms is that China-based insiders are law-proof. Instead of forcing currently-trading firms to delist if the PCAOB cannot inspect their auditor, Congress should consider barring future listings from countries that impede PCAOB inspections or otherwise frustrate the pursuit of cross-border wrongdoers. Such a forward-looking bar would come too late to help investors in already-listed China-based firms, but it would at least limit the amount of future expropriation.

The complete paper is available here.