SEC finalizes Holding Foreign Companies Accountable Act rules, PCAOB focuses on audits in CN and HK

This is an updated version of our earlier briefing, revised to reflect the PCAOB’s recent actions. 

As required by the Holding Foreign Companies Accountable Act (the “HFCAA”), the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) has adopted a final rule that will soon require certain SEC registrants – mainly those based in China – to submit documentation and make disclosures relating to Chinese government control and influence over these companies. The rule also establishes the process by which the SEC may impose trading prohibitions on the securities of these companies. On December 16, 2021, the Public Company Accounting Oversight Board (“PCAOB”) announced that it has designated China and Hong Kong as the jurisdictions where the PCAOB is not allowed to conduct full and complete audit inspections. 

The SEC will begin to list “Commission-Identified Issuers” on its website shortly after registrants begin filing their annual reports for 2021. A Commission-Identified Issuer is one that has retained, for the preparation of the audit report on its financial statements included in its Form 10-K, 20-F, 40-F, or N-CSR (the “annual report forms”), a registered public accounting firm that has a branch or office that is located in a foreign jurisdiction, and that the PCAOB is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction (a “PCAOB-Identified Firm”). 

Why is the SEC issuing the rule? 

The HFCAA, which was adopted in late 2020, specifically directs the SEC to promulgate rules implementing the following provisions:

• Commission-Identified Issuers must submit documentation to the SEC that establishes that they are not owned or controlled by a governmental entity in that foreign jurisdiction;
• If the company is determined to be a Commission-Identified Issuer for three consecutive years, the SEC is directed to prohibit trading of the registrant’s securities; and
• Commission-Identified Issuers that are also “foreign issuers” (i.e., a foreign government, foreign national or entity organized under laws of a foreign country) (a “Commission-Identified Foreign Issuer”) are subject to additional specified disclosure requirements, including ownership and control by non-U.S. governmental entities, and the identification of Chinese Communist Party officials on their boards of directors.

How and when will the SEC identify affected companies? 

The SEC will start listing Commission-Identified Issuers on a rolling basis at https://www.sec.gov/hfcaa, as soon as possible after registrants begin filing their annual reports for 2021. The list, which will be in the following form, will also indicate the number of consecutive years a Commission-Identified Issuer has been published on the list and whether it has been subject to any prior trading prohibitions under the HFCAA:

Promptly after a registrant files its annual report, the SEC will evaluate, using soon-to-be-required Inline XBRL tagging or other structured data, whether the annual report contains an audit report signed by a PCAOB-Identified Firm. The PCAOB has issued a report identifying 35 audit firms in mainland China, and 28 audit firms in Hong Kong. The list of PCAOB-Identified firms includes branches of all the so-called “Big Four” audit firms in China and Hong Kong. Please see the PCAOB report or Appendix A to this briefing to see the full list. 

The SEC’s view is that a registered public accounting firm is “retained” by a registrant, for the purposes of the HFCAA, when the registered public accounting firm signs the accountant’s report on the registrant’s consolidated financial statements that is included in a registrant’s SEC filings. 

Once a registrant has been identified, the SEC will provisionally identify it as a Commission-Identified Issuer. The SEC’s website will clearly delineate between provisional identifications and “conclusive identifications,” and registrants will not be deemed a Commission-Identified Issuer until a conclusive determination has been made. 

For a period of 15 business days after the provisional identification, a registrant may contact the SEC by email if it believes it has been incorrectly identified and provide evidence supporting its claims. If the registrant does not contact the SEC to dispute the provisional identification, the determination that the registrant is a Commission-Identified Issuer will be conclusive 15 business days after the provisional identification.

Registrants will be responsible for monitoring the list on their own, as the SEC will not be contacting registrants individually to notify them that they have been deemed a Commission-Identified Issuer. As a practical matter, however, registrants can check the list of PCAOB-identified firms on the PCAOB’s report. If a registrant intends to continue using a PCAOB-identified firm for its upcoming annual report, it can expect to be listed as a Commission-Identified Issuer. 

What kind of documentation must be submitted? 

A Commission-Identified Issuer must submit electronically to the SEC documentation that establishes that it is not “owned” or “controlled” by a governmental entity in the foreign jurisdiction. The SEC’s view is that the terms “owned or controlled” and “owned” and “controlling financial interest” in the HFCAA are intended to refer to a person’s or governmental entity’s ability to “control” the registrant as that term is used in the U.S. Securities Exchange Act of 1934 and its rules.

The SEC is not prescribing the type of documentation that can or should be submitted to the SEC to establish that a Commission-Identified Issuer is not owned or controlled by a governmental entity in the foreign jurisdiction. It is up to the issuer to determine how best to satisfy the requirement. The SEC also declined to provide a non-exclusive list of appropriate documentation. 

Commission-Identified Issuers that are owned or controlled by a foreign governmental entity will not be required to submit documentation to the SEC. 

How must the documentation be submitted? 

The documentation must be submitted through EDGAR, but the SEC does not specify how. A registrant could submit the documentation with its annual report; on Forms 8-K or 6-K; or using another appropriate method.

What disclosures must be made?

A Commission-Identified Foreign Issuer must also make additional disclosures in its annual report. For every year that the issuer is identified as retaining a PCAOB-Identified Firm for the preparation of the audit report on its financial statements included in its annual report forms (a “non-inspection year”), it must disclose: 

• that, for the immediately preceding annual financial statement period, a registered public accounting firm that the PCAOB was unable to inspect or investigate completely, because of a position taken by an authority in the foreign jurisdiction, issued an audit report for the issuer;
• the percentage of its shares owned by governmental entities in the foreign jurisdiction in which the registrant is incorporated or otherwise organized;
• whether governmental entities in the foreign jurisdiction with respect to the PCAOB-Identified 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 issuer’s board of directors or the operating entity with respect to the issuer; and
• whether the issuer’s articles of incorporation (or equivalent organizing document) contains any charter of the Chinese Communist Party, including the text of any such charter (together, the “HFCAA disclosures”).

When must companies begin to comply with the documentation and disclosure requirements? 

The interim rule becomes effective 30 days after it is published in the Federal Register. As a practical matter, however, the SEC must first determine which registrants are Commission-Identified Issuers, and the earliest that the SEC could make the identifications would be after annual reports for 2021 are filed. As noted above, registrants will be able to determine if they are likely to be a Commission-Identified Issuer by checking the audit firms listed on the PCAOB’s report. 

Once the SEC makes the identifications, the documentation establishing that a Commission-Identified Issuer is not owned or controlled by a governmental entity in the foreign jurisdiction of the PCAOB-Identified Firm must be submitted on or before the due date of the registrant’s next annual report. Thus, if a registrant is identified as being a Commission-Identified Issuer based on its annual report filing made in 2022 for the fiscal year ending December 31, 2021, it will be required to comply with the documentation and, if applicable, the disclosure requirements in its annual report filing covering the fiscal year ending  December 31, 2022, that it is required to file in 2023.

Registrants will not be subject to a non-inspection year determination for any fiscal year ending on or prior to December 18, 2020.

When will any trading prohibitions begin?

A registrant must be deemed a Commission-Identified Issuer for three consecutive years before the SEC imposes any trading prohibitions. As discussed above, the earliest that the SEC could identify any Commission-Identified Issuers would be after companies file their annual reports for 2021, which for calendar year issuers would be spring 2022. Consequently, the earliest any trading prohibitions would be imposed is in 2024, once any issuer has been a Commission-Identified Issuer for three consecutive years (i.e., 2022, 2023, and 2024).

However, if the U.S. Congress adopts the Accelerating Holding Foreign Companies Act, trading prohibitions could be triggered if an issuer is a Commission-Identified Issuer for only two consecutive years. The U.S. Senate has adopted the legislation, but the U.S. House of Representatives has not yet voted on it. 

How does a company terminate a trading prohibition? 

The SEC will terminate an initial trading prohibition if a Commission-Identified Issuer certifies to the SEC that it has retained a registered public accounting firm that the PCAOB has inspected to the satisfaction of the SEC. The certification must be preceded or accompanied by the filing of an annual report or an amended annual report with financial statements that include an audit report on the consolidated financial statements signed by a non-PCAOB-Identified Firm. 

If, however, the SEC ends a trading prohibition and later the registrant is again determined to be a Commission-Identified Issuer, the HFCAA requires the SEC to impose a subsequent trading prohibition on the registrant for a minimum of five years. After the end of the five-year period, the registrant can end the trading prohibition if it certifies to the SEC that it will retain a non-PCAOB-Identified Firm. 

An order ending an initial or subsequent trading prohibition will provide that the termination of the trading prohibition will be effective the next business day after the order is published by the SEC. 

How many companies are expected to be affected? 

Based upon a preliminary review of SEC-reporting issuers in calendar year 2020, the SEC has identified 273 registrants who could be deemed Commission-Identified Issuers. Nearly 80% of the potential Commission-Identified Issuer candidates are Form 20-F filers. Approximately 22% were incorporated in the United States while 78% were incorporated in foreign jurisdictions, including 4.8% who self-disclosed to be state-owned enterprises. The vast majority (88.7%) are listed on a U.S. national exchange, nearly 10% are OTC-listed (9.9%), and 1.5% report no U.S. listing. 

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We will continue to monitor developments in this area and welcome any queries you may have about the interim rule, the HFCAA and your listing options.