Section I: Regulatory Developments 2021

A. The Holding Foreign Companies Accountable Act

On December 18, 2020, President Donald J. Trump signed the Holding Foreign Companies Accountable Act (the “HFCA Act”) into law, which mandates new disclosure requirements for certain foreign issuers and prohibits the trading of certain foreign issuers’ securities in the United States. The HFCA Act received bipartisan support in Congress following years of escalating tensions between the United States and China.

The HFCA Act aims to address restrictions China has placed on the ability of the Public Company Accounting Oversight Board (the “PCAOB”) to inspect or investigate PCAOB-registered public accounting firms in connection with their audits of Chinese issuers listed on U.S. securities exchanges. The Sarbanes-Oxley Act of 2002 created the PCAOB “to oversee the audit of companies that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.” Specifically, the PCAOB is responsible for registering public accounting firms, establishing standards applicable to the preparation of audit reports for companies, conducting inspections and investigations of public accounting firms to ensure they are complying with those standards, and bringing enforcement actions when they are not.

The Sarbanes-Oxley Act requires that both domestic and foreign audit firms that prepare or issue an audit opinion for a company that issues securities in the United States produce the underlying audit work papers at the request of the PCAOB or the Securities and Exchange Commission (the “SEC” or “Commission”). For more than a decade, Chinese law has restricted the ability of the SEC and PCAOB to access the audit work papers of China-based issuers listed on U.S. exchanges.

The HFCA Act amends the Sarbanes-Oxley Act and directs the SEC to identify public companies that use an audit firm that has a branch or office that:

1. is located in a foreign jurisdiction; and
2. authorities in that foreign jurisdiction restrict the PCAOB’s ability to inspect or investigate the audit firm (as determined by the PCAOB).

Any identified issuer must comply with additional submission-and-disclosure requirements and may face a trading prohibition if, for three consecutive years, the PCAOB is unable to fully inspect or investigate the issuer’s audit firm.

B. SEC and PCAOB Implementing Rules

The HFCA Act requires certain PCAOB and SEC actions in order to carry out the mandates in the legislation, which resulted in several rulemakings and other official actions in 2021. First, the SEC adopted interim final rules on March 18, 2021 to implement the disclosure requirements in the HFCA Act. The amendments to the SEC’s annual report forms that set forth the new disclosure requirements were not proposed pursuant to the Administrative Procedure Act because the SEC determined that doing so would be impractical and unnecessary in light of the HFCA Act’s ninety-day implementation mandate and prescriptive disclosure requirements. While, as a result, no notice-and-comment period was required, the SEC requested that market participants and other members of the public provide feedback on the implementation of the new rules. The expectation was that the SEC would subsequently propose rules to implement the trading prohibition required by the HFCA Act. This expectation was, in part, based on the language in the interim final rules release, which stated that “[t]he Commission staff, in deciding what to recommend to the Commission, is actively considering ways to implement the trading prohibition, and the Commission anticipates seeking comment from the public.”

Next, the PCAOB adopted PCAOB Rule 6100, Board Determinations Under the Holding Foreign Companies Accountable Act, on September 22, 2021. PCAOB Rule 6100, which was approved by the SEC on November 4, 2021, creates a framework for the PCAOB to make its determinations regarding its ability to inspect or investigate audit firms as required by the HFCA Act. Specifically, Rule 6100 provides that the PCAOB will consider various factors and issue a report to the SEC with its determinations as to which public accounting firms in which jurisdictions the PCAOB is unable to fully inspect or investigate (“PCAOB-Identified Firms”). The PCAOB will provide its report to the public and reevaluate its determinations at least annually. The SEC will then be able to use this report to identify the issuers whose audits were conducted by the PCAOB-Identified Firms, referred to by the SEC as “Commission-Identified Issuers.”

On December 2, 2021, the SEC adopted amendments to finalize the interim final rules, at the same time unexpectedly adopting final rules to implement the HFCA Act’s trading prohibition without the anticipated notice-and-comment process. Two weeks later, the PCAOB published its first report on December 16, 2021, identifying registered public accounting firms in mainland China and Hong Kong as PCAOB-Identified Firms. With respect to next steps, the SEC’s adopting release explains:

[T]he Commission will identify registrants pursuant to the HFCA Act based on the PCAOB’s determination and on registrants’ annual reports for fiscal years beginning after December 18, 2020. The earliest that the Commission could identify a Commission-Identified Issuer would be after registrants file their annual reports for 2021 and identify the accounting firm that audited their financial statements.

Once identified, Commission-Identified Issuers will be listed on the SEC’s website and the fiscal year for which each issuer is identified will be considered a “non-inspection year.” A Commission-Identified Issuer’s annual report filed in the following year will cover that non-inspection year.

1. Disclosure-and-Submission Requirements

Each Commission-Identified Issuer will be required to submit to the SEC, via its Electronic Data Gathering, Analysis, and Retrieval system, documentation establishing that the issuer is not owned or controlled by a governmental entity in the foreign jurisdiction of the PCAOB-Identified Firm. Commission-Identified Issuers must also provide certain disclosures regarding their ownership and any ties to the Chinese Communist Party during each non-inspection year in which a PCAOB-Identified Firm has prepared an audit report. The disclosures are required to be included in the Commission-Identified Issuer’s annual report covering the non-inspection year filed with the SEC. The SEC’s annual report forms—Form 10-K, Form 20-F, and Form 40-F—have been amended to include a new line-item requirement that prescribes this disclosure.

2. Mandatory Trading Prohibition

If the SEC determines that a company has three consecutive non-inspection years, the HFCA Act requires that the SEC prohibit the securities of the company from being traded on a national securities exchange or through any other method regulated by the SEC, including over-the-counter trading. The legislation allows for the removal of the trading prohibition if the issuer later “certifies to the Commission that the covered issuer has retained a registered public accounting firm that the [PCAOB] has inspected under this section to the satisfaction of the Commission.” However, if the issuer subsequently falls out of compliance again—even for having just one non-inspection year—the issuer must wait another five years before it can apply to have the subsequent prohibition removed.

The process adopted by the SEC provides that a list of all Commission-Identified Issuers will be made available to the public on the SEC’s website, along with the number of consecutive years in which each such issuer has been a Commission-Identified Issuer, and any prior trading prohibitions applied to such issuer. Upon the public identification of an issuer as a Commission-Identified Issuer for the third consecutive year, the SEC will issue an order prohibiting trading. Such order will become effective on the fourth business day after publication. The SEC did not adopt any additional rules, or amend any existing rules, to further implement or facilitate a trading prohibition or de-listing from a national securities exchange. Instead, the SEC explained in a footnote that “the existing rules of national securities exchanges that list issuers that are subject to an initial trading prohibition are applicable to delisting of such issuers’ securities, as appropriate.” Thus, it appears that U.S. securities exchanges, such as the New York Stock Exchange and Nasdaq, as well as the over-the-counter markets, will have to determine how best to implement trading prohibitions required by the HFCA Act. The PCAOB has provided the following information, which puts the scope of expected de-listings into context:

In 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. The ten largest of these companies had a combined market capitalization of approximately $1.1 trillion.

While the trading prohibition applies to the securities of the issuer, compliance with the HFCA Act and its implementing rules is largely outside of the control of the issuer. Rather, the rules apply to the accounting firm that audits the issuer’s financial statements. For this reason, it is expected that, unless China and Hong Kong abandon their policy of restricting PCAOB inspections and investigations of accounting firms in their respective jurisdictions, issuers based in China and Hong Kong will face de-listing in 2024.