In December 2020, President Donald Trump signed into law the Holding Foreign Companies Accountable Act (the HFCAA). The HFCAA requires auditors of foreign companies that are publicly traded in the US to allow the Public Company Accounting Oversight Board (PCAOB) to inspect the auditors’ audit work papers for audits of non-US operations. If a company’s auditors fail to comply with the inspection requirement for three consecutive years, trading in such foreign company’s securities would be prohibited in US markets. The HFCAA also amends the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act), mandates that the Securities and Exchange Commission identify foreign issuers that use an audit firm that is located in a foreign jurisdiction in which the PCAOB is restricted from inspecting or investigating the audit firm, and imposes additional SEC disclosure requirements on such foreign issuers.
To protect investors, the Sarbanes-Oxley Act formed the PCAOB in order to register both domestic and foreign public company audit firms and create standards for audit reports, inspect and investigate such firms, and take action when reports fail to comply with the established standards. The Sarbanes-Oxley Act mandates that such audit firms turn over any audit work papers upon the request of the PCAOB or the SEC. For more than a decade, China has barred audit firms in China and Hong Kong from providing such paperwork to the PCAOB — a prohibition that has raised questions regarding the reliability of financial disclosures of some Chinese companies.
The US Response to China’s Prohibition of Compliance: The HFCAA
The HFCAA has amended the Sarbanes-Oxley Act to require the SEC to identify any “covered issuer” (i.e., a company that is required to file reports under Section 13 or 15(d) of the Securities Exchange Act of 1934) that has engaged an audit firm located in a foreign jurisdiction and which results in the PCAOB being unable to inspect or investigate completely due to a position taken by an authority in that foreign jurisdiction (hereinafter referred to as an “identified issuer”). In turn, such identified issuer must supply the SEC with documentation showing that the foreign government (or body thereof) that prohibits the auditor from complying with a PCAOB inspection or investigation does not own or control the identified issuer. The HFCAA also mandates that the SEC issue rules within 90 days of the HFCAA’s enactment to implement this disclosure requirement.
The HFCAA also requires each identified issuer to make certain additional disclosures in its annual report on Form 10-K or Form 20-F covering a non-inspection year in which an audit firm prepared an audit report, including: (1) a statement that, during the period covered by the report, a foreign registered public accounting firm issued an audit report for the issuer in a foreign jurisdiction that prohibits PCAOB inspections; (2) the percentage of shares owned by governmental bodies where the issuer is incorporated or organized; (3) whether such governmental entities have a controlling financial interest in the issuer; (4) the names of any Chinese Communist Party officials who are on the board of directors for the identified issuer or an operating entity of the identified issuer; and (5) whether the identified issuer’s articles of incorporation (or any other similar organizational document) contains any charter (which term is not defined in the HFCAA itself), or the text of any charter, of the Chinese Communist Party.
Repercussions for Non-Inspection
If the SEC determines that the PCAOB cannot inspect or investigate an identified issuer’s audit firm for three consecutive years, the HFCAA requires the SEC to prohibit trading of the identified issuer’s securities on any national securities exchange in the United States or through any other SEC-regulated method, including over-the-counter trading. The SEC will remove the trading embargo from any such identified issuer’s securities if and when the identified issuer certifies that it has engaged a registered public accounting firm that has been inspected by the PCAOB to the SEC’s satisfaction. If an identified issuer (1) cures an initial three-year violation by providing a satisfactory certification to the SEC; and (2) subsequently falls out of compliance (even for one non-inspection year), the SEC is required under the HFCAA to prohibit the trading of the issuer’s securities for an additional five years. Following the end of such five-year suspension, the identified issuer may again have the trading prohibition removed if it certifies that it has engaged a PCAOB-inspected audit firm.
SEC Action and Reaction to the HFCAA
In a public statement issued on the same day when the HFCAA was signed into law, now former SEC Chairman Jay Clayton directed the staff of the SEC to consider consolidating SEC implementation of the HFCAA with the SEC’s efforts to address recommendations made by the President’s Working Group on Financial Markets in its July 2020 Report on Protecting United States Investors from Significant Risks from Chinese Companies (the PWG Report), noting the substantial overlap between the HFCAA and the staff’s proposals in response to the PWG Report. Chairman Clayton also asked the staff to “consider additional issues relating to the [HFCAA’s] implementation,” including how its disclosure requirements can be implemented expeditiously and in a way that addresses any actual or perceived uncertainty in order to ensure “investor protection and the fair and orderly operation of our markets.”