SEC Finalizes Rules to End the Trading of Chinese Company Shares in the U.S.; China Remains Optimistic that a Solution Is Possible

On December 2, the U.S. Securities and Exchange Commission (SEC) finalized the rules on disclosure requirements for Chinese companies in relation to audit reports issued by foreign accounting firms that the U.S. government does not have access to. While the future of Chinese companies operating in the U.S. financial market is uncertain, Chinese officials remain optimistic that the two sides may find a solution.

The final rule is part of the implementation of the Holding Foreign Companies Accountable Act passed in December 2020. The HFCAA requires, among other things, the removal of Chinese companies from U.S. exchanges if they fail to comply with American auditing requirements for three consecutive years.

The final rule applies to “registrants” that the SEC “identifies as having filed an annual report with an audit report issued by a registered public accounting firm that is located in a foreign jurisdiction and that the Public Company Accounting Oversight Board (‘PCAOB’) is unable to inspect or investigate completely because of a position taken by an authority in that jurisdiction.”

In this case, the rules require “the submission of documentation to the Commission establishing that such a registrant is not owned or controlled by a governmental entity in that foreign jurisdiction” and "disclosure in a foreign issuer’s annual report regarding the audit arrangements of, and governmental influence on, such registrants.”

Similar to the interim final rule issued in March, the final rule does not provide a list of what documentation may be required to prove that a company is not owned or controlled by a government, as the SEC believes that “such a list may be too limiting or become the de facto means of satisfying the requirement.”

The final rule also requires companies identified by the SEC to submit additional information in the annual report, including the accounting firms’ information and “[t]he percentage of the shares of the issuer owned by governmental entities.” Such requirement would apply to Chinese businesses listing in the United States via a vehicle known as a variable interest entity (VIE). The VIE is a popular business structure, which is used to bypass some Chinese restrictions on listing overseas. The SEC stated that “we do not believe that a registrant should be able to avoid the HFCA Act’s requirements by using a VIE structure or other similar structures.” Therefore, “any Commission-Identified Foreign Issuer that uses a VIE or any structure that results in additional foreign entities being consolidated in the financial statements of the registrant must provide the required disclosures for itself and its consolidated foreign operating entities.”

If one company has been identified by the SEC as an issuer that “retains” a foreign accounting firm that PCAOB is unable to inspect or investigate for three consecutive years, the SEC will impose an "initial trading prohibition” and “issue an order prohibiting the trading of an issuer’s securities on a national securities exchange and in the over-the-counter market.” In other words, "issuers will have a period of three years to retain a non PCAOB-Identified Firm before an initial trading prohibition would be imposed, and investors would have the same period of time in which to determine what action, if any, to take regarding their investments in any Commission-Identified Issuer.” “[T]rading prohibition will be effective on the fourth business day after the order is published by the Commission,” according to the final rule.

“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]. While more than 50 jurisdictions have worked with the PCAOB to allow the required inspections, two historically have not: China and Hong Kong," said the chairman of SEC, Gary Gensler. “We hope foreign governments will, working with the PCAOB, take action to make that possible," he said. China has not allowed the PCAOB to inspect its auditors, citing national security concerns.

On December 5, the spokesperson of China’s Securities Regulatory Commission stated on a press conference (link in Chinese) that “recently, the CSRC has had candid and constructive communications with regulatory agencies such as the U.S. SEC and the PCAOB on solving problems in cooperation, and has made positive progress in promoting cooperation on some key issues. We believe that as long as the regulatory agencies of both sides continue to carry out dialogues and consultations based on the principles of mutual respect, pragmatism, professionality and mutual trust, we will be able to find a path to cooperation that is acceptable to both parties.”

But the spokesperson was also critical of the new U.S. policy. He said that “in recent years, some political forces in the United States have politicized capital market supervision, suppressed Chinese companies listed in the United States, and forced Chinese companies to delist. This not only goes against the basic principles of market economy and the concept of the rule of law, but also harms the interests of global investors and the international status of the U.S. capital market."

Without the two sides reaching an agreement, more than 200 Chinese companies could be delisted from U.S. stock exchanges.

As the United States is poised to delist more Chinese companies, Chinese company Didi recently announced that it would delist from the New York Stock Exchange and is preparing for listing in Hong Kong. Didi's IPO in New York triggered investigations from the Chinese government, after it reportedly failed to complete all data security assessments with the government.

China also recently proposed rules to require security reviews for companies with large amounts of personal information to go public overseas. The rules have not been finalized and it is unclear whether they will be applied retroactively to impact Chinese companies that are already traded on the U.S. stock exchanges.

Commenting on the future of Chinese companies going public in the United States, the CSRC spokesperson stated (link in Chinese) that “the CSRC and relevant regulatory authorities have always been open to companies choosing to go public overseas” and that recent policies to regulate companies “are not a suppression of specific industries or private enterprises, nor are they necessarily related to companies' overseas listing activities.”