Yesterday, Corp Fin posted CF Disclosure Guidance: Topic No. 10, Disclosure Considerations for China-Based Issuers, which provides guidance regarding disclosure considerations for companies based in or with the majority of their operations in the People’s Republic of China (China-based Issuers). You might recall that, in August, the President’s Working Group on Financial Markets, which includes Treasury Secretary Steven T. Mnuchin, Fed Chair Jerome H. Powell, SEC Chair Jay Clayton and CFTC Chair Heath P. Tarbert, issued a Report on Protecting United States Investors from Significant Risks from Chinese Companies, which made a number of recommendations, among them that regulators should require enhanced and prominent issuer disclosures of the risks of investing in China-based Issuers and should issue interpretive guidance to clarify these disclosure requirements and increase awareness of the risks of investing in these companies. (See this PubCo post.) This guidance appears designed to implement that recommendation. The clear implication of the guidance is that China-based Issuers need to consider beefing up their risk factor and related disclosures; in outlining risks and posing questions to consider, the guidance provides a great starting point.
Through direct and index-based investing, over the past 10 years, U.S. investors have increased their exposure to China-based Issuers. As the staff has previously observed (see, e.g., this PubCo post), although China-based Issuers that sell securities in the U.S. public capital markets have “the same disclosure obligations and legal responsibilities as other non-U.S. issuers,” the SEC’s ability to “promote and enforce high-quality disclosure standards for China-based Issuers may be materially limited. As a result, there is substantially greater risk that their disclosures may be incomplete or misleading,” and harmed investors have substantially less access to recourse for their losses. Summarized below are risks highlighted in the guidance.
Risks Associated with China-based Issuers
Financial Reporting. One of the most significant risks has been the inability of the PCAOB to “inspect audit work and practices of PCAOB-registered public accounting firms in China and on the PCAOB’s ability to inspect audit work with respect to China-based Issuer audits by PCAOB-registered public accounting firms in Hong Kong.” To address this issue, in May, the Senate passed the Holding Foreign Companies Accountable Act, which would amend SOX to impose certain requirements on public companies that are audited by a registered public accounting firm that the PCAOB is unable to inspect, and a version was subsequently passed by the House as an amendment to a defense funding bill. Around the same time, Nasdaq also proposed rule changes aimed at addressing similar issues in restricted markets, including new initial and continued listing standards. (See this PubCo post.) The President’s Working Group on Financial Markets also recommended enhancing the listing standards of U.S. exchanges to require, as a condition of initial and continued exchange listing, PCAOB access to main auditor work papers either directly or through “co-audits.” (See this PubCo post.) If enacted, these bills and recommendations could result in delisting companies, after a transition period, that use an auditor that the PCAOB is not able to inspect, which could have an adverse impact on trading prices of securities or terminate the trading of securities of China-based Issuers with PCAOB-registered public accounting firms in China and Hong Kong.
Access to Information and Regulatory Oversight. The guidance indicates that, as a result of state secrecy and national security laws, blocking statutes or other laws or regulations, U.S. regulators are frequently restricted in their ability to access information or investigate or pursue remedies regarding China-based Issuers. A new law, Article 177 of the PRC Securities Law, which became effective in March 2020, prohibits overseas securities regulators from directly conducting “investigations or evidence collection activities within the PRC and no entity or individual in China may provide documents and information relating to securities business activities to overseas regulators without Chinese government approval.” As a result, U.S. authorities “face substantial challenges in bringing and enforcing actions” against China-based Issuers and their officers and directors, limiting the potential beneficial effect of the U.S. regulatory environment.
Company’s Organizational Structure. To circumvent regulations in China that limit or prohibit foreign investment in Chinese companies operating in certain industries, such as telecom and education, many China-based Issuers form non-Chinese holding companies to enter into contractual relationships with Chinese operating companies, referred to as variable interest entities, which are typically consolidated with the China-based Issuer. Chinese law determines whether the China-based Issuer maintains legal control of the Chinese operating company. Under this structure, “the Chinese operating company, in which the China-based Issuer cannot hold an equity interest, typically holds licenses and other assets that the China-based Issuer cannot hold directly.” Risks arising out of these VIE structures include, for example, limitations and enforcement costs that may result from the exercise of control through contractual arrangements rather than through direct equity ownership, including potential difficulties related to the distribution of funds among the entities. In addition,
“the Chinese government could determine that the agreements establishing the VIE structure do not comply with Chinese law and regulations, including those related to restrictions on foreign ownership, which could subject a China-based Issuer to penalties, revocation of business and operating licenses, or forfeiture of ownership interests. A China-based Issuer’s control over a VIE may also be jeopardized if a natural person who holds the equity interest in the VIE breaches the terms of the agreements, is subject to legal proceedings, or if any physical instruments, such as chops and seals, are used without the China-based Issuer’s authorization to enter into contractual arrangements in China.”
Regulatory Environment. Risks and uncertainties related to China’s legal system may arise out of the “intent, effect, and enforcement of its laws, rules, and regulations, including those that restrict the inflow and outflow of foreign capital or provide the Chinese government with significant authority to exert influence on a China-based Issuer’s ability to conduct business or raise capital.” Interpretation or enforcement could be inconsistent and unpredictable, impeding the ability of China-based Issuers to obtain or maintain required permits or licenses, which could lead to the imposition of material sanctions or penalties against the company.
Differences in Shareholder Rights and Recourse, Governance and Reporting
Limitations on Shareholder Rights and Recourse. Investors may find it difficult or impossible to pursue or enforce legal claims, including federal securities law claims, against China-based Issuers, or their officers, directors and gatekeepers, in U.S. courts. Enforcement could be especially difficult where assets of the China-based Issuer or related persons are located in jurisdictions that may not recognize or enforce U.S. judgments. Legal claims and remedies in China or other jurisdictions where the China-based Issuer may maintain assets “are often significantly different from those available in the United States and difficult to pursue.”
Corporate Law, Corporate Governance and Reporting Differences. If China-based Issuers are organized in jurisdictions such as the Cayman Islands and British Virgin Islands, there may be additional material risks and even fewer shareholder protections, such as more limited fiduciary duties of directors.
To the extent that China-based Issuers qualify as foreign private issuers, they are exempt from certain rules of U.S. exchanges and are often permitted to rely on home country corporate governance practices. As a result, they may be exempt from audit committee independence rules and may not be required to have a majority of independent directors, have independent board committees or hold executive sessions, among other things. In addition, they would be exempt from certain reporting requirements under the federal securities laws, such as the requirement to file quarterly reports, executive officer certifications and current reports on Form 8-K. They would also be exempt from requirements to solicit proxies under Section 14 of the Exchange Act, and to comply with Section 16 and Reg FD.
Disclosure Considerations for China-based Issuers
Corp Fin suggests the following questions to consider in assessing material risks and related disclosure obligations in connection with the operations of China-based Issuers:
- “Does the company provide clear and prominent disclosure of PCAOB inspection limitations and lack of enforcement mechanisms, as well as the risks relating to the quality of the financial statements? For example, for China-based Issuers that engage audit firms based in China or Hong Kong, does the company caution investors about:
- the ongoing inability of the PCAOB to inspect the audit work of its outside audit firm?
- whether and how its audit committee has taken the lack of inspection into account in connection with the oversight of the outside audit firm and its procedures?
- the difficulty regulators such as the SEC and PCAOB may have in obtaining audit work papers from the company’s auditors and the company and how that difficulty may impact the company and its shareholders?
- the possibility that SEC proceedings against the audit firm that the issuer employs (whether in connection with an audit of the issuer or other issuers operating in China) could result in the imposition of penalties against the audit firm, such as suspension of the auditor’s ability to practice before the SEC?
- the possibility that legislative or other regulatory action in the United States may result in listing standards or other requirements that, if the company cannot meet, may result in delisting and adversely affect the company’s liquidity or the trading price of the company’s securities that are listed or traded in the United States?
- limits imposed by Chinese law on the ability of U.S. authorities, including the SEC, PCAOB, and the Department of Justice, to conduct investigations and bring actions, including Article 177?
- Does the company use VIEs in its organizational structure? If so, does the company include sufficient disclosure about the related party transactions in the VIE structure and caution investors about the risks associated with the VIE structure employed in China, including that:
- the VIE structure may be determined by Chinese authorities to be inconsistent with the laws and regulations of China, including those related to foreign investment in certain industries?
- the VIE structure may be disregarded by PRC tax authorities resulting in increased tax liabilities?
- the VIE structure may not be as effective as direct ownership in controlling entities organized in China, which often hold the licenses necessary to conduct the company’s business in China?
- control over, and funds due from, the VIE may be jeopardized if the natural person or persons that hold the equity interest in the VIE breach the terms of the agreement?
- the VIE structure may result in unauthorized use of indicia of corporate power or authority, such as chops and seals?
- Does the company disclose risks relating to the regulatory environment in China, including risks related to a less developed legal system, which may result in inconsistent and unpredictable interpretation and enforcement of laws and regulations? For example, does the company caution investors that:
- evolving laws and regulations and inconsistent enforcement thereof could lead to failure to obtain or maintain licenses and permits to do business in China?
- intellectual property rights and protections may be insufficient for companies with material intellectual property in China?
- the increased global focus on environmental and social issues and China’s potential adoption of more stringent standards in these areas may adversely impact the operations of China-based Issuers?
- non-citizen shareholders may experience unfavorable tax consequences, including for dividends payable and gains on sales of securities for China-based companies if determined to be a resident enterprise for PRC tax purposes?
- uncertainties in China’s legal system could limit the enforcement of contractual arrangements?
- Chinese law restricts certain foreign investments in China and these laws continue to evolve?
- Chinese governmental authorities have significant discretion that can be used to influence how the company conducts its business operations?
- PRC law, and government control of currency conversion, may restrict the ability to transfer funds into or out of China?
- Does the company provide risk disclosure about differing shareholder rights and remedies in the company’s country of organization and/or based on where a company’s operations are located? For example, does the company caution investors about:
- the difficulties in effecting service of legal process, enforcing judgments obtained in U.S. courts, and bringing claims against the company or its directors and officers?
- the lack of shareholder rights and protections if the company is organized outside of the United States, particularly in jurisdictions where the law is less developed?
- If the company is a foreign private issuer, does it describe:
- corporate governance differences pursuant to Item 16G of Form 20-F?
- differences in reporting requirements between U.S. domestic issuers and foreign private issuers such as the frequency of financial reporting, the exemption from filing quarterly reports and proxy solicitation materials, and the exemption from Regulation FD?”