When the U.S. Senate recently passed legislation that would bar access to U.S. securities exchanges to any foreign company whose auditor is not subject to the same regulatory inspections as domestic U.S. companies, it was the culmination of a series of moves by regulators, market authorities, and legislators to try to “level the playing field” and subject the foreign companies to the same scrutiny U.S. companies and their auditors face. The recently passed Senate legislation, Senate Bill 945, known as the Holding Foreign Companies Accountable Act, was promoted by its co-sponsor, Republican Senator John Kennedy of Louisiana, as a bill that would “kick deceitful Chinese companies off U.S. exchanges.” As discussed below, in addition to the recent Senate bill, efforts by regulators and market authorities with respect to rights to inspect and supervise auditors of foreign companies with securities listed on U.S. exchanges, are continuing.
Background
The need for U.S.-listed foreign domiciled companies to be subject to the same audit oversight as listed domestic U.S. companies has long been the subject of Congressional and regulatory scrutiny. Indeed, as discussed here, as early as July 2019, legislation was introduced in Congress that would require that U.S. listed foreign companies provide U.S. regulators access to accounting records tied to audit reports.
On April 21, 2020, SEC Chair Jay Clayton and other SEC and PCAOB officials issued a detailed public statement on the risks involved with investing in the securities of companies based in emerging markets, including China. Among other things, the statement underscored the fact that the U.S. regulators’ “ability to promote and enforce” their standards of “meaningful, principled oversight and enforcement” is “significantly dependent on local authorities,” which in turn are “constrained by national policy considerations.” As a result, “in many emerging markets, including China, there is a substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less recourse, in comparison to U.S. domestic companies.” The overall message in the statement is that notwithstanding the similarity in form of the disclosures by both U.S. and non-U.S. listed companies, the disclosures from companies in emerging markets may well differ in scope and quality.
At the same time, as discussed in a May 21, 2020 post on the Cooley PubCo blog (here), NASDAQ has introduced a series of proposals that would apply to companies with businesses principally administered by “Restrictive Markets.” Under the NASDAQ rules, a “Restrictive Market” is “a jurisdiction that NASDAQ has determined to have “secrecy laws, blocking statutes, national security laws or other laws or regulations restricting access to information by regulators of U.S.-listed companies in such jurisdiction.” Among the new requirements introduced in the NASDAQ proposals are additional and more stringent criteria to an applicant for listing or a listed company located in a Restrictive Market based on the qualifications of the company’s auditor.
In addition, on May 19, 2020, the SEC announced that on July 9, 2020, its staff would be hosting a roundtable to “hear the views of investors, other market participants, regulators, and industry experts on the risks of investing in emerging markets, including China.” The meeting announcement noted that while the same disclosure requirements apply to both U.S. and non-U.S. companies listed on U.S. exchanges, “the practical effects are often substantially different, based on the inability of the U.S. regulators to inspect for compliance and to enforce rules and regulations.”
The Senate Legislation
As discussed in a May 20, 2020 Wall Street Journal article entitled “Chinese Companies Could Be Forced to Give Up U.S. Listings Under Senate Bill” (here), on May 20, 2020, the U.S. Senate passed by unanimous consent a bill entitled the Holding Foreign Companies Accountable Act. As the Journal article notes, at the heart of the dispute that led to the Senate’s passage of the legislation is “China’s unwillingness to grant routine access to audit regulators by American regulators.”
The Act would, according to the May 20, 2020 Law360 article discussing the Act (here), “prohibit a public company’s securities from being listed on any U.S. securities exchange if the business hasn’t complied with the Public Company Oversight Board’s audit standards for three years in a row.” The Act would also require public companies to disclose whether they are owned or controlled by a foreign government.
Democratic Senator Chris Van Hollen of Maryland, who was one of the bill’s co-sponsors, said in a May 20, 2020 press release (here) that “For too long, Chinese companies have disregarded U.S. reporting standards, misleading our investors…. Publicly listed companies should all be held to the same standards, and this bill makes commonsense changes to level the playing field and give investors the transparency they need to make informed decisions.
In a May 20, 2020 press release (here), the bill’s other co-sponsor, Republican Senator John Kennedy of Louisiana, said that, “The SEC works hard to protect American investors from being swindled by American companies. It’s asinine that we’re giving Chinese companies the opportunity to exploit hardworking Americans—people who put their retirement and college savings in our exchanges—because we don’t insist on examining their books. There are plenty of markets all over the world open to cheaters, but America can’t afford to be one of them.”
In order to become law, the Act must be passed by the House of Representatives. According to a May 21, 2020 client memo from the Sidley law firm (here), on the same day that the Senate bill passed, Rep. Brad Sherman (D. Calif.) introduced in the House a bill with the same language as the Senate bill. Sherman is the Chairman of the House Financial Services Committee’s subcommittee on Investor Protection, Entrepreneurship, and Capital Markets, the subcommittee that would have jurisdiction over the bill in the House, which, according to the Sidley memo, “could increase the likelihood of its enactment.” The text of the House bill can be found here.
Discussion
Concern about the inability to scrutinize auditors of U.S.-listed Chinese companies, and U.S.-listed companies from other emerging markets, have been around for years. The level of alarm around these issues was significantly raised following recent high-profile revelations of U.S.-listed Chinese coffee company, Luckin Coffee. Among other things, press reports about the Luckin Coffee scandal suggest that the company’s employees may have fabricated as much as $310 million in sales.
According to the Journal article to which I linked above, Luckin Coffee is one of more than 200 non-U.S. companies with U.S. listings whose auditor is beyond the reach of the PCAOB. Most of these companies are based in China or Hong Kong, although some are based in in France and Belgium, where, according to the Journal, “the PCAOB has also faced some issues with inspection records.”
As the Luckin Coffee scandal shows, this controversy about accounting and auditing oversight is not a small issue. The regulatory concerns in fact raise substantial issues.
These concerns are not small from the perspective of Chinese companies, either. Since 1997, Chinese companies have raised over $66 billion through IPOs on U.S. exchanges. In 2019 alone, there were 25 IPOS of Chinese companies in the U.S. Were the Senate legislation to become law, the possibility that the Chinese companies could be kicked off the U.S. exchanges would make the U.S. exchanges far less attractive.
However, it is not just U.S. regulators and legislators that are aiming to try to step up the scrutiny of Chinese companies. As discussed in a May 11, 2020 Financial Times article (here), Chinese authorities have themselves also increased their scrutiny of publicly traded Chinese companies. Among other things, the FT article reports that in the first four months of the year Chinese authorities have disciplined nearly 300 Chinese companies (including for insider trading and accounting fraud). In addition, the FT reports that in March, a securities law tightening corporate disclosure standards and making it easier for investors to sue company directors took effect. (Not too surprisingly, interest among Chinese companies in D&O insurance recently has stepped up as well, according to the FT article.)
Whether or not the Senate bill ultimately becomes law remains to be seen. However, the heightened scrutiny facing Chinese companies is not going to go away any time soon. Among other things, the SEC will be hosting its roundtable on July 9, 2020. The one thing that is clear is that publicly traded Chinese companies – particularly those with U.S. listings – are going to be watched very closely. If, as a result of all of these efforts, Chinese companies are more transparent, investors and markets will benefit. However, an alternative result could be fewer U.S listings for companies from emerging markets, including, in particular, China.
In its statement earlier this spring about U.S.-listed companies from emerging markets, the SEC sought to inform investors about the absence of scrutiny of and transparency surrounding companies from emerging markets, particularly from China. The same alarms that the SEC raised, and that are the source of the regulatory and legislative action discussed above, will raise concerns among D&O insurance underwriters, both within the U.S. and even domestically in China. It doesn’t take many scandals like Luckin Coffee to change perceptions and alter perspectives. The continuing regulatory focus on these issues are likely to add to the heightened awareness among D&O insurance underwriters of the risks associated with Chinese companies. The concerns surrounding these companies is unlikely to change soon, unless and until greater regulatory controls are put in place and taking substantial effect.
The Sidley law firm memo to which I linked above contains a detailed summary of the provisions of the Senate bill.