SEC Targets Publicly Traded Chinese Issuers Under the Holding Foreign Companies Accountable Act

Since Baidu, Inc. (BIDU) completed its going public transaction in August 2005 on the NASDAQ Stock Market, many U.S. investors have found themselves fascinated and frustrated by Chinese companies. Baidu, a technology giant and AI developer offering, among many other things, the world’s second-largest search engine, has been a winner overall. But not all publicly traded Chinese companies in the States have been as kind to their investors. Some have simply failed to succeed, but others have committed serious fraud. Blatant as it often is, it’s also hard to nail down because Chinese companies, and even the Chinese government, have shown resistance to accounting safeguards we’ve come to consider normal in the wake of our own public company scandals of the first decade of the century. 

In 2020, Congress passed the Holding Foreign Companies Accountable Act (HFCAA); it was signed into law on December 18. Technically an amendment to the Sarbanes-Oxley Act of 2002, it requires “foreign issuers” to declare that they aren’t owned or staffed by the Chinese Communist Party. In addition, Chinese companies that have securities registered with the SEC must use auditors whose work can be inspected by the Public Company Accounting Oversight Board (“PCAOB”). The PCAOB was created by the Sarbanes-Oxley Act in 2002 and, since then, has regularly inspected auditing firms that deal with public companies. The HFCAA requires that the PCAOB do the same in China, inspecting the firms that audit Chinese companies trading on U.S. exchanges. 

Unsurprisingly, the Chinese government is not enthusiastic about accepting orders from Congress, the Securities and Exchange Commission, and the PCAOB. If no agreement can be reached, the SEC will begin to delist issuers who do not retain auditors willing to submit to regular PCAOB inspections. As we shall see, the plan of action is complicated, and deadlines are fast approaching.

The Chinese government has its own concerns about Chinese companies with overseas listings. It says its chief interests are in data security protection and cross-border data flows. On July 6, 2021, the General Offices of the Chinese Communist Party Central Committee and State Council jointly issued Opinions on Strictly Cracking Down on Illegal Securities Activities in accordance with the Law. While the offenses meant to result in those strict crackdowns are not specifically described, what will happen to violators is rather menacingly explained:

Market restraint mechanisms shall be strengthened. The reform of the delisting system shall be advanced, and delisting supervision shall be strengthened. The compulsory delisting system shall be strictly implemented. The regulatory and risk disposal systems for delisted companies shall be studied and improved so as to improve the virtuous circle mechanism for the survival of the fittest of listed companies.

As of March 31, 2022, there were 261 Chinese companies listed on the New York Stock Exchange, the NASDAQ, and the NYSE American, with a total market capitalization of $1.3 trillion. Approximately 70 more currently trade over-the-counter; a useful list of them seems to be a few months out of date, as it does not include DIDI/DIDIY, which moved to the OTC from the NYSE in mid-June. A few have already been pressured to delist; probably more will follow. And for the issuers, there’s a new cop on the beat: the Cyberspace Administration of China (CAC). It created new rules that took effect in February (though they don’t apply to issuers already listed abroad) and is said to be meeting with companies it suspects of wrongdoing.

Obviously, none of this is good for investors interested in exploring the potential of Chinese companies. Neither is it good for our markets, the exchanges, or the companies themselves. It’s bad enough for investors to be unsure about an issuer’s prospects but much worse for them to feel as if they’re caught in the middle of a regulatory battle with an uncertain outcome.

The HFCAA

The HFCAA seems to have been a rare Congressional feel-good, bipartisan effort. But naturally, its passage was just the beginning: the administration of the new law would be left to the SEC and the PCAOB. It was succinctly described as an Act:

To amend the Sarbanes-Oxley Act of 2002 to require certain issuers to disclose to the Securities and Exchange Commission information regarding foreign jurisdictions that prevent the Public Company Accounting Oversight Board from performing inspections under that Act, and for other purposes.

The bill seems to some extent have been inspired—or at least fueled—by the sorry tale of Luckin Coffee (now LKNCY). Luckin went public in May 2019 to some fanfare. It was a Starbucks knockoff, serving lattes and muffins all over China. Luckin raised $561 million in its IPO, and the stock rose from $17 to more than $50 in January 2020. In the same month, short seller Carson Block, known as “Muddy Waters,” published a detailed and damning report on the company. As the scheme unraveled, it was discovered that the company officers had engaged in multiple kinds of financial fiddles to cover the fact that they had fabricated more than $300 million in retail sales.

The NASDAQ sent a delisting notice, and after a brief flirtation with the idea of defending itself at a hearing, Luckin dropped its request and was, in turn, dropped from the exchange at the open of business on June 29, 2020. It began trading on OTC Link as a Pink and continues to trade there today. 

On December 16, 2020, the SEC announced a settled enforcement action against the company, which had agreed to pay a $180 million penalty. In its litigation release, the Commission noted that “[a]fter Luckin’s misconduct was discovered in the course of the annual external audit of the company’s financial statements, Luckin reported the matter to and cooperated with SEC staff, initiated an internal investigation, terminated certain personnel, and added internal accounting controls.” The SEC does not reveal what firm worked on that audit. Luckin filed no annual report in 2020 but eventually caught up and is now compliant with its filing obligations. 

For an interesting take on the story as of August 2021, see this case study.

The Luckin fraud had also come to the attention of John Neely Kennedy, the Louisiana senator who co-sponsored the HFCAA bill. In a letter of March 25, 2021, to Allison Herren Lee, Acting Chair of the Commission, he noted:

China has refused to allow U.S. regulators to examine their books since the Sarbanes-Oxley Act established the PCAOB. This standoff continued for years at the expense of American workers and families: Countless Chinese companies defrauded investors-most notably Luckin Coffee, which lost half of its stock valuation overnight. Because this threat to our capital markets system remains, the Commission should act swiftly to identify non-compliant companies that are located in a foreign jurisdiction and have 30% or more of their audit work conducted outside of the reach of the PCAOB.

The fraud committed by Luckin was appalling, yet the company soldiered on. Management, some of it new and some of it gone, appears to have learned a lesson. It’s issued more stock than it probably would have liked—1.48 billion shares—but it’s amazing it’s still alive after the SEC litigation and a class action. This year, it enjoyed blowout first quarter earnings and even booked its first profit. It now has more stores in China than Starbucks. Its stock price, at just under $14, is high enough to give new hope to investors. 

The SEC’s Near-Term Responsibility

The SEC’s role at the outset was (and still is) to:

identify public companies that have retained a registered public accounting firm to issue an audit report where the firm has a branch or office that: (1) is located in a foreign jurisdiction, and (2) the Public Company Accounting Oversight Board (“PCAOB”) has determined that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction.

But before compiling a list, the Commission had to come up with a plan of action, define the terms and scope of that action, and give thought to its implementation. To that end, it produced an Interim Final Release and published it on March 18, 2021; it would become effective on May 5, though a compliance date had not yet been set. On December 2, 2021, the Commission published a Final Release, which would become effective on January 10, 2022. The Final Release was substantially similar to its predecessor, though expanded to offer a reaction to some of the comment letters received.

First of all, the staffers tasked with the job of making a list of “Commission-Identified Foreign Issuers” needed to ask possible candidates to submit documentation to the Commission establishing that they were not owned or controlled by a governmental entity “in that foreign jurisdiction.” That was easy to deal with. The issuers are now required to submit the required declaration, along with supplemental information, if necessary, through Edgar on or before the due date of the relevant annual report form.

Each issuer will also have to provide certain additional disclosures in its annual report:

• That, during the period covered by the form, the PCAOB-Identified Firm that has prepared an audit report for the issuer;
• That, during the period covered by the form, the PCAOB-Identified Firm that has prepared an audit report for the issuer;

• The percentage of the shares of the issuer owned by governmental entities in the foreign jurisdiction in which the issuer is incorporated or otherwise organized;
• Whether governmental entities in the applicable foreign jurisdiction with respect to that registered public accounting firm have a controlling financial interest with respect to the issuer;
• The name of each official of the Chinese Communist Party (“CCP”) who is a member of the board of directors of the issuer or the operating entity with respect to the issuer; and
• Whether the articles of incorporation of the issuer (or equivalent organizing document) contains any charter of the CCP, including the text of any such charter.

Some commenters objected that this kind of information was likely to be unhelpful and might be misunderstood by investors. Their examples were varied, but we might suggest that singling out a businessman in China as a member of the CCP may not be unlike singling out a businessman in this country as a member of the Rotary Club. The SEC’s response was that the commenters were, rightly or wrongly, objecting to the Act itself, and the Commission had no control over its provisions.

A thoughtful letter by Joseph Chan, Chief Legal Officer of Yum China Holdings (YUMC), raises a number of valid points and one particularly troubling question. Yum’s revenue is almost entirely derived from its operations in China, where it operates American branded restaurants: KFC, Pizza Hut, and Taco Bell. It’s incorporated in Delaware and trades on the NYSE. Ten of its 11 board members are independent, as are five members of its audit committee. But its independent public accounting firm (KPMG Huazhen LLP) and the documentation related to its audit report are located in China. As Chan explains it, “The PCAOB is currently unable to conduct full inspections in China or review audit documentation located within China without the approval of Chinese authorities. From the Company’s perspective, there is no administratively feasible way for the company to allow or facilitate PCAOB inspection of our auditors in China.”

His explanation suggests that the same would be true for any Commission-Identified Foreign Issuer whose audits are performed in China. If the issuers can do nothing about the problem, shouldn’t a different approach be considered? Are we counting on U.S. listings for Chinese issuers being important to the Chinese government? Some of them are good companies with institutional investors. Shut them down, or even threaten often enough, and the risk-averse among them will flee. What is in the best interests of our markets and our investors?

The SEC will expect to screen companies at the time they file their annual report. If a company meets all the criteria, it will be “provisionally identified,” and added as such to the Commission’s website. The issuer will then have 15 business days in which to provide the SEC with evidence that it’s been incorrectly “identified.” If the Commission is persuaded, the issuer will be removed from the list. If it is not, the issuer will become a Commission-Identified Issuer.” If the company doesn’t contact the Commission, it will become a Commission-Identified Issuer 15 business days after the provisional identification. Presumably, most companies will join the long list of Commission-Identified Issuers.

The Next Steps

The HFCA Act requires that if an issuer remains on the list for three consecutive years, the Commission must “prohibit the trading on a national securities exchange or through any other method which is within the jurisdiction of the Commission to regulate, including through over-the-counter trading, of the securities of certain Commission-Identified Issuers.” That will be an “initial trading prohibition.” If the issuer certifies to the Commission that it’s retained an auditor the PCAOB has inspected, the Commission can lift the trading prohibition. If the issuer sins again, it will be slapped with a five-year trading prohibition. At the end of the five years, it can try again, making the appropriate representations.

The Commission points out that:

Other commenters noted the importance of clear rules relating to the trading prohibition. One of these commenters highlighted the importance of the Commission establishing a “transparent and well communicated” process with clear information and adequate notice of delisting to minimize disruption to investors in such entities.

That would seem to go without saying. But it raises another point. Just how will the SEC invoke these trading prohibitions? As the Commission says, “t]he federal securities laws generally allow the SEC to suspend trading in any stock for up to ten business days.” But suspensions are nearly always applied to OTC issuers. When the suspension ends, the issuer will need to become compliant with Rule 15c2-11 once again, and so will need a new Form 211. The SEC can suspend trading in exchange-listed stocks, but it rarely does so. However, if it happens, when the suspension ends, no new Form 211 is required. 

But let’s return to the duration of the “trading prohibition.” A suspension lasts 10 days. Perhaps that should be qualified. When the Commission announces the initiation of administrative proceedings to revoke the registration of a delinquent filer, it says the purpose of the proceedings is to determine “[w]hether it is necessary and appropriate for the protection of investors to suspend for a period not exceeding twelve months or revoke the registration of each class of securities registered pursuant to Section 12 of the Exchange Act…” If that option was ever used, it must have been decades ago; we’ve never seen it. But even if it could be applied in this case, it has a time limit of one year. 

So how will these “trading prohibitions” be managed? There has to be a mechanism by which the SEC can do it. We know it can’t get stop symbols from trading, even if they represent no business and have no active corporate identity. They’re called “zombie tickers,” and they can tick on forever. If even they can’t be stopped from trading, what’s to be done with a potentially long list of Commission-Identified Issuers? Does it have anything to do with this?

The Commission is adopting new Rule 30-1(m) that delegates Commission authority to the Director of the Division of Corporation Finance to identify a registrant as a Commission-Identified Issuer. This delegated authority is designed to conserve Commission resources by permitting Commission staff to carry out the procedures described herein in connection with the identification of Commission-Identified Issuers.

Do the “procedures described herein” extend to ordering “trading prohibitions” as well as identifying errant issuers?

The regulator also explains:

After a company has been a Commission-identified issuer for three consecutive years, the SEC will issue an order prohibiting the trading of the company’s securities on any national securities exchange or in the over-the-counter market in the United States.  Trading in the company’s securities will cease once the trading prohibition in the order becomes effective.  Investors holding these securities will have severely limited opportunities to sell the securities, potentially affecting the value of the securities significantly. [Emphasis original.]

Does that mean these stocks—all SEC registrants—will be removed to the Grey Market, or, as OTC Markets calls it, the Expert Market?

And what about penny stocks with a China connection? As we’ve seen, there are currently at least 70. We didn’t check them all, but it looks as if quite a few, not unexpectedly, are or were ADRs (American Depository Receipts) or ADSs (American Depository Shares). Both can be terminated or cancelled by the foreign issuer or by the bank that sells them. Probably that’s what happened to the securities issued by most of these 70 companies. OTC Markets or FINRA ought to take a look at them; FINRA can delete the tickers of inactive issuers.

But what about OTC foreign (i.e., Chinese) issuers that are not SEC filers? We assume they have no problem. At least 31 potential Commission-Identified Issuers have engaged in going-private transactions to deregister their stock. Some were simply bought out by management. It’s a possibility for some issuers, but not for all. Five other companies, these state-owned, are on the verge of voluntary delisting. None has yet departed the NYSE, but China Life Insurance Co. Ltd. (LFC), Sinopec Shanghai Petrochemical Co. Ltd (SHI), PetroChina Co., Ltd. (PTR), and Aluminum Corporation of China Ltd. (ACH) have announced their intention to do so in the near future. It isn’t difficult to see why they’d rather not go into detail about Party bigshots who may sit on the boards of, or own large amounts of stock in, these important issuers.

Returning to the small fry, there are likely to be others that will never undergo SEC scrutiny either because they deregistered years ago and have been trading OTC ever since or were never SEC filers to begin with. They may never have used an auditor because they were not required to do so. In none of its publications on this subject does the SEC consider that possibility.

They say more than once: “Under federal securities laws, the financial statements of public companies must be audited by a registered public accounting firm.” That is incorrect. Issuers without audited financials cannot be listed on a national stock exchange, but they can and do trade on the OTC market. They make whatever disclosure they want, generally using OTC Markets Group’s Alternative Reporting Standard as a rough template.

All of the above is likely to upset retail investors. Institutional investors may decide to cut their losses, making the situation worse for everyone else. If that isn’t enough, the Chinese themselves are, as noted above, worried about data security and other things that have convinced them they need to begin delisting companies that trade in China, encouraging companies that trade elsewhere to deregister, even when that’s the last thing the companies want to do.

DiDi

A case in point is DiDi Global Inc. (DIDIY). Once a high-flying transportation stock, it’s now an example of a different kind. The company is less than 10 years old; it was founded in June 2012. Its only product at that time was an app that customers could use to request taxis and ride shares. By November of the same year, Tencent Holdings (TCEHY), a Chinese tech and entertainment giant, invested $15 million in DiDi. By 2016, Apple (AAPL) was an investor, as was an affiliate of Alibaba (BABA). DiDi was ready for prime time and acquired Uber China. By 2019, Uber (UBER) owned a 15.4 percent stake in DiDi. In the meanwhile, the company was bringing in billions in investment funds.

It seemed unstoppable. At the end of June 2021, it went public on the NYSE, raising $4.4 billion.  But only a few weeks earlier, the Chinese State Administration for Market Regulation had opened an investigation concerning pricing and competitive practices. Only days after the IPO, the CAC stepped in, complaining about the company’s use of personal information. By the end of July, the stock price was cratering. Over the next months, pressure increased on DiDi and other Chinese companies planning IPOs in the United States or already trading on a U.S. exchange. Regulators in China had opposed the NYSE listing, and the government reportedly believed the company had defied it. 

By December, the Chinese authorities were putting pressure on DiDi to delist from the NYSE. That was not accomplished till June 10, 2022. In late spring, it was rumored that the issuer would somehow move, with its securities intact, to the Hong Kong exchange. But that hasn’t yet materialized. In the trading session after the delisting, DIDIY opened on the OTC Market as a Pink Current Information stock. In July, the company was fined the equivalent of $1.2 billion by the CAC for its alleged failure to protect data. To make matters even worse, DiDi was informed on May 3 that the SEC was investigating the 2021 IPO.    

Perhaps DiDi will recover, but it won’t be easy. While the moment of panic that accompanied the tumble the Chinese stocks took this summer has passed, retail investors shouldn’t assume there won’t be more bad news. We now have U.S. and Chinese regulators trying to cooperate, at least to some extent, but making no visible progress. We also have competing politicians, American and Chinese. That is probably not helpful. Add a sprinkling of unhappy institutional investors. 

The SEC has been working on its list of Commission-Identified Issuers. It released the first version on March 30, 2022, and has been updating it frequently. As explained above, whenever a Chinese company, or a company with strong connections to China, files a 10-K or a 20-F, the SEC will check to see if it belongs on the list. If it does, it’ll be added. With luck, now and then, some will be removed. Currently, there are four provisional issuers and nearly 200 issuers on the “conclusive” list. The most recent additions—which include Alibaba Group (BABA)—were made on August 22. 

You’ll find the current provisional and conclusive lists below. It will probably change frequently in earnings season. And save this URL: it’ll take you to it whenever you need:

https://www.sec.gov/hfcaa

Provisional List (they can still dispute) 

 * Must dispute by August 26th 

** Must dispute by September 13th  

Conclusive List (dispute period has passed) 

 *** Has already been delisted 

**** Went private 

To speak with a Securities Attorney about going public or SEC Registration Statements on Form S-1, please contact Brenda Hamilton at 200 E Palmetto Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates | Securities Attorneys
Brenda Hamilton, Securities Attorney
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