The Holding Foreign Companies Accountable Act (the “Act”), Pub. L. No 116–222, was signed into law by President Trump on December 18, 2020. The Act aims to protect American investors from foreign companies that are listed on U.S. stock exchanges but are not willing to be subject to the full oversight of the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB). Although the Act refers to “foreign jurisdictions” that do not permit inspections, Chinese companies are the primary target of the Act. According to a statement by Senator Chris Van Hollen (D-MD) who sponsored the bill, “millions of Americans … have been cheated out of their money after investing in seemingly-legitimate Chinese companies that are not held to the same standards as other publicly listed companies. The Act rights that wrong, ensuring that all companies on the U.S. exchanges abide by the same rules.” The “seemingly-legitimate Chinese companies” he mentioned include companies like Luckin Coffee, Kangmei Pharmaceutical, GSX Techedu, and many others. Luckin Coffee was delisted from the Nasdaq Stock market for faking its sales after it raised more than $1 billion. Kangmei, a Chinese company included in Morgan Stanley Capital International (MSCI) global indexes, mysteriously “lost” $4.4 billion.GSX Techedu, a Chinese tutoring company,is being investigated by the SEC for inflating its sales. Before the investigation began, GSX had a market capitalization of $22.6 billion.
For decades Chinese companies avoided oversight by PCAOB, a principal U.S. regulator that oversees the quality of audits of public companies, issuers that file financial statements with the SEC, and SEC-registered brokers and dealers. This is because the Chinese government has shielded their auditing firms from inspections by enacting state secrets and national security laws that limit foreign access to China-based business records. As of January 2021, out of the 247 issuers whose auditor is located outside of PCAOB inspection jurisdiction, 222 (90 percent) have auditors based in mainland China or Hong Kong. PCAOB carries out inspections outside of US based on the formal cooperative arrangements that it executes with foreign audit regulators. Currently, PCAOB has such arrangements with 24 countries.
The lack of transparency into accounting and governance practices of Chinese firms became critical due to substantial growth of Chinese listings on U.S. exchanges. By the end of 2019, Chinese companies so listed had a combined market capitalization of $1.2 trillion. Alibaba Group Holding Ltd (BABA.N), Baidu Inc. (BIDU.O) and JD.com Inc. (JD.O) together have a combined U. S. market capitalization of more than $500 billion. American investors have also taken on more exposure through indexes—as emerging-market indexes have substantially increased the proportional share of Chinese companies in the past years. In 2019, the International Monetary Fund estimated that the inclusion of Chinese domestic securities into major global indexes will generate within two years approximately $450 billion net inflow into the Chinese economy, which equals 3 to 4 % of China’s GDP.
The Act prohibits securities of a company from being listed on any of the U.S. securities exchanges if the company has failed to comply with the PCAOB’s audits for three years in a row. This is a fair proposition: if Chinese companies want to be listed on U.S. exchanges, they must comply with American laws and regulations for financial transparency and accountability. Moreover, more than a decade of sustained and focused PCAOB efforts to work within Chinese government limitations and to compensate for such obstacles has proven ineffective.[1] Additionally, the Act will level the playing field for American companies that spend an average of $1.5 million per year in compliance costs — costs not paid by Chinese companies. The Act also requires public companies to disclose whether they are owned or controlled by China’s communist government.
The day the Act was signed by President Trump, SEC Chairman Jay Clayton announced that the Commission will not issue a separate rule it was considering. That rule was based on recommendations made by the President’s Working Group on Financial Markets Report on Protecting United States Investors from Significant Risks from Chinese Companies due to its “substantial overlap” with the Act. Instead, it will “consider providing a single consolidated proposal for the Commission’s consideration on issues related to the PCAOB’s access to audit work papers, exchange listing standards, and trading prohibitions.” In the same announcement, the SEC Chairman stated that the agency will work on additional issues relating to the Act’s implementation, such as expediting disclosure requirements and addressing any perceived uncertainties.
Besides gaps in regulatory oversight addressed by the Act, Chinese stocks carry additional risks due to ownership structure and concerns of supporting human right abuses or harming U.S. national security by subsidizing firms that work closely with the Chinese military. Many U.S.- listed Chinese firms employ an ownership structure that carries legal ramifications, risks of owner expropriation, taxation, and corporate governance. There is also growing debate over the ethics of investing in Chinese companies that are complicit in human-rights violations, including genocide of the Muslim Uyghur population.
It will take three years before we start seeing the tangible results from the Act because the SEC can prohibit the covered securities from being traded on a national securities exchange only after three consecutive years of non-inspections. In the meantime, President Trump barred U.S. investments in Chinese firms that are owned or controlled by the military. The New York Stock Exchange (NYSE) has already started the process of delisting securities of three Chinese telecom companies: China Telecom Corporation Limited, China Mobile Limited 0941.HK, and China Unicom (Hong Kong) Limited. Other global index providers such as MSCI, S&P, Dow Jones, FTSE Russell, and Nasdaq are also in the process of deleting various Chinese companies from their indexes.
[1] Despite the PCAOB’s efforts, there is little sign of improved inspection access to audit firms in China. In March 2020, Article 177 of the newly amended Securities Law of the People’s Republic of China came into effect, declaring that “no entity or individual from [China] may provide documents and material related to securities business activities to overseas [regulators]” without approval of the governmental securities regulatory authority. See PWG Report, note 21, at 7.