In new guidance, the division also offers questions that China-based issuers should consider as they try to fulfill their disclosure obligations.
The SEC’s Division of Corporation Finance has issued new disclosure guidance offering its views on disclosure considerations for companies based in or with the majority of their operations in China. As a baseline matter, the staff reminded investors that its ability to promote and enforce high-quality disclosure standards for China-based issuers may be materially limited, and that in the event of investor harm investors generally will have substantially less access to recourse than they do for U.S. companies.
According to the staff, one of the most significant risks to high-quality, reliable disclosure and financial reporting by China-based issuers results from restrictions on the PCAOB’s ability to inspect audit work and practices of PCAOB-registered public accounting firms in China and Hong Kong. The Sarbanes-Oxley Act requires the PCAOB to inspect registered accounting firms to assess their compliance with auditing standards, but China has not provided the PCAOB access to inspect or investigate registered public accounting firms with respect to their audits of China-based issuers.
Congressional action. Both the House and Senate have independently pursued bills that could result in delisting companies that use an auditor that the PCAOB is not able to inspect. The Senate bill, S. 945, passed the Senate by unanimous consent in May and is scheduled for a vote in the House on Wednesday.
The bill amends the Sarbanes-Oxley Act to require disclosures about foreign companies that reside in jurisdictions that bar PCAOB inspections. If it passes the House, the legislation would be sent to the president, whose signature is likely.
Access and oversight. The guidance also discusses China’s restriction of U.S. regulators’ access to information and limitations on regulators’ ability to investigate or pursue remedies with respect to China-based issuers. Under a Chinese law enacted in March, no overseas securities regulator can directly conduct investigations or evidence collection activities within China, 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, the SEC and other U.S. authorities face substantial challenges in bringing and enforcing actions against China-based companies.
The guidance addresses the fact that Chinese regulations currently limit or prohibit foreign investment in some Chinese entities such as telecommunications companies and educational institutions. In order to circumvent these restrictions, many China-based companies form non-Chinese holding companies that enter into contractual arrangements intended to mimic direct ownership with Chinese operating companies known as variable interest entity (VIEs).
The staff advised that VIE structures pose risks to U.S. investors that are not present in other organizational structures. For example, 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, the staff noted.
The staff also points out in the guidance that the Chinese legal system is substantially different from the system in the U.S. and may raise risks concerning the intent, effect, and enforcement of its laws, including those that restrict the inflow and outflow of foreign capital. As a result, the Chinese government may be able to exert significant influence on a China-based company’s ability to conduct business or raise capital.
Recourse, governance and reporting. The guidance states that legal claims, including federal securities law claims, against China-based issuers or their principals may be difficult for investors to pursue in U.S. courts. Even if an investor obtains a judgment in a U.S. court, the staff continued, the investor may be unable to enforce that judgment because China may not recognize or enforce U.S. judgments. Claims and remedies in non-U.S. jurisdictions are often significantly different from those available in the U.S. and difficult to pursue, the staff noted.
With respect to governance issues, the guidance states that China-based issuers are often organized or incorporated in jurisdictions outside of both China and the U.S. where the fiduciary duties that directors owe investors may be narrower in scope or less developed than in the U.S. Moreover, Chinese companies qualify as foreign private issuers in the U.S. which means, among other things, they may not be required to: (1) have a majority of independent directors; (2) have independent audit committee members, compensation committee members, and nominating committee members; (3) have independent board members meet in executive session; (4) hold annual meetings; or (5) obtain shareholder approval for certain issuances of securities.
The guidance also reminds investors that to the extent that China-based companies qualify as foreign private issuers, they are exempt from certain reporting requirements under the federal securities laws. This includes an exemption from filing quarterly reports, current reports on Form 8-K, and the solicitations of proxies under Exchange Act Section 14. Foreign private issuers also have four months after the end of the fiscal year to file their annual reports.
Disclosure considerations. As part of the guidance, the staff provided a number of questions for a China-based company to consider as it prepares to disclose the material risks related to its operations in China. According to the staff, a company should ask itself whether it provides 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 China-based companies that engage audit firms based in China or Hong Kong, the staff recommends that 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 them, 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 U.S.; and
- 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.
In instances where the China-based company uses VIEs in its organizational structure, the staff suggests that the company ask whether it has provided sufficient disclosure about the related party transactions in the VIE structure. It also should caution investors about the risks associated with the VIE structure employed in China, the staff said.
Finally, the staff recommends that a China-based issuer consider whether it has disclosed 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. The guidance provides a list of specific questions that could guide a company’s disclosure in this area.
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