On December 2, the U.S. House of Representatives passed the Holding Foreign Companies Accountable Act (the “HFCAA” or the “Act”). The Act was passed by the Senate last May, and now just awaits the President’s signature.
The HFCAA is summarized here in this Paul, Weiss client memo, and there’s no need for me to repeat everything that memo says. I just have a few comments on things not covered by the memo. But a brief review of how the Act operates is necessary to set the stage for the questions. I’ll use a lot of acronyms that don’t appear in the Act itself, but they’re there for a purpose and I hope they will assist more than impair understanding. My thanks up front to Paul Gillis and Jesse Fried, who saved me from a couple of embarrassing mistakes.
- The Act covers essentially any company required to file periodic reports under the 1934 Securities Act. Such a company is called a “covered issuer.”
- The Act then asks whether the covered issuer was audited by what I’ll call an “inspection-impaired auditor” (IIA): a registered public accounting firm that has a branch or office in a foreign jurisdiction that the PCAOB was unable to inspect or investigate completely because the foreign government blocked it from doing so. The specific language (Section 2(i)(2)(A)) speaks of
a registered public accounting firm that has a branch or office that—
(i) is located in a foreign jurisdiction; and
(ii) the Board is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction described in clause (i), as determined by the Board
If so, I’ll call it a “disclosure-mandated covered issuer” (DMCI). I’ll talk about the bolded section below in Questions 1 and 2.
- All DMCIs must submit to the SEC documentation establishing that they are not owned or controlled by a governmental entity in the foreign jurisdiction (actually, any of the foreign jurisdictions) where the PCAOB cannot conduct inspections because of foreign government blocking. Let’s call this the “government ownership disclosure requirement” (GODR).
- A “non-inspection year” means every year in which a covered issuer is a DMCI with respect to all reports required to be filed under sections 13 or 15(d) of the 1934 Securities Exchange Act (basically, all the basic disclosure filings). If a covered issuer has three consecutive non-inspection years, trading in its shares must stop. (This is technically a little different from delisting, but the ultimate effect is the same.) There are provisions for cure, but I won’t cover them here. But note that a “non-inspection year” could, as noted below in Question 2, occur for a wholly domestic U.S. firm inspected by a U.S.-based auditor that is subject to PCAOB inspection.
- A DCMI that is a foreign issuer must also disclose:
(a) that its auditor is an IIA;
(b) 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;
(c) 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;
(d) the name of each official of the Chinese Communist Party who is a member of the board of directors of—
(A) the issuer; or
(B) the operating entity with respect to the issuer; and
(e) whether the articles of incorporation of the issuer (or equivalent organizing document) contains any “charter”—the Act does not define this term—of the Chinese Communist Party, including the text of any such charter.
Here are my questions:
- What counts as a “branch or office” (Para. 2 above), and where is this term defined? The Big 4 accounting firms operate essentially on a franchise model in which group members are affiliates in a network. The accounting firm in China that calls itself Ernst & Young Hua Ming is not meaningfully a branch or office of an Ernst & Young entity in the United States. They don’t share management responsibilities or profits and losses. Neither can tell the other what to do, and there is no superior entity that can tell both what to do. Thus, the Act should not apply to firms audited by US-based auditors where those auditors merely happen to have network affiliates in China, provided of course that those China-based network affiliates have nothing to do with the audits. But presumably that will depend on whatever definition of “branch or office” the SEC comes up with.
- Let’s take a non-China situation and consider a country where, unlike in China, foreign-owned auditing firms are allowed to practice. This makes it theoretically possible for the following situation to occur: a wholly domestic U.S. company, incorporated in the U.S., owned entirely by U.S. shareholders, and operating entirely in the U.S., is audited by a U.S. auditing firm that has a “branch or office” in a foreign country that doesn’t allow inspections. The auditor then becomes an IIA, and the company then becomes a DMCI, subject to all the rules that apply to DMCIs. This is true even though the uninspectable foreign branch or office had nothing to do with the audit of the U.S. company. This obviously makes no sense at all. I don’t understand why the drafters didn’t take the simpler route and just define an IAA as an auditor that the SEC is unable to inspect, and thus a DCMI as any company audited by an auditor that the SEC is unable to inspect. (In other words, just delete “that has a branch or office” from Sec. 2(i)(2)(A).) That’s surely what the heart of the problem is.
- What is the point of the GODR imposed on DMCIs (Para. 3 above)? What happens if they cannot truthfully submit the required documentation? The Act doesn’t specify any consequences.
- Formalistic conceptions of ownership: The Act seems to take a very formalistic (and in the Chinese context, unrealistic) view of ownership. It’s concerned about foreign (OK, let’s admit it: Chinese) government influence over companies. But it asks questions about formal matters such as the percentage of shares owned by governmental entities and whether there are Chinese Communist Party officials (are all CCP members deemed “officials”?) on the Board of Directors (Para. 5(b) & (d) above). The CCP does not exercise its influence in such a straightforward manner and those questions don’t touch on a lot of important information. It would be utterly wrong to conclude that if the state owns no shares and there are no CCP members on the board, then there is no need to worry about Party-state influence.
- I just don’t understand the disclosure requirement about the “charter of the Chinese Communist Party” (Para. 5(e) above). The charter of the CCP is a specific document. What does it mean to ask whether a company’s articles of incorporation contain “any charter” of the CCP? Does it mean, “any provision for a CCP body or CCP influence within the company”? Is so, why not just say so? The use of the term “charter” is confusing and ambiguous, at least to me.
1 thought on “The Holding Foreign Companies Accountable Act: some questions”
I’m really not sure how any of this helps anyone, except the issuers themselves. In case of any cease trading situations, it will be the shareholders in the US who will be left holding the bag.
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