The Holding Foreign Companies Accountable Act (“HFCA”) was adopted on December 18, 2020, requiring both the SEC and the PCAOB to adopt rules and procedures implementing its provisions. The HFCA requires foreign-owned issuers to certify that the PCAOB has been able to audit specified reports and inspect their audit firm within the last three years. If the PCAOB is unable to inspect the company’s public accounting firm for three consecutive years, the company’s securities are banned from trading on a national exchange.
As part of the HFCA’s implementation, on November 5, 2021, the SEC approved PCAOB Rule 6100 establishing a framework for the PCAOB’s determination that it is unable to inspect or investigate completely registered public accounting firms located in foreign jurisdictions because of a position taken by an authority in that jurisdiction (see HERE .) On December 2, 2021, the SEC adopted amendments to finalize rules implementing the submission and disclosure requirements in the HFCA and published a sample letter that could be issued to China-based companies. In early 2022, the SEC began publishing a list of companies identified under the HFCA and providing notice to those companies.
In late December 2021 and early 2022, a slew of China-based companies delisted from U.S. Exchanges or announced an intention to do so, including many high-profile entities such as Didi Global, which had completed a $4.4 billion IPO just months earlier. Around the same time, Chinese-based IPO’s and de-SPAC transactions grounded to a halt, some voluntarily and some involuntarily as the SEC authorized an informal pause on any new listings utilizing a variable interest entity (“VIE”) structure. A VIE structure is one where a newly created shell company enters into service and other contracts with the China-based operating entity such that the monetary substance of the operations flows through the shell company. Even though the shell does not have any direct ownership in the China-based operations, it is able to consolidate financial statements as it has the monetary benefit. The VIE structure is often used to avoid China regulatory restrictions on foreign ownership.
Other companies have opted to change auditors to a firm located in the U.S. or elsewhere, prompting the SEC’s acting chief accountant, Paul Munter, to issue a warning statement on September 6, 2022, directed at the newly hired auditing firms. The statement came shortly after the PCAOB and the China Securities Regulatory Commission and Ministry of Finance signed a Statement of Protocol reaching a tentative deal to allow the PCAOB to fully inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong. Despite the deal, there remains a large degree of skepticism as to whether implementation and practice will satisfy the requirements of the Sarbanes-Oxley Act of 2002 (“SOX”) and related PCAOB standards.
This blog will discuss the final SEC rules implementing the HFCA and in next week’s blog, I will discuss the PCAOB Statement of Protocol reached with China officials. Finally, in a third blog in the series, I will delve into the sample comment letter to China-based issuers, which provides important disclosure guidance.
Background
SOX mandates that the PCAOB inspect registered public accounting firms in both the United States and in foreign jurisdictions and investigate potential statutory, rule, and professional standards violations committed by such firms and their associated persons. The HFCA requires that the SEC identify each “covered issuer” that has retained a registered public accounting firm to issue an audit report where that firm has a branch or office located in a foreign jurisdiction. Further, as to a covered issuer, the PCAOB must determine that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction.
The HFCA requires foreign owned issuers to certify that the PCAOB has been able to audit specified reports and inspect their audit firm within the last three years. If the PCAOB is unable to inspect the issuer’s public accounting firm for three consecutive years, the issuer’s securities are banned from trading on a national exchange or through other methods.
To implement compliance with the requirements of the HFCA, the SEC adopted final interim rules on July 30, 2021 (see HERE). The rules apply to covered companies that the SEC identifies as having filed an annual report on Forms 10-K, 20-F, 40-F or N-CSR with an audit report issued by a registered public accounting firm that is located in a foreign jurisdiction and that the PCAOB has determined it is unable to inspect or investigate completely because of a position taken by an authority in that jurisdiction.
The SEC rules require identified companies to submit documentation to the SEC, on or before its annual report due date, establishing that it is not owned or controlled by a governmental entity in that foreign jurisdiction. The company will also be required to include disclosure in its annual report regarding the audit arrangements of, and governmental influence on the company. If the company is identified by the SEC (“Commission-Identified Issuers”) for three consecutive years, the SEC will prohibit trading of the company’s securities.
In addition, Commission-Identified Issuers must include disclosure for each non-inspection year:
- Identifying the registered accounting firm that prepared an audit report;
- the percentage of shares owned by governmental entities where the issuer is incorporated;
- whether these governmental entities have a controlling financial interest;
- information related to any board members who are officials of the Chinese Communist Party; and
- whether the articles of incorporation of the issuer contain any charter of the Chinese Communist Party.
Amendments to Finalize HFCA Rules
On December 2, 2021, the SEC adopted amendments to finalize rules implementing the submission and disclosure requirements in the HFCA and published a sample letter that could be issued to China-based companies. The final rules substantially conform to the interim rules published on July 30, 2021 (see HERE).
The final amendments require Commission-Identified Issuers to submit documentation to the SEC establishing that, if true, it is not owned or controlled by a governmental entity in the public accounting firm’s foreign jurisdiction. The amendments also require that a Commission-Identified Issuer that is a “foreign issuer,” as defined in Exchange Act Rule 3b-4, provide certain additional disclosures in its annual report for itself and any of its consolidated foreign operating entities. The release also provides information regarding the procedures the SEC has established to identify issuers and to impose trading prohibitions on the securities of certain Commission-Identified Issuers, as required by the HFCA.
Documentation Submission Requirements
As stated above, the HFCA requires identified companies to submit documentation to the SEC, on or before its annual report due date, establishing that it is not owned or controlled by a governmental entity in that foreign jurisdiction. As part of the interim final rules, the SEC amended Form 10-K, Form 20-F, Form 40- F, and Form N-CSR to implement this provision. Disclosure must be tagged with inline XBRL. Neither the interim rules nor the HFCA specified the particular types of documentation that could or should be submitted for this purpose allowing for flexibility by the particular company to satisfy the requirement.
The final amendments require any Commission-Identified Issuer to submit to the SEC, on or before the due date of the relevant annual report form, through EDGAR, documentation establishing that the issuer is not owned or controlled by a governmental entity in the foreign jurisdiction of the PCAOB-Identified Firm. This submission will be made publicly available on EDGAR. The final amendments continue to allow the Commission-Identified Issuer to determine the appropriate documentation to submit in response to the requirement, based on their organizational structure and other company-specific factors. The SEC specifically declined to provide examples of the type of documentation.
Although the terms are not defined in the statute, the SEC rule release indicates that the meaning of the terms “owned or controlled,” “owned,” and “controlling financial interest” in the HFCA reference a person’s or governmental entity’s ability to “control” the registrant as that term is used in the Exchange Act and the Exchange Act rules.
Disclosure Requirements
Commission-Identified Issuers must include disclosure for each non-inspection year:
- Identifying the registered accounting firm that prepared an audit report;
- the percentage of shares owned by governmental entities where the issuer is incorporated;
- whether these governmental entities have a controlling financial interest;
- information related to any board members who are officials of the Chinese Communist Party; and
- whether the articles of incorporation of the issuer contain any charter of the Chinese Communist Party.
The rules require a company to provide the disclosure for each year that it is a Commission-Identified Issuer with a look back at prior years, even if there has been a change in status. As part of the interim rules, the SEC amended Form 10-K, Form 20-F, Form 40-F,32 and Form N-CSR33 to reflect the disclosure requirements.
The final amendments modify the interim rules to specifically state that the disclosure is required for all entities consolidated in the financial statements, whether by VIE or any other structure.
Timing
The SEC reiterates that a company will not be subject to a non-inspection year determination for any fiscal year ending on or prior to December 18, 2020. Consistent with this, the SEC started identifying Commission-Identified Issuers after such companies filed their annual reports for 2021 and identified their accounting firms. Any Commission-Identified Issuer would need to comply with the submission and, if applicable, the disclosure requirements in its annual report filing covering the fiscal year ended December 31, 2022, that it is required to file in 2023.
Determination of Commission-Identified Issuer
The SEC determines a Commission-Identified Issuer based on the audit report included in a company’s final report filed with the SEC. Likewise, an auditor is determined to be retained by a company when it signs the accountant’s report on the company’s consolidated financial statements that is included in a registrant’s Exchange Act report. The SEC publishes a list of Commission-Identified Issuers, including the number of consecutive years so identified, on its website on a page dedicated to the HFCA.
Process for Trading Prohibition
In accordance with the HFCA, if a company is identified by the SEC as a Commission-Identified Issuer for three consecutive years, the SEC will prohibit trading of the company’s securities. The HFCA also provides that the SEC shall end an initial trading prohibition if the issuer certifies to the SEC that it “has retained a registered public accounting firm that the [PCAOB] has inspected” to the satisfaction of the SEC. If a subsequent trading prohibition is imposed under the HFCA, the second prohibition must be for a minimum of five years.
As mentioned, the SEC publishes a list of Commission-Identified Issuers, including the number of consecutive years so identified, on its website on a page dedicated to the HFCA. The list will also include any prior trading prohibition under the HFCA. The SEC believes this provides adequate notification to investors and public market participants.
The SEC believes that a trading prohibition should be imposed “as soon as practicable” after the company has been determined to be a Commission-Identified Issuer for three consecutive years. Procedurally the SEC will publish an order of the trading suspension and the actual suspension shall begin on the fourth business day after the order is published.
Process for Terminating Trading Prohibitions
A Commission-Identified Issuer subject to an initial trading prohibition can make the required certification that it “has retained” a non-PCAOB-Identified Firm to the satisfaction of the SEC only if such certification is preceded or accompanied by the filing of an annual report or an amended annual report with financial statements that include an audit report on the consolidated financial statements signed by a non-PCAOB-Identified Firm. Once the SEC receives the certification and has verified that the company has, in fact, filed an annual or amended annual report with financial statements that includes the required audit report, the SEC shall issue an order ending the initial or subsequent trading prohibition, as soon thereafter as practicable. The order will be effective the following business day after issuance.
Refresher on PCAOB Rule 6100
SOX mandates that the PCAOB inspect registered public accounting firms in both the United States and in foreign jurisdictions and investigate potential statutory, rule, and professional standards violations committed by such firms and their associated persons. The PCAOB realized early on that certain aspects of these mandates raised concerns for non-U.S. firms, including potential conflicts with local laws. To address these concerns, the PCAOB worked with international counterparts to develop arrangements and working practices to allow the PCAOB and foreign regulators to achieve their respective requirements.
To ensure that cooperation with foreign regulators maintain the spirit and requirements imposed by SOX, any arrangement with a foreign regulator must allow the PCAOB to: (i) conduct inspections and investigations in accordance with SOX; (ii) select the audit work and potential violations to be examined; and (iii) access firm personnel, audit work papers and other information and documents deemed relevant by the PCAOB.
Although most companies cooperate, not all regulators have despite repeated efforts. Over the years, the PCAOB has maintained a “Denied Access List” which identifies the jurisdictions where the PCAOB cannot conduct inspections because foreign authorities have denied access, and the auditors from those jurisdictions issue audit reports filed with the SEC for U.S.-listed foreign public companies. As of today, the PCAOB can conduct inspections everywhere it needs to do so except in mainland China and Hong Kong. Against this backdrop, Congress enacted the HFCA requiring the PCAOB to determine whether it is unable to inspect or investigate completely a registered public accounting firm that is located in a foreign jurisdiction because it is denied access by one or more authorities in that jurisdiction.
PCAOB Rule 6100 establishes the process for the PCAOB’s determinations under the HFCA; the factors the PCAOB will evaluate and the documents and information the PCAOB will consider when assessing whether a determination is warranted; the form, public availability, effective date, and duration of such determinations; and the process by which the Board will reaffirm, modify, or vacate any such determinations.
Determinations as to Registered Firms Headquartered in a Particular Jurisdiction
A determination by the PCAOB that it is denied access to a firm headquartered in a foreign jurisdiction because of a position taken by one or more authorities in that jurisdiction, applies to all firms headquartered in that jurisdiction. A jurisdiction-wide determination not only assists in the administrative efficiency of the statute, but is also consistent with the HFCA’s language that access must be denied due to a position taken by an authority (regulator/government) in that jurisdiction. Moreover, a jurisdiction-wide assessment will allow for consistency.
Rule 6100 provides for jurisdiction wide determinations related to firms headquartered in that jurisdiction. “Headquarters” are defined as where the firm has its principal place of business, including where the firm’s management directs, controls and coordinates the firm’s activities. The PCAOB will make a rebuttable presumption that a firm is headquartered at the physical address reported by the firm as its headquarters to the PCAOB in the firm’s required filings. Where a firm is not headquartered but merely has a presence in the jurisdiction, the PCAOB will consider the extent of the firm’s presence and the nature of the audit work performed. However, based on experience, the PCAOB believes that most determinations will be jurisdiction-wide.
In making a jurisdiction-wide determination, the board will consider laws that restrict access, not whether the accounting firms are abiding by or availing themselves of those laws. For example, foreign laws may only deny access for certain business sectors or companies with specific business models. Even if only a few registered firms in that jurisdiction presently are auditing issuers in that sector or with that business model, the PCAOB would assess whether its access would be equally impaired should any registered firm in the jurisdiction perform the restricted engagements. Moreover, the PCAOB will consider restrictions by any regulator or governmental authority in that jurisdiction.
Determinations as to a Particular Firm with an Office in a Foreign Jurisdiction
Although as of now the PCAOB believes all determinations will be jurisdiction-wide, to account for unforeseen circumstances, Rule 6100 provides for a scenario in which the problem is with a particular firm and allows the PCAOB to make a determination of denied access on a firm-by-firm basis. For example, although it is not the case today, a foreign jurisdiction could impose rules that apply to registered accounting firms headquartered in its jurisdiction but not to firms that merely have an office there.
Apart from the determination being directed to a firm as opposed to a jurisdiction, the standards for making a determination are exactly the same under the Rule. Also, if a firm is a member of an international network but a separate legal entity, the other member firms will not be affected by a PCAOB determination of denied access.
Factors for Board Determinations
In determining whether it can inspect or investigate completely in a particular jurisdiction or as to a particular firm, the PCAOB will assess whether “the position taken by the authority (or authorities)” in the jurisdiction “impairs the PCAOB’s ability to execute its statutory mandate with respect to inspections or investigations.” The HFCA does not define “inspect or investigate completely.” The PCAOB defines the term broadly and includes when it is not able to commence an inspection or investigation or when, based on the PCAOB’s knowledge and experience, it has concluded that commencing an inspection or investigation would be futile as a result of the position taken by a foreign authority.
Rule 6100 ties the PCAOB’s ability to “inspect or investigate completely” to three core principles that guide the PCAOB’s framework for international cooperation. Specifically, the PCAOB will consider whether it: (i) can select the audits and audit areas it will review during inspections and the potential violations it will investigate; (ii) has timely access to firm personnel, audit work papers, and other documents and information relevant to its inspections and investigations, and the ability to retain and use such documents and information; and (iii) can otherwise conduct its inspections and investigations in a manner consistent with SOX and the PCAOB’s rules.
In making a determination, the PCAOB does not have to find that all three considerations are present. Impairment in any one respect may be sufficient under the circumstances to support a PCAOB determination. Similarly, the PCAOB does not need to conclude that it has been impaired as to both its inspections and its investigations.
Timing of Board Determinations
To begin, the PCAOB will make any determinations promptly upon the Rule’s effectiveness. Thereafter, the PCAOB will make an annual review of its findings to see if any changes in facts and circumstances warrant an adjustment to a determination, or if new jurisdictions or firms should be added. In addition, the Rule allows the PCAOB to make interim determination whenever it deems appropriate.
Basis for Determinations
Rule 6100 provides that when assessing whether its ability to execute its mandate has been impaired, the PCAOB may consider “any documents or information it deems relevant.” From there, the rule specifies three non-exclusive categories of documents and information that the PCAOB can rely upon when making a determination, but stresses that the PCAOB can consider anything it deems relevant.
The three non-exclusive categories include: (i) a foreign jurisdiction’s laws, statutes, regulations, rules, and other legal authorities as well as relevant interpretations of those laws; (ii) the entirety of the PCAOB’s efforts to reach and secure compliance with agreements with foreign authorities in the jurisdiction, including whether an agreement was reached, the terms of the agreement, interpretation and performance under the agreement; and (iii) the PCAOB’s experience with foreign authorities’ other conduct and positions relative to PCAOB’s inspections or investigations.
Form and Publication of Board Determinations
When the PCAOB makes a determination, it will issue a report to the SEC. The PCAOB’s report will describe its assessment of whether the position taken by the foreign authority (or authorities) impairs the PCAOB’s ability to execute its mandate with respect to inspections or investigations. The report will analyze the relevant factor(s) and describe the basis for the PCAOB’s conclusions. The PCAOB will identify the firm(s) subject to the PCAOB’s determination by the name under which the firm is registered with the PCAOB, and by the firm’s identification number with the PCAOB.
Promptly upon furnishing the report to the SEC, the report will be published on the PCAOB website. If necessary, the report will be redacted if it includes private personal information that is confidential as a matter of law. A copy of the report will also be sent to the effected firm(s) by email.
Effective Date and Duration of Board Determinations
A determination becomes effective upon the PCAOB’s delivery of a report to the SEC and will be re-assessed at least annually.
Reassessment of Determination
The PCAOB will consider whether changes in facts and circumstances warrant a reassessment of a determination that is in effect. If the PCAOB concludes that a reassessment is warranted, the PCAOB will analyze the same factors as when making an initial determination and decide whether to leave its determination undisturbed or issue a new report modifying or vacating the determination. Apart from that annual process, the PCAOB also can reassess a determination on its own initiative or at the SEC’s request at any time.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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