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 (see HERE) and published a sample letter that could be issued to China-based companies whether on the HFCA list or not.
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. Other companies have opted to change auditors to a firm located in the U.S. or elsewhere. Amid the turmoil, on August 26, 2022, 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 Statement of Protocol, 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.
In the first blog in this series, I discussed the final SEC rules implementing the HFCA and gave important background information (see HERE). In the second blog I covered the PCAOB Statement of Protocol reached with China officials (see HERE.) Finally, in this third blog in the series, I will delve into the sample comment letter to China-based issuers, which provides important disclosure guidance.
Sample Letter to China-Based Companies
On December 20, 2021, the SEC Division of Corporation Finance (“CorpFin”) published a sample letter to be issued to China-based companies requesting additional disclosures in registration statements and periodic reports. Although the letter came shortly after the publication of the final rules implementing the HFCA, it is not intended to be utilized solely in connection with HFCA-listed companies. The sample letter follows a series of statements and investor warnings related to China-based companies, including a speech by Gary Gensler in July 2021 (see HERE).
CorpFin’s letter covers many risks associated with investing in China-based companies with an emphasis on risks related to variable interest entity (VIE) structures. The sample letter also addresses risks on additional legal, regulatory, and enforcement matters that may apply to investments in China-based companies, such as the potential impact of the HFCA and related rules and any necessary PRC permissions a China-based company may need to operate its business or offer securities to foreign investors.
As a reminder, a VIE structure is one in which there is a contractual arrangement between the China-based and -owned entity and a new shell company created for the sole purpose of entering into the arrangement. The contract between the China based entity and the new shell company is designed to mimic ownership and ownership rights, including rights to profits and responsibilities for liabilities and the ability to consolidate financial statements. The public shareholders are shareholders of the new shell company and not the China-based entity.
CorpFin is concerned that investors have an understanding of the actual legal structure and risks, including the relationship between the entity conducting the offering and the entities conducting the operating activities, risks associated with a company’s use of the VIE structure, and the potential impact on the company’s operations and investors’ interests if such structure were disallowed or the contracts were determined to be unenforceable. In that regard, the SEC requires clear and unequivocal disclosure that the company is a Cayman Islands (or similar) holding company with operations conducted by a subsidiary through contractual arrangements with a VIE based in China and that this structure involves unique risks to investors, including that the contracts have not been tested in court. Similarly, the SEC requests that companies avoid the terms “we” or “our” when talking about the Chinese operating entity to avoid any misunderstanding that the investment is in the VIE entity.
Further to avoid confusion, the SEC wants structural diagrams identifying the person or entity that owns the equity in each depicted entity. Of course, all contracts must be thoroughly described and attached as exhibits. Although a VIE is designed to mimic ownership and control, it is not in fact ownership or control and the SEC sample comment letter requests that a company refrain from implying that the contractual agreements are equivalent to equity ownership in the business of the VIE.
The SEC expects disclosure as to whether the VIE structure is used to provide investors with exposure to foreign investment in China-based companies where Chinese law prohibits direct foreign investment in the operating companies and disclose that investors may never hold equity interests in the Chinese operating company itself. In addition, disclosure would need to include the fact that Chinese regulatory authorities could disallow the structure and describe the negative effects of such an action.
The SEC goes further, not just wanting disclosure of legal and operational risks associated with operations in China but requesting statements warning that the value of an investment can be rendered worthless as a result. Some of the risks that must be described in detail include those related to the legal system in China, including risks and uncertainties regarding the enforcement of laws and that rules and regulations in China can change quickly with little advance notice, and the risk that the Chinese government may intervene or influence operations at any time, or may exert more control over offerings conducted overseas and/or foreign investment in China-based issuers. Likewise, disclosure of any approvals or permissions needed by Chinese regulatory authorities is required as well as the risks associated with a denial or rescission of such approvals.
The SEC is also imposing additional financial disclosures on China based companies with a VIE structure. In particular, the sample comment letter requests a table disaggregating consolidated financial information to separately illustrate financial position, cash flows, revenues, costs of goods sold and results of operations of the holding company and operating entity as of the same dates and for the same periods for which audited consolidated financial statements are required. The SEC is also requiring separate disclosure of intercompany transactions and any other material line item that would help an investor evaluate the nature of assets held by, and the operations of, entities apart from the VIE.
Not surprisingly, the CorpFin publication also sends a message to SPACs with China-based sponsors, executive offices in China, have or a majority of executive officers and/or directors located in or with significant ties in China, or which are contemplating merging with a company incorporated in China. Specifically, CorpFin expects robust disclosures associated with the SPAC’s operations and the challenges that investors in the SPAC might face in enforcing their rights under the SPAC’s controlling agreements.
Also, disclosures should address any impact PRC law or regulation may have on the SPAC’s ability to complete a merger transaction with an operating company in China, or the cash flows associated with the business combination, including shareholder redemption rights. Similarly, the disclosure should cover the risks related to an investment in a China-based company after any business combination with an operating company, including any PRC government regulation of that entity’s business or industry.
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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