Private US securities offerings by China-based companies could become subject to the same scrutiny as publicly traded securities, says Nick Morgan.
Recent legislation designed to increase US semiconductor competitiveness with China likely will accelerate an already contentious relationship between the SEC and China-based companies seeking to access US capital markets. In early February, the House voted (largely along party lines) to pass the America COMPETES Act, which corresponds to a Senate counterpart that passed with bipartisan support last June.
The last-minute House version included an amendment requiring all entities (not just those based in China) that issue securities under a registration exemption to report certain information to the SEC, such as the country in which the issuer is based and the intended use of the proceeds from such issuance. This requirement modestly increases current SEC requirements for registration-exempt securities offerings.
The biggest change, and the change most directly aimed at Chinese securities issuers, would require the SEC to report quarterly to a Congressional committee if any such issuer: (1) is incorporated in China, (2) is incorporated outside of China, but with significant assets in the country, or (3) intends to invest the proceeds in China. The disclosure requirement would apply to transactions 270 days after the measure’s enactment.
That part of the proposed bill represents the latest salvo in on-going efforts by US regulators and lawmakers to promote and enforce disclosure standards for companies based in or with the majority of their operations in China. While past legislative and regulatory efforts have focused on the lack of reliable disclosures and audit inspections of China-based companies whose securities are publicly traded, this amendment focuses on a narrow class of issuers that are normally exempt from traditional registration requirements and, thus, from greater regulatory scrutiny.
Background: History of Clashes
Conflicts between China-based issuers of securities in the US markets and the SEC began decades ago, and tensions have long been simmering. In 1994, the SEC and its counterpart, the China Securities Regulatory Commission (CSRC), kicked off a formal relationship by signing a memorandum of understanding (MOU) to enhance cooperation between the two countries. But as Chinese companies began entering US markets, the increased engagement brought with it clashes with US regulators seeking to enforce disclosure and audit requirements similar to those for domestic companies.
The Public Company Accounting Oversight Board (PCAOB), created by the Sarbanes-Oxley Act of 2002 to oversee the audits of public companies, was limited in its ability to inspect audits of China-based issuers conducted by accounting firms located in China and Hong Kong. Though the PCAOB signed an MOU with the CSRC and the Chinese Ministry of Finance in 2013 to address the issue, Chinese authorities continued to cite state secrecy and national security laws to restrict US regulators from inspecting audit work and conducting investigations.
The lack of regulatory cooperation, though, did little to abate the rush of Chinese companies entering the US capital markets. In the late 2000s, hundreds of Chinese companies went public in the US through a reverse merger process whereby a private company merges with a public shell company. But many of those companies came under scrutiny for potential misrepresentations and omissions in their disclosures, and the SEC ultimately investigated and delisted numerous companies.
US regulators also targeted accounting firms of China-based issuers for failing to cooperate with investigations. In 2012, the SEC initiated administrative proceedings against the China affiliates of the Big Four accounting firms and one other firm for refusing to produce documents for an investigation into their China-based clients. After an adverse ruling against the firms, the four China affiliates agreed to a settlement with the SEC in 2015.
Whether accessing public US markets through reverse mergers or otherwise, variable interest entities (VIEs) were and are an integral vehicle for China-based issuers. In a VIE-listing structure, China-based issuers form foreign shell companies that enter into contractual arrangements with Chinese companies. US investors purchase shares in these shell companies, foregoing direct equity ownership and corresponding voting rights.
In a 2019 report, the US-China Economic and Security Review Commission recommended legislation precluding Chinese companies from issuing securities on US stock exchanges through VIEs. In 2021, SEC Chairman Gary Gensler expressed concern “that average investors may not realize that they hold stock in a shell company rather than a China-based operating company.”
The Holding Foreign Companies Accountable Act – Legislative Shot Across the Bow
In 2020, US lawmakers passed and President Trump signed into law the Holding Foreign Companies Accountable Act (HFCAA) to strengthen enforcement capabilities over foreign companies and their accounting firms, representing a substantial escalation in regulatory efforts to inspect or investigate audit work.
The HFCAA requires the SEC to prohibit the trading of an issuer’s securities if the PCAOB is unable to inspect the issuer’s accounting firm for three consecutive years. Moreover, under the HFCAA, a foreign issuer must submit documentation establishing that it is not owned or controlled by a foreign governmental entity.
According to Chairman Gensler, the “three-year clock began ticking in 2021”, and in 2022 the SEC will begin identifying foreign companies in violation of the HFCAA based on annual reports for the fiscal year that ended 31 December 2021.
Indeed, last week five Chinese companies listed in New York were named as the first that will be delisted in early 2024 if they do not hand over detailed audit documents for inspection by the PCAOB.
If the America COMPETES Act becomes law with the securities disclosure and reporting provisions, China-based companies issuing securities in registration-exempt offerings will be subject to some of the same heightened SEC scrutiny as US publicly traded China-based companies.
One US Senator recently observed that “[w]e’re in an economic war” with China, and these new requirements would represent another missile strike.
China-based issuers, foreign companies contemplating raising funds under one of the safe harbors targeted by this proposed law, and investors should keep abreast of the legislative space related to increasing SEC enforcement activity.
The article was contributed by partners Nick Morgan and Tom Zaccaro, and associate Peter Cho at Paul Hastings in Los Angeles, as well as Shaun Wu, a partner at Paul Hastings in Hong Kong.
 Companies that issue securities pursuant to one of three safe harbors to registration requirements fall under the purview of the amendment: Rule 506(b) of Regulation D (private placements); Regulation S (offshore sales); and Rule 144A (private resales to qualified institutional buyers). In addition, the issuance of securities must either “equal $25,000,000 or greater” or have “an aggregate issuance of $50,000,000 or greater” in any one year period.
 Soon after the SEC finalized amendments to the HFCAA in December 2021, lawmakers introduced a bill in Congress that would shorten the three-year time frame to two years. The Accelerating Holding Foreign Companies Accountable Act (H.R. 6285) builds on top of the HFCAA to put additional pressure on China, and represents a House companion to the same bill in the Senate, which passed in June 2021.