Division of Corporation Finance Issues New Guidance on Disclosures for China-Based Issuers

Currently, PCAOB is restricted from inspecting the audit work and practices of PCAOB-registered public accounting firms in China and Hong Kong. While the Sarbanes-Oxley Act of 2002 requires the PCAOB to inspect registered accounting firms to access compliance with auditing standards, investigate, and bring enforcement actions for non-compliance, China has not provided the PCAOB access to inspect or investigate these firms with respect to China-based issuers.

In response, the U.S. House of Representatives and U.S. Senate have passed bills that could result in the delisting of companies that use an auditor that the PCAOB is not permitted to inspect. Moreover, the PWG has recommended that U.S. stock exchanges require PCAOB access to working papers of the principal audit firm as a condition to initial and continued listing.

These efforts may have an adverse impact on the trading prices of securities or terminate the trading of securities of China-based issuers.

China has restricted U.S. regulator access to information, as well as investigations of, or the pursuit of remedies against, China-based issuers, under state secrecy and national security laws. Under Article 177 of the PRC Securities Law, no overseas securities regulator is permitted to directly conduct investigations or perform evidence-collecting activities within the PRC, and no entity or individual in China is permitted to provide documentation or information relating to securities business activities to an overseas regulator without governmental approval.

U.S. authorities have faced significant challenges in bringing and enforcing actions against China-based issuers, as well as against their officers and directors. As a result, investors in China-based issuers may not benefit from a transparent regulatory environment.

Current regulations in China limit or prohibit foreign investment in Chinese companies operating in certain industries (e.g., telecommunications, educational institutions, etc.). To circumvent these restrictions, many China-based issuers form non-Chinese holding companies that are intended to mimic direct ownership of the companies and that enter contractual arrangements with Chinese operating companies. Through these arrangements, China-based issuers can consolidate the Chinese operating company (or variable interest entity (VIE)) into its financial statements even though its legal control of the operating company is a question of Chinese law.

These structures can pose risks to U.S. investors that are not present in other organizational structures, because (1) exerting control through contractual obligations may be less effective than direct equity ownership; (2) the Chinese government could determine that these structures do not comply with applicable Chinese laws and regulations, including restrictions on foreign ownership; and (3) a China-based issuer’s control over a VIE may be jeopardized if a natural person who holds equity interest in the VIE breaches the terms of the agreements, is subject to legal proceedings, or if physical instruments (i.e., chops and seals) are used without the China-based issuer’s authorizations to enter into contractual obligations in China.

The Chinese legal system is substantially different from the American legal system, which may raise risks concerning the intent, effect, and enforcement of its laws, rules, and regulations, including those that restrict the inflow and outflow of foreign capital or provide the Chinese governmental with significant authority to exert influence on a China-based issuer’s ability to conduct business or raise capital.

This lack of certainty may result in the inconsistent and unpredictable interpretation and enforcement of laws, rules, and regulations, which may change quickly.

Legal claims, including securities law claims, against China-based issuers or their officers, directors, and gatekeepers may be difficult or impossible for investors to pursue in U.S. courts. Enforcing a judgment against China-based issuers, whose related assets or persons are typically located outside the U.S. and in jurisdictions that do not recognize or enforce U.S. judgments, may also be difficult. The claims and remedies available in jurisdictions where a China-based issuer maintains assets may be significantly different than those available in the U.S. and may be difficult to pursue.

China-based issuers may be organized or incorporated in jurisdictions outside of both China and the U.S. (e.g., the Cayman Islands, British Virgin Islands, etc.), and the differences between the corporate law and governance rules and practices of these jurisdictions and U.S. jurisdictions may give rise to additional material risks and fewer shareholder protections.

Some China-based issuers qualify as foreign private issuers (FPIs), which are exempt from certain corporate governance rules of U.S. stock exchanges that are applicable to U.S. domestic issuers, including (1) having a majority of independent directors; (2) having independent audit committee members, compensation committee members, and nominating committee members; (3) having independent board members meet in executive session; (4) holding annual meetings; and (5) obtaining shareholder approval for certain issuances of securities.

If a China-based issuer qualifies as an FPI, it will be exempt from certain reporting requirements under the U.S. federal securities laws applicable to U.S. domestic issuers, including (1) quarterly reports and certifications by the principal executive and financial officers; (2) current reports on Form 8-K that domestic issuers are required to file upon the occurrence of specified events; (3) the solicitation of proxies, consents, or authorizations under Section 14 of the Exchange Act; (4) rules that require insiders to comply with Section 16 of the Exchange Act; and (5) Regulation FD.