Congress and Nasdaq Propose Rules that May Result in Delisting of Chinese Companies
Congress and The Nasdaq Stock Market have both proposed rules that may result in the delisting of Chinese companies. On May 20, 2020, the Senate passed by unanimous consent S. 945, the Holding Foreign Companies Accountable Act, which would prohibit securities of a company from being listed on any U.S. securities exchange or traded "over-the-counter" if its auditor has not been subject to Public Company Accounting Oversight Board (PCAOB) oversight for three years.
Federal securities laws and Nasdaq rules require that issuers' financial statements be audited by an independent public accountant subject to oversight by the PCAOB. However, the PCAOB is currently prevented from inspecting the audit work and practices of PCAOB-registered auditors in China and Hong Kong (to the extent their audit clients have operations in mainland China) due to prohibitions imposed by the Chinese government.
Nasdaq has separately filed three rulemaking proposals with the SEC aimed at companies that operate principally in jurisdictions, including China, that have secrecy, national security laws, or other laws that restrict U.S. regulators' access to information concerning U.S.-listed companies. Nasdaq's rule proposals provide for more stringent listing standards for companies in these markets and, notably, clarify Nasdaq's authority to deny initial or continued listing to companies whose auditors have not been subjected to PCAOB oversight. Unlike Congress' rules, which would provide for bright lines and time periods for delisting, Nasdaq's new rules stress its discretion and contain no mandatory time periods.
In addition, on June 4, 2020, the White House issued a Presidential Memorandum titled "Protecting United States Investors from Significant Risks from Chinese Companies" ordering the President's Working Group on Financial Markets1 to report, within 60 days, recommendations for actions that the executive branch, the SEC, other federal agencies or the PCAOB should take to protect U.S. investors in Chinese companies, including enforcement action against accounting firms that fail to comply with U.S. securities laws, and setting new listing standards or governance safeguards.
The following is a description of the proposed legislation and Nasdaq rulemaking and the likely impact of these rule changes on the approximately 200 Chinese and Hong Kong companies2 with auditors that have not complied with PCAOB rules, as well as on Chinese companies seeking to go public through business combinations with U.S. listed special purpose acquisition companies (SPACs).
Holding Foreign Companies Accountable Act
This bipartisan legislation would prohibit securities of a company from being listed on any of the U.S. securities exchanges or traded over-the-counter if the company's auditor has a branch or office in a foreign jurisdiction that has not been subject to PCAOB oversight for three years due to a position taken by an authority in such foreign jurisdiction. The bill would also require certain foreign issuers to disclose, among other things, whether they are owned or controlled by a foreign government, whether they have members of the Chinese Communist Party (CCP) on their board of directors, and whether their articles of incorporation contain any text of any CCP charter. While the bill is written to apply to all foreign companies, the bill's multiple references to the CCP, as well as comments by the bill's sponsors, make clear that the primary objective of the legislation is to remedy the problem of the PCAOB's inability to inspect audits of Chinese companies.
Consideration of the legislation comes amid high tensions between the U.S. and China. The bill was initially introduced in March of 2019 but was largely unaddressed until recently when the Senate Banking Committee swiftly advanced the legislation to the Senate floor where it passed the same day - a series of actions that are fairly unusual in Congress.
On May 22, 2020, Representative Brad Sherman (D-CA) introduced H.R. 7000, a companion bill to S. 945. Representative Sherman serves as the Chair of the House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets and co-chairs the Congressional Caucus on CPAs and Accountants. The subcommittee that Representative Sherman chairs has jurisdiction over the legislation, which increases the likelihood of its advancement through the committee process.
Jay Clayton, Chairman of the SEC, has publicly indicated his support of the pending legislation.3
Identification of Issuers Retaining Audit Firms Not Subject to PCAOB Oversight
The Holding Foreign Companies Accountable Act would require the SEC to identify each covered issuer4 that retains a registered public accounting firm that has a branch or office located in a foreign jurisdiction, and that the PCAOB is unable to inspect or investigate completely because of a position taken by an authority in such foreign jurisdiction. Each covered issuer would then be required to submit documentation to the SEC establishing that such covered issuer is not owned or controlled by a governmental entity in the relevant foreign jurisdiction.
Prohibition on Trading on U.S. Stock Exchanges and OTC Markets
If the SEC determines that a covered issuer has three consecutive non-inspection years,5 the issuer's securities would be prohibited from trading on a national securities exchange or through any other method within the SEC's regulatory jurisdiction, including "over-the-counter" trading. The prohibition would be removed if the issuer certifies to the SEC that it has retained a registered public accounting firm that the PCAOB has inspected to the SEC's satisfaction. If following a removal of the prohibition, a covered issuer subsequently has a non-inspection year, the SEC will reinstitute the prohibition for a minimum of five years. To have such re-instituted prohibition removed thereafter, the covered issuer would need to certify to the SEC that it will retain a registered public accounting firm that the PCAOB is able to inspect.
Disclosure of Ownership by Government and Ties to Chinese Communist Party
Each covered issuer that is a foreign issuer6 that retains a registered public accounting firm not inspected by the PCAOB would be required to disclose such fact in its annual report covering the non-inspection period and disclose any governmental entity's ownership in the foreign issuer. The foreign issuer would also be required to disclose the name of each official of the CCP who is a member of its board of directors, and/or whether its organizational documents contain any charter of the CCP, including the text of any such charter.
Nasdaq Proposals to Amend Listing Rules for Companies in "Restrictive Markets"
In May 2020, Nasdaq filed three separate rule proposals aimed at companies whose businesses are principally administered in jurisdictions that have secrecy laws, blocking statutes, national security laws or other laws or regulations that restrict access to information by regulators of U.S.-listed companies in such jurisdictions (Restrictive Markets).7 Nasdaq has indicated that the proposals are intended to address the unique risks that Restrictive Market companies present to U.S. investors due to limitations on the ability of U.S. regulators to conduct investigations or bring or enforce actions against the company and non-U.S. persons.8
Auditor Qualification ProposalNasdaq has broad authority under Rule 5101 to deny initial or continued listing or to apply additional and more stringent criteria based on the qualifications of a company's auditor. Nasdaq proposes to codify this discretion by adding a new subparagraph (b) to IM-5101-1, setting forth factors that Nasdaq may consider in making this determination, and making clear that it may also use its discretionary authority to impose additional or more stringent criteria in other circumstances, including when a company's business is principally administered in a Restrictive Market. These factors include:
- whether the auditor has been subject to a PCAOB inspection;
- if a PCAOB inspection indicates that the auditor has failed to respond to PCAOB requests, or that the inspection has uncovered significant deficiencies in the auditors' conduct in other audits or in its system of quality controls;
- whether the auditor can demonstrate that it has adequate personnel in the offices participating in the audit with expertise in applying applicable accounting standards in the company's industry;
- whether the auditor has an adequate training program;
- for non-U.S. auditors, whether the auditor is part of a global network or other affiliation of individual auditors where the auditors draw on globally common technologies, tools, methodologies, training and quality assurance monitoring; and
- whether the auditor can demonstrate sufficient resources, geographic reach or experience as it relates to the company's audit.
Nasdaq will consider these factors holistically and may be satisfied with an auditor's qualifications even if the auditor raises concerns with respect to some of the foregoing factors.
Examples of additional and more stringent criteria that Nasdaq may apply could include requiring more stringent quantitative listing standards than would otherwise be required; requiring that an offering be underwritten on a firm commitment basis (which typically involves more underwriter due diligence); or imposing lock-up restrictions on officers and directors to allow market mechanisms to determine an appropriate price for the company before such insiders can sell shares.9 Nasdaq may impose each of these requirements separately or in combination, or in some cases, deny initial or continued listing to a company.
Additional Initial Listing Criteria ProposalNasdaq has also proposed additional initial listing criteria for Restrictive Market companies. Nasdaq believes the risks posed by these companies are compounded when such companies do not have sufficient public float, investor base or trading interest to provide the liquidity necessary to promote fair and orderly trading.
As a result, Nasdaq has proposed that a Restrictive Market company that is listing in connection with its IPO must offer a minimum amount of securities in a firm commitment offering in the U.S. to public holders10 that: (i) will result in at least $25 million in gross proceeds; or (ii) will represent at least 25% of the company's post-offering market value of listed securities,11 whichever is lower. Restrictive Market companies will also need to comply with all other applicable listing requirements, including requirements related to minimum market value of unrestricted publicly held shares.12
With respect to business combinations involving a Restrictive Market company, Nasdaq has proposed a new rule that would require the listed company to have a post-transaction market value of unrestricted publicly-held shares equal to at least the lesser of: (i) $25 million; or (ii) 25% of the post-transaction entity's market value of listed securities. Applicable transactions would include an acquisition by a listed company of a Restrictive Market company if the listed company intends to transfer listing from one Nasdaq market to another in connection with the business combination (e.g., Nasdaq Capital Market to Nasdaq Global Select Market). In addition, the rule would apply when a listed company plans to combine with a non-Nasdaq entity, where the non-Nasdaq entity will become the Nasdaq-listed company, e.g., business combinations by Nasdaq-listed SPACs.
For direct listings, Nasdaq has proposed limiting Restrictive Market companies to listing on the Nasdaq Global Select Market or Nasdaq Global Market, requiring they comply with the higher standards applicable to these tiers rather than the less stringent standards of the Nasdaq Capital Market.
The proposed rules reflect Nasdaq's continued focus on improving the integrity of its trading markets by preventing market manipulation of stocks of companies with low public floats. Nasdaq adopted more stringent liquidity standards in August 2019, adopting initial listing rules requiring issuers to have a minimum number of unrestricted publicly held shares with a minimum market value. The rules were aimed at ensuring listed companies have sufficient public float and trading interest to promote a liquid trading market.
Issuers that will likely be impacted by the more stringent listing criteria include SPACs. Nasdaq's requirements with respect to the market value of unrestricted publicly held shares have made it more difficult for some SPACs to remain listed following their business combinations, particularly in situations in which a large number of public stockholders exercise their redemption rights in connection with the vote to approve the business combination. Nasdaq's most recent proposed rule changes will further impact SPACs completing business combinations with Chinese companies by adding an additional set of listing criteria. SPACs have historically been a popular vehicle for Chinese sponsors looking to access the U.S. capital markets. There are currently at least 10 SPACs specifically focused on completing a business combination in China/Asia, including CITC Acquisition Corp., a $200 million SPAC sponsored by CITC Capital, a Chinese private equity firm that is the flagship alternative investment arm of the state-run conglomerate CITC Group.
Nasdaq states in this proposed rulemaking that it has observed that the management of certain listed companies appears to lack familiarity with Nasdaq's disclosure and minimum corporate governance requirements and are otherwise unprepared for the rigors of operating as a public company. Nasdaq believes that risks arising from these situations are heightened when a company's business is principally administered in a Restrictive Market.
Nasdaq has proposed a new listing standard that would require Restrictive Market companies applying to list on Nasdaq to certify that they have, and will continue to have, a member of senior management or a director with relevant past employment experience at a U.S.-listed public company or other experience, training or background providing such person with general familiarity with the regulatory and reporting requirements applicable to a U.S.-listed public company under Nasdaq rules and federal securities laws. Alternatively, the company could retain, on an ongoing basis, an advisor or advisors acceptable to Nasdaq to provide such guidance.
These proposed rule changes would apply to companies from Restrictive Market countries that apply to list on Nasdaq after their effective date, but not to companies from other countries or to companies already listed on Nasdaq. However, to the extent there are future concerns about a company that is already listed arising from an apparent unfamiliarity with U.S.-listed public company requirements, Nasdaq could consider that lack of familiarity when determining whether to allow the company to remain listed.
These requirements are similar to those of other global markets which include management qualification requirements, including the Hong Kong Stock Exchange.
Potential Impact of S. 945 and Nasdaq Proposals
The official reaction from China was swift. In a published press Q&A four days after the bill was passed by the Senate, the China Securities Regulatory Commission (CSRC) characterized the bill as "directly targeting at China" and "not based on the considerations for securities market oversight." CSRC further voiced its "strong objection to politicizing regulation of securities markets." CSRC also cited examples of its past cooperation with PCAOB, and expressed its desire to "expedite the promotion of relevant joint inspection of auditing firms" through mutual consultation.13
The road ahead to resolving the conflict between the two legal regimes is far from clear given the conflict between PCAOB requirements and Chinese laws that prohibit access to and the transfer of information out of the country, if, for example, such information involves national security.
In an effort to address this conflict, the PRC Ministry of Finance (MOF), CSRC and the PCAOB signed a Memorandum of Understanding in 2013. The Memorandum of Understanding provides that the PCAOB may make requests to the MOF and CSRC for working papers when conducting an auditing firm review. However, the implementation of the Memorandum thus far has fallen short of SEC and PCAOB expectations. Underscoring this conflict is China's new amended and restated Securities Law, effective March 1, 2020, which reiterates that overseas securities regulatory authorities may not directly conduct investigations and collect evidence in China, and that no one may provide overseas documents related to securities business without the consent of CSRC.14
Chinese companies listed in the U.S. have taken a note of the bill as well.15 Notably, Chinese companies that are listed on a U.S. stock exchange and that are now seeking dual listing on the Hong Kong Stock Exchange (HKSE) have specifically disclosed as a risk factor potential adverse outcomes if the Holding Foreign Companies Accountable Act is enacted. For example, NetEase, a Nasdaq-listed company with an NYSE-listed subsidiary, disclosed in its listing documents to the HKSE that the Holding Foreign Companies Accountable Act, if it becomes effective, may "cause investors uncertainty for affected issuers" which in turn may adversely affect the price of NetEase's ADRs. NetEase stated further that it could also face delisting from Nasdaq if it is unable to meet PCAOB's inspection requirements in time.16 JD.Com, also a Nasdaq-listed company that is seeking a dual listing on the HKSE, made an identical disclosure regarding the potential impact of the bill.17
If the Holding Foreign Companies Accountable Act is enacted and regulators of both countries cannot work out a compromise, larger Chinese companies will likely seek alternatives to a U.S. listing. In recent years, a number of Chinese companies listed on a U.S. exchange have already added listings on the HKSE, and with the Senate bill and Nasdaq proposals looming, the number of Chinese companies seeking dual listing will likely increase.
Chinese companies may also cease to be listed on a U.S. exchange and seek listing elsewhere. From 2011 to May 2019, 73 Chinese companies exited from the U.S. stock market.18 One of the major reasons driving this decision is the depressed stock prices of some Chinese companies. Chinese companies delisting from U.S. exchanges may also return to China for relisting in addition to the traditional choice of the HKSE. For its part, China has ambitions to build up its own capital market. On June 1, 2020, the Chinese government issued a master plan for building the Hainan free trade port. The plan envisions building Hainan into a major cross-border financial market.19 In February 2019, the Chinese government issued a development plan for the Guangdong-Hong Kong-Macao Greater Bay Area. The plan contemplates "establishing in Macao a securities market denominated and cleared in RMB."20 If Chinese companies have to exit the U.S. market, Chinese mainland, Hong Kong and Macao may welcome some of them back.21
© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
Comprised of the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the SEC, the Chairman of the Commodity Futures Trading Commission or their respective designees.
In an interview during the Bloomberg Invest Talks conference on June 2, 2020, Mr. Clayton said of the bill: "This is a very sensible way to approach a problem that's been around for a while." During the interview, Clayton also said that the PCAOB's inability to inspect audits of Chinese companies that trade in the U.S. creates an "unlevel playing field" for investors.
A non-inspection year is any year that begins after the enactment of the Holding Foreign Companies Accountable Act during which the SEC identifies a covered issuer (as described above) with respect to every Exchange Act report filed by such covered issuer during that year.
A "foreign issuer" is any issuer which is a foreign government, a national of any foreign country or a corporation or other organization incorporated or organized under the laws of any foreign country. A "foreign government" is the government of any foreign country or of any political subdivision of a foreign country. A "foreign private issuer" is any foreign issuer other than a foreign government except for an issuer meeting the following conditions as of the last business day of its most recently completed second fiscal quarter: (1) more than 50% of the issuer's outstanding voting securities are directly or indirectly held of record by residents of the U.S.; and (2) any of the following: (i) the majority of the executive officers or directors are U.S. citizens or residents; (ii) more than 50% of the assets of the issuer are located in the U.S.; or (iii) the business of the issuer is administered principally in the U.S.
In determining whether a company's business is principally administered in a Restrictive Market, Nasdaq has indicated that it may consider the geographic locations of the company's: (a) principal business segments, operations or assets; (b) board and shareholders' meetings; (c) headquarters or principal executive offices; (d) senior management and employees; and (e) books and records, covering both foreign private issuers based in Restrictive Markets and companies based in the U.S. or another jurisdiction that principally administer their businesses in Restrictive Markets.
An example of the risks to U.S. investors posed by US-listed companies whose auditors are not subject to PCAOB oversight is the recent scandal surrounding Chinese coffee chain, Luckin Coffee, where preliminary results of a massive accounting fraud investigation triggered a collapse of its Nasdaq-traded shares, immediately wiping out billions of dollars of shareholder wealth.
Nasdaq may also have concerns that a company listing on Nasdaq through an IPO, business combination, direct listing, or issuing securities previously trading over the counter (OTC) may not develop sufficient public float, investor base, and trading interest to provide the depth and liquidity necessary to promote fair and orderly trading, resulting in a security that is illiquid. In such cases, Nasdaq may impose additional liquidity measures on the company, such as requiring a higher public float percentage, market value of unrestricted publicly held shares, or average OTC trading volume.
Beneficial holders and holders of record, but excluding any holder who is, either directly or indirectly, an executive officer, director, or the beneficial holder of more than 10% of the total shares outstanding.
Unrestricted publicly held shares exclude securities subject to resale restrictions, whether contractual or because not freely tradeable under securities laws. The Nasdaq Global Select Market and Nasdaq Global Market require a company to have at least 1.25 million and 1.1 million of unrestricted publicly held shares, respectively, and a market value of such shares of at least $45 million and $8 million, respectively. In contrast, the Nasdaq Capital Market requires a company to have at least 1 million unrestricted publicly held shares, and a market value of such shares of at least $5 million.
Posting Hearing Information Pack of JD: https://www1.hkexnews.hk/app/sehk/2020/101935/documents/sehk20060500054.pdf.
Global Times, a newspaper controlled by the Chinese Central Government, asserted that "stock exchanges in China have been going through reform to be more open. Even if the Chinese companies have to be delisted, the domestic exchanges will be welcoming." https://www.globaltimes.cn/content/1189378.shtml.