October 15, 2020
“There are plenty of markets all over the world open to cheaters, but America can’t afford to be one of them,” explained Senator John Kennedy (R-La.), when announcing the chamber’s passage of the Holding Foreign Companies Accountable Act (“Accountability Act”) in May 2020. The bill seeks to close a loophole that allows foreign companies to evade the same scrutiny as U.S. corporations, requiring them to submit their earnings statements to the Public Company Accounting Oversight Board (PCAOB) for review.
In a rare show of bipartisan support, the Senate approved the bill by unanimous consent. That same day, Representative Brad Sherman (D-Calif.), Chair of the House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets, introduced a companion bill in the House. Two months later, Representative Sherman, who is also Co-Chair of the Congressional Caucus on CPAs and Accountants, was able to attach his bill as an amendment to the National Defense Authorization Act for Fiscal Year 2021, which passed. With passage in both houses, albeit through different vehicles, Congress appears poised to see the bill become law later this year.
This was not the first time that Congress introduced legislation to increase oversight of foreign corporations listed on U.S. stock exchanges. But this year’s introduction coincided with a massive accounting scandal that cost U.S. investors in China-based Luckin Coffee billions of dollars. Unlike U.S. public companies that submit to inspections of their audits by the PCAOB, Luckin had been able to refuse such inspections. As a result, it was easier for the company, which had already raised over half a billion dollars on Wall Street, to lie to investors about its worth. In 2019 alone, Luckin Coffee overvalued its revenue by $300 million. Once the truth was revealed, the company’s shares tumbled 95% from January to May before it was delisted from Nasdaq.
Luckin Coffee is far from the only ticking time bomb for investors. Eleven percent of all securities class actions in 2011 were brought against Chinese-owned companies not subject to PCAOB oversight and, according to the SEC, 224 U.S.-listed companies with market capitalization of more than $1.8 trillion are located in countries where there are obstacles to PCAOB inspections.1
Congress felt pressure to act on a problem that has been festering since 2013. In 2013, the U.S. negotiated a Memorandum of Understanding allowing for Chinese companies to be listed on U.S. stock exchanges— with the understanding that China would eventually allow greater access to PCAOB inspections. The 2002 Sarbanes-Oxley Act, which created the PCAOB, was never meant to exempt foreign corporations from the same scrutiny as U.S. companies. But that was the result. As Representative Sherman sees it: “China got tough and we got weak.”
By introducing the Accountability Act, Congress is now more forcefully confronting China’s refusal to honor its agreement. The bill would delist issuers that block their financial audits from PCAOB inspection. Although it is written broadly to apply to any foreign company, it is primarily targeted at China, one of only a few countries that does not allow the U.S. to inspect financial audits conducted in a company’s country of residence. The only other countries preventing such inspections are France, Belgium, and in some circumstances Hong Kong (if the audit client has operations in mainland China). The U.S. is expected to soon finalize agreements with Belgium to allow for such inspections and in the case of France renew a previous agreement that expired in December 2019.2
Representative Sherman says he did not sponsor the House bill to delist foreign companies and reduce U.S. investors’ opportunities but rather “to demand that China do what every other country has done and agree that if their companies want to participate in U.S. capital markets, they agree to live by U.S. capital markets rules.”
The bill amends Section 104 of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7214) by adding language to govern foreign companies that refuse PCAOB inspection—requiring them to disclose whether government entities control a financial interest or the company has any ties to the Chinese Communist Party, for example. If a foreign company refuses inspection three years in a row, it will be delisted and its securities will be prohibited from being traded on a U.S. national securities exchange or on U.S. over-the-counter markets. The bill also provides an avenue for redemption for companies that certify they have hired a public accounting firm inspected by the PCAOB, though they face a five-year minimum delisting if they again refuse PCAOB inspection in any subsequent year. The House bill differs only slightly from the Senate version.
The White House is also eager to reign in foreign companies. In August, the White House Working Group on Financial Markets announced policy proposals that would give already-listed Chinese companies until 2022 to either comply with U.S. audit requirements or be delisted from U.S. exchanges. Any new companies that wish to trade on the U.S. exchange would need to comply with PCAOCB inspections first. Moreover, the White House working group proposed heightened warnings to investors about the risks associated with investing in companies that don’t allow PCAOCB inspections.
With Congress and the White House busily working to close a loophole that has been open for years, it is very likely that by 2021 Chinese companies will have to submit to inspections or risk delisting. In the most likely scenario, the Accountability Act provisions will be incorporated into the final passage by both houses of the National Defense Authorization Act for Fiscal Year 2021. The House version of that bill, which Congress approves each year, includes Representative Sherman’s Accountability Act language. It seems unlikely the Senate will seek to strike that language during the conference committee discussions since the Senate’s standalone bill, which enjoyed unanimous consent, contains nearly identical provisions. While these actions come too late for Luckin Coffee investors, they should reduce investors’ exposure to losses through any future accounting fraud at non-U.S. companies.whether government entities control a financial interest or the company has any ties to the Chinese Communist Party, for example. If a foreign company refuses inspection three years in a row, it will be delisted and its securities will be prohibited from being traded on a U.S. national securities exchange or on U.S. over-the-counter markets. The bill also provides an avenue for redemption for companies that certify they have hired a public accounting firm inspected by the PCAOB, though they face a five-year minimum delisting if they again refuse PCAOB inspection in any subsequent year. The House bill differs only slightly from the Senate version.
2 The only impediment to the finalizing of the agreements with Belgium and France is final approval regarding data protections under the European Union’s recent General Data Protection Regulation.