The SEC Division of Corporation Finance has provided its views regarding certain disclosure considerations for companies based in or with the majority of their operations in the People’s Republic of China.
The US Securities and Exchange Commission (SEC) recognizes the increased exposure of US investors to companies based in or with the majority of their operations in the People’s Republic of China (China-based Issuers) and the SEC’s limited ability to promote and enforce high-quality disclosure standards for China-based Issuers. The Division of Corporation Finance (Corp Fin) published CF Disclosure Guidance: Topic No. 10, Disclosure Considerations for China-Based Issuers (Guidance), on November 23 to warn investors of potential risks associated with investments in China-based Issuers and to highlight what these issuers should consider as they seek to fulfill their disclosure obligations.
Risks Associated with China-Based Issuers
The Guidance notes that one of the most significant risks to reliable disclosure and financial reporting by China-based Issuers is the limited ability of the Public Company Accounting Oversight Board (PCAOB) to inspect audit work with respect to audits of China-based Issuers by PCAOB-registered public accounting firms in China and Hong Kong. Congress has made several bipartisan efforts to pass bills that, if enacted, would require the SEC to prohibit trading in a company’s securities if the company’s auditor has not been subject to PCAOB inspection for three consecutive years. These efforts could adversely affect trading prices, or even terminate the trading, of securities of China-based Issuers that employ PCAOB-registered public accounting firms in China and Hong Kong.
Other risks include China’s restrictions on US regulators’ access to information regarding, and ability to investigate, China-based Issuers. These restrictions make it difficult for the SEC and other US authorities to bring and enforce actions against China-based Issuers.
The Guidance also highlights that an organizational structure used by many China-based Issuers presents unique risks to investors. To circumvent China’s limitation on foreign investment in certain industries, some China-based Issuers create non-Chinese holding companies that contract with Chinese operating companies, structurally referred to as variable interest entities (VIEs). Under this structure, although a China-based Issuer cannot directly own the VIE, it can generally consolidate the VIE into its financial statements as a result of the contractual arrangement. However, this structure may be weaker than direct equity ownership, and presents the risk that the Chinese government could invalidate the structure and penalize these China-based Issuers by revoking their business and operating licenses.
Lastly, the Guidance notes the risks and uncertainties of China’s legal system, especially regarding foreign capital. Evolving laws and regulations in China could hinder China-based Issuers’ efforts to obtain and maintain all the permits and licenses required to conduct their business in China.
Differences in Shareholder Rights and Recourse, Governance, and Reporting Associated with China-Based Issuers
Jurisdictions outside of the United States may not recognize or enforce US judgments. Therefore, the Guidance points out that it may be difficult or impossible for investors to bring securities law claims against China-based Issuers in US courts. Investors may be able to rely on remedies available in China or other overseas jurisdictions where the China-based Issuers maintain assets, but these remedies could be significantly different from those available in the United States and difficult to pursue.
The Guidance also noted that some China-based Issuers may be organized in jurisdictions with fewer shareholder protections, such as the Cayman Islands. These jurisdictions might, for example, impose narrower fiduciary duties that directors owe to shareholders than those imposed on US issuers.
Additionally, certain China-based Issuers might qualify as foreign private issuers. This means that they may not be required to comply with certain US corporate governance practices, including, but not limited to, the requirements to
- have a majority of independent directors;
- have independent audit, compensation, and nominating committee members;
- have independent board members meet in executive session;
- hold annual meetings; and
- ·obtain shareholder approval for certain issuances of securities.
China-based Issuers qualifying as foreign private issuers are also exempt from certain reporting requirements, such as the need to file quarterly reports, current reports on Form 8-K, and proxy solicitation materials with the SEC, as well as the need to comply with Regulation FD. Insiders of these issuers are also exempt from filing responsibilities required by Section 16(a) of the Securities Exchange Act of 1934.
Disclosure Considerations for China-Based Issuers
In light of the risks and differences associated with China-based Issuers, the Guidance provides a nonexhaustive list of topics that China-based Issuers assessing their risks and related disclosure obligations may wish to consider, including the following:
- Disclosure of PCAOB inspection limitations and lack of enforcement mechanisms, as well as risks relating to the quality of the financial statements
- Whether the company uses VIEs in its organizational structure and, if so, whether the company includes sufficient disclosure about the risks associated with the VIE structure in China
- Risks relating to the regulatory and legal environment in China and the possibility of inconsistent and unpredictable interpretation and enforcement of laws and regulations
- Disclosure about differing shareholder rights and recourses in the company’s country of organization, particularly in jurisdictions where there is less developed shareholder protection law as compared to US law
- Risks relating to legislation and potential rulemaking that may result in delisting or otherwise adversely affect the company’s liquidity or the trading price of the company’s securities that are listed or traded in the United States
- If the company is a foreign private issuer, the differences in governance and reporting requirements, such as the frequency of financial reporting, the exemption from filing quarterly reports and proxy solicitation materials, and the exemption from Regulation FD
The Guidance emphasizes the significance of disclosing the risks and differences from US issuers discussed above, and encourages China-based issuers to consider the cumulative effects of these risks and differences as they assess their disclosure obligations under the federal securities laws.
While many of the concerns raised by the SEC are already reflected in the cautionary disclosures and risk factors of most China-based Issuers, these issuers should review the Guidance in detail and continue to monitor any legislative or regulatory changes—especially given that some SEC officials are reportedly pushing for a new rule that would lead to the delisting of companies that do not comply with US auditing rules.
This post comes to us from Morgan, Lewis & Bockius LLP. It is based on the firm’s memorandum, “SEC Releases Guidance on Disclosure Considerations for China-Based Issuers,” dated December 1, 2020, and available here. Law clerk Lixin Lin contributed to the memorandum.