Cease and Delist: The Holding Foreign Companies Accountable Act
Tensions between the United States (“U.S.”) and China have been flaring up, and the COVID-19 pandemic has only made things worse. Now, Luckin Coffee, a Chinese owned entity traded on a U.S. exchange (NASDAQ:LK), added fuel to the fire with the recent discovery that senior executives fabricated as much as 2.2 billion yuan (approximately $310 million) in sales last year. (Fox, Business Insider). Such misrepresentation deceives investors and raises doubt around the adequacy of existing market regulation, supporting the argument for more stringent oversight. The Senate, Securities and Exchange Commission (“SEC”), and Nasdaq are in support of rule changes to restore faith in the marketplace and protect investors. The question remains: will the rule proposals provide greater investor protection or chill the free market?
The Senate, in a bipartisan effort, has recently passed the Holding Foreign Companies Accountable Act (“HFCAA”; see Footnote), a bill to delist companies who will not abide by U.S. accounting laws. (Jain, Business Insider). Although the law would apply to all foreign entities, the “move to strengthen disclosure requirements was aimed at China.” Id. Senator Chris Van Hollen stated that the bill is intended to require China to “play by the same rules as everybody else.” Id. There is concern that U.S. money is inappropriately funding Chinese efforts to dominate fields including artificial intelligence and internet data collection. (Clark, Money & Markets). Last week, the White House directed the Federal Retirement Thrift Investment Board, the body that manages the 401(k) for federal employees, to halt investments in Chinese companies. (Rubio and Shaheen, CNBC) (Jain, Business Insider).
A number of key players are speaking up to endorse the proposed bill. SEC Chair Jay Clayton supports the legislation and described the bill as a “sensible way to approach a problem that’s been around for a while… This is a problem that I believe needs to be addressed and I hope it can be.” (Posner, Cooley PubCo). Luckin Coffee’s actions of fabricating sales and misleading investors emulates why the SEC was formed: to protect investors from fraud. (Clark, Money & Markets). The SEC requires U.S. companies to provide financial statements to mitigate market manipulation. Id. Foreign companies should be obliged to “play by the same rules.” Id.
On May 19, 2020, Nasdaq Stock Market LLC put out the following three proposals for emerging market companies pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934: “(1) a proposal to adopt a new requirement related to the qualifications of management; (2) a proposal to apply additional initial listing criteria related to offering size and liquidity; and (3) a proposal to apply additional and more stringent criteria to an applicant for listing or a listed company based on the qualifications of the company’s auditor.” (Posner, Cooley PubCo). Since then, the SEC has published a notice to solicit comments on the proposed rulemaking changes. Id. See the SEC’s response here.
Secretary of State Mike Pompeo commented that, “American investors should not be subjected to hidden and undue risks associated with companies that do not abide by the same rules as U.S. firms.” (Posner, Cooley PubCo). The proposed rules undoubtedly would protect many U.S. investors, however, delisting foreign companies could be perceived as anti-free market, which may negatively impact U.S. investors.
Jesse Fried, a law professor at Harvard Law School, warned that if this bill becomes law it could backfire and not be in the best interest of U.S. investors. (Tan, CNBC). Delisting Chinese companies from U.S. stock exchanges would be a huge detriment to Chinese companies seeking U.S. capital or U.S. initial public offerings, such as TikTok and Alibaba’s Ant Financial. (Clark, Money & Markets). Fried illustrated his point using Alibaba as an example: Fried stated, “there’s a ‘good chance’ shares of China’s tech giant Alibaba, for example, will stop trading after three years if the bill becomes law. ‘It’s highly unlikely that China is going to allow inspections of audits done in mainland China. This will cause the stock prices of these firms to fall. The people controlling these firms will then be able to take these firms private at a very low price — to the disadvantage of U.S. investors — and then re-list the firms in China or elsewhere.’” (Tan, CNBC).
The bill will be subject to further debate as it works its way through Congress and potentially lands on the President’s desk. It is a critical decision and will set precedent for future lawmakers in balancing investor protection while fostering the U.S. free market.
Footnote
The Holding Foreign Companies Accountable Act requires certain issuers of securities to establish that they are not owned or controlled by a foreign government. (Jain, Business Insider). Specifically, an issuer must make this certification if the Public Company Accounting Oversight Board is unable to audit specified reports because the issuer has retained a foreign public accounting firm not subject to inspection by the board. Id. Furthermore, if the board is unable to inspect the issuer's public accounting firm for three consecutive years, the issuer's securities are banned from trade on a national exchange or through other methods. Id.
Foreign issuers of securities that use such a firm to prepare an audit report must disclose for each non-inspection year:
the percentage of shares owned by governmental entities where the issuer is incorporated;
whether these governmental entities have a controlling financial interest;
information related to any board members who are officials of the Chinese Communist Party; and
whether the articles of incorporation of the issuer contain any charter of the Chinese Communist Party. Id.