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CAUGHT IN THE MIDDLE How Will Chinese Companies React to the HFCAA? XX June 2020 The United States’ relations with China have deteriorated under the Trump Author: administration. In 2018 Trump launched a trade war by imposing tariffs on Chinese Paul L Gillis imports. The global Covid-19 pandemic began in China in December 2019 and Guanghua School of rapidly spread around the world, causing U.S. government officials to effectively Management shut down the U.S. economy by April 2020. These events have strained the Peking University economic and financial ties between the United States and China. Ray Tang Hou On Wednesday, May 20, 2020, the United States Senate passed by unanimous School of Law consent Senate Bill 945, known as the Holding Foreign Companies Accountable Act University of Virginia (“HFCAA”). Louisiana Senator John Kennedy (R) introduced the HFCAA with four bipartisan co-sponsors. It now goes to the House of Representatives where Representative Brad Sherman (D-California) introduced the House version of the HFCAA. If the House bill passes, routine conference procedures will reconcile any differences between the House and Senate versions. After passage by both branches, it moves to President Donald Trump for signature into law. The White House signaled support for the legislation in its June 4, 2020, memorandum, stating that “[w]e must ensure that laws providing protections for investors in American financial markets are fully enforced for companies listed on United States stock exchanges.” The argument for holding Chinese companies to the same standards as American companies when listed on U.S. stock exchanges has merit, but the legislation targets a minor issue – Public Company Accounting Oversight Board (“PCAOB”) inspections. While we think the PCAOB should inspect Chinese auditors if they audit U.S.-listed companies, we think such inspections will not likely alter the performance of such auditors nor eliminate the amount of fraud in Chinese companies. We believe that the culture of the Big Four accounting firms, which audit most of the U.S.-listed Chinese companies, has integrated PCAOB practices into its audit methodology and inspections in China will unlikely significantly change the way they audit. Moreover, the legislation does nothing to address other related issues, like the exclusion from Reg FD disclosure requirements, the absence of quarterly reporting, and the lack of inspection on audit work in China for multinational companies, such as the Chinese operations of IBM or Apple. This paper examines the proposed legislation and its effect on U.S.-listed Chinese companies and their investors. We examine how the present situation developed out of Sarbanes Oxley (“SOX”) reforms almost 20 years ago, and how the proposed legislation deals with it. We speculate on the likely responses by U.S.-listed Chinese companies, including moving the listing to other markets like Hong Kong, taking the company private, or going dark. Finally, we suggest how Congress can strengthen HFCAA as it works its way through the legislative process. GMT Research prohibits the redistribution, replication, retransmission, circulation or publication of this document (in whole or in part in any medium, print, electronic or otherwise, for any purpose) without its prior written permission Historical Background China had robust stock markets prior to the establishment of the People’s Republic Shanghai and of China in 1949 and these markets reopened in the early 1980’s to serve the Shenzhen are amongst reforming Chinese economy. State-owned enterprises (“SOE”) initially dominated the largest stock the exchanges, using their public listings to introduce new shareholders and markets in the world corporate governance reforms. The listing rules initially did not allow privately- owned companies to list, but this changed over the years as the importance of private investment in the economy became clear. Today, most job growth and most IPOs on Chinese exchanges comes from private companies. The Chinese stock exchanges in Shanghai and Shenzhen have grown to join American and Hong Kong exchanges among the largest in the world. Chinese SOEs incorporated in China began to list as so-called “H-shares” in Hong Started off listing Kong in the early 1990’s, usually in addition to their listing on the Shanghai Chinese companies in Exchange. Later, many Chinese SOEs began incorporating offshore companies and Hong Kong listing them in Hong Kong to obtain foreign currency or lower tax rates, and are known as “red chips”. Some private companies, called “P-chips”, also incorporated offshore and listed in Private Chinese Hong Kong. This category includes companies such as Tencent and Xiaomi. companies preferred to However, most private companies chose to list in New York instead, for several list in New York reasons. First, the U.S. market has greater depth and experience with technology companies than the Hong Kong market. Second, U.S. markets allow the use of dual class shares and Variable Interest Entity (“VIE”) structures, which the mainland exchanges did not permit until recently, and then only on a limited basis. Chinese foreign investment laws require some evasive governance structures, such as VIE structures, to allow foreign investment in certain Chinese sectors, including the technology sector. Thirdly, U.S. exchanges permit unprofitable companies to list and defer to the law of the company’s incorporation on corporate governance matters, such as when to hold annual meetings. The mainland exchanges require companies to have profitable earnings records before allowing them to list, while Hong Kong often waives this requirement. Finally, we think that investment bankers encourage New York listings because they earn higher fees for such listings compared with listings on the Hong Kong or mainland exchanges. Over the last few decades, the Hong Kong Stock Exchange (“HKSE”) undertook a Hong Kong modified its series of reforms that reduced the regulatory advantages of U.S. exchanges. Since rules to compete with 2005, the HKSE has allowed companies with VIE structures to list. After the HKSE New York lost the Alibaba listing to New York in 2014 over its unwillingness to allow dual class shares, it modified its rules in 2018 to allow large companies with dual class shares and no profitable earnings record to list. Sarbanes Oxley Act A series of corporate scandals headlined by Enron in the early 2000s led the U.S. The PCAOB was Congress to enact the Sarbanes Oxley Act (“SOX”) to reform corporate governance established to regulate in the U.S. SOX established the Public Company Accounting Oversight Board the accounting (“PCAOB”) to regulate the accounting profession that audits public companies. While profession that audits state boards of accountancy typically license and regulate accountants, the public companies profession had, since its inception, regulated itself with respect to the work related to audits of public companies. The PCAOB has three primary functions: 1. Set the standards for how auditors should perform audits of public companies. Previously, the American Institute of CPAs set these standards, which it still does for private companies. Ó2020 GMT Research Limited Page 2 of 23 2. Register auditors that wish to audit public companies and inspect their work periodically. Any auditor anywhere in the world that intends to audit U.S.- listed public companies must register with the PCAOB and consent to inspections. Prior to the PCAOB, auditors inspected auditors through peer review, which many critics found toothless. 3. Investigate alleged violations of PCAOB standards and administer appropriate punishment. Prior to the PCAOB, investigations and enforcement belonged to state boards of accountancy and the Securities and Exchange Commission (“SEC”), neither of which frequently acted. The allegations arise from PCAOB inspections or from outside whistle blowers. Following the enactment of SOX, over 50 Chinese CPA firms sought registration with Over 50 Chinese CPA the PCAOB. The PCAOB requires registration in two cases: if a CPA firm signs an firms sought audit report on a U.S.-listed company; or, if a CPA firm performs a significant role registration with the (over 20%) of the audit of a U.S.-listed company where another auditor signs the PCAOB even though report. Few Chinese CPA firms, other than the Chinese member firms of the Big these firms failed to Four, fell under these requirements, and many appear to have sought registration certify compliance for marketing purposes. The PCAOB requires registering firms to certify that they will comply with all PCAOB rules. Despite its own rules, the PCAOB has registered Chinese CPA firms even though these firms failed to certify compliance. For example, PwC China provided the PCAOB with a 25-page legal letter outlining the conflicts between Chinese and American rules and the PCOAB went ahead and registered PwC China. On October 7, 2010, the PCAOB announced it would no longer register accounting firms it could not inspect but took no action to de-register firms already registered. PCAOB Inspections SOX requires the PCAOB to inspect accounting firms periodically. The PCAOB The PCAOB inspects annually inspects firms which audit over 100 public companies. These large firms larger audit firms include the U.S. member firms of the Big Four, plus several smaller CPA firms. The annually and smaller PCAOB inspects smaller auditors that audit fewer than 100 public companies only ones every three years once every three years. All foreign CPA firms registered with the PCAOB audit fewer than 100 public companies per year, and fall into the latter category. Note the organization and governance of the Big Four firms differ from Local partners of the multinationals because they do not have a common parent company. Instead, local Big Four firms are partners tend to own each country’s branch of the firm, which operates like a considered separate franchise operation. For example, the PCAOB appropriately considers the Chinese entities firm PricewaterhouseCoopers Zhong Tian CPAs LLP as an entity separate from the U.S.

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