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Against the backdrop of ongoing tensions between the U.S. and China, as well as the financial irregularities following Luckin Coffee’s high-profile NASDAQ listing, U.S. regulators have renewed their focus on Chinese companies listed on U.S. securities exchanges. On 21 April 2020, the Chairmen of the U.S. Securities and Exchange Commission (the SEC) and the Public Company Accounting Oversight Board (the PCAOB) issued a joint statement highlighting the PCAOB’s inability to inspect audit work papers in China and the substantial difficulties faced by U.S. authorities in bringing and enforcing actions against non-U.S. companies and non-U.S. persons. This was followed by the passage of the Holding Foreign Companies Accountable Act (the HFCAA) by unanimous consent of the U.S. Senate on 20 May 2020, which if passed by the U.S. House of Representatives and signed into law by the U.S. President, could conflict with securities and state secrecy laws and regulations in China and result in Chinese companies being prohibited from listing and trading their securities on any U.S. securities exchanges.
As a result, U.S.-listed Chinese companies are now looking at alternative listing venues, including the Hong Kong Stock Exchange (the HKEX or the Exchange). This publication highlights the difficult issues facing Chinese companies currently listed in the United States and the mechanics and process for a listing on the HKEX.
Overview of the HFCAA
The HFCAA would amend the Sarbanes-Oxley Act of 2002 (SOX) by requiring certain issuers to disclose to the SEC information regarding foreign jurisdictions that prevent the PCAOB from performing inspections under SOX. More specifically, the HFCAA would require the SEC to identify all reporting issuers who are audited by registered accounting firms with a branch or office in a foreign jurisdiction and where the PCAOB is unable to inspect or investigate such accounting firms completely, including their audit work and working papers, due to a position taken by an authority in such foreign jurisdiction. Such reporting issuers would be required to establish and confirm to the SEC that they are not owned or controlled by a governmental entity in the relevant foreign jurisdiction.
In addition, if the PCAOB is unable to inspect the auditors of such reporting issuers for three consecutive years, the SEC will be required to prohibit the trading of such issuers’ securities on any national securities exchange or over-the-counter markets in the United States (the Initial Prohibition). The SEC would be allowed to lift the Initial Prohibition if the issuer certifies to the SEC’s satisfaction that the issuer has retained an auditor that the PCAOB has inspected. However, if the PCAOB later determines that it is unable to inspect such issuer’s auditor in a year subsequent to the end of the Initial Prohibition, the SEC would then be required to impose a subsequent prohibition on trading of the issuer’s securities for a period of at least five years (the Subsequent Prohibition). The SEC will be allowed to lift the Subsequent Prohibition after the five-year period if the issuer certifies to the SEC’s satisfaction that it will retain an auditor that the PCAOB is able to inspect.
The HFCAA would also require reporting issuers to make additional disclosures for a non-inspection year, including with respect to the percentage of its shares owned by governmental entities in its jurisdiction of incorporation, whether governmental entities in the applicable foreign jurisdiction have a controlling financial interest in it, and, if applicable, the names of any Communist Party of China officials who are its directors or directors of its operating entity.
Implications for Chinese Issuers
If enacted, the HFCAA could cause a serious compliance dilemma for Chinese issuers listed on U.S. securities exchanges. Under SOX, U.S.-listed companies are required to be audited by firms that are inspected by the PCAOB. However, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers. This ongoing conflict escalated in December of 2012 when the SEC initiated administrative proceedings against the China affiliates of each of the “Big Four” accounting firms and another large U.S. accounting firm for refusing to produce audit work papers and other documents related to China-based companies under investigation by the SEC for potential accounting fraud against U.S. investors.
In an attempt to resolve the issue, the PCAOB entered into a memorandum of understanding (the MOU) with the China Securities Regulatory Commission (CSRC) and the Ministry of Finance on 7 May 2013, which established a cooperative framework for the production and exchange of audit documents relevant to investigations in both countries’ respective jurisdictions. However, under the MOU, access to audit papers can still be withheld based on “grounds of public interest or essential national interest”, and the PCAOB has continued to raise concerns that Chinese cooperation has not been sufficient for the PCAOB to obtain timely access to relevant documents and testimony necessary for the PCAOB to carry out enforcement matters.
In addition, new provisions under Article 177 of the Securities Law of the People’s Republic of China came into effect on 1 March 2020, which provide that no entity or individual in China may provide documents and/or materials relating to securities business activities overseas without the approval of CSRC and various regulatory authorities under the China State Council. These new provisions, together with existing state secrecy laws and regulations in China that prohibit the sharing of sensitive information with foreign parties, put Chinese companies listed on U.S. securities exchanges in the precarious position of trying to comply with conflicting laws in the U.S., which require disclosure of certain information, and laws in China, which prohibit such disclosure. As a result, U.S.-listed Chinese companies may have a renewed interest in terminating their U.S. listings and reporting obligations and seeking a listing in another jurisdiction.
Delisting and Reregistration from the U.S. – Going Dark or Going Private
Chinese companies listed on a U.S. securities exchange may terminate their reporting obligations in the U.S. and delist from a U.S. securities exchange by either “going dark” or “going private”. The primary difference between these two routes, which are described below, is that a company that “goes dark” will continue trading after the date of deregistration, whereas a company that “goes private” will no longer trade after deregistration.
Going Dark. U.S.-listed companies are entitled to voluntarily delist their securities and deregister under the U.S. Securities Exchange Act of 1934 (the Exchange Act), provided they satisfy certain conditions. Foreign private issuers that are also listed outside the U.S. are generally eligible to proceed with a streamlined delisting and deregistration process under Rule 12h-6 of the Exchange Act, provided that:
- the issuer must have been a reporting company under the Exchange Act for at least one year, have filed or submitted all Exchange Act reports required for this period and have filed at least one annual report;
- the issuer must not have made a registered offering in the U.S. for the past 12 months (with limited exceptions);
- the issuer must have maintained a non-U.S. listing, which is its primary trading market, that constituted at least 55% of its trading in a recent 12-month period;
- (i) the average daily trading volume (ADTV) of the issuer’s shares in the U.S. during a recent 12-month period must not be greater than 5% of the ADTV of the issuer’s shares on a worldwide basis and/or (ii) the issuer has fewer than 300 holders who are U.S. residents or fewer than 300 holders worldwide, on a date falling within 120 days of filing the requisite notice to the SEC; and
- there is a further 12-month waiting period if the issuer did not meet the 5% ADTV test when delisted.
Going Private. Companies that are not eligible to “go dark” can still pursue a privatization process that involves cashing-out all or a substantial portion of their public shareholder’s so that they become eligible to delist and deregister their shares under the Exchange Act. Depending on company-specific factors, including the participation of controlling shareholders and affiliates, going-private transactions are often structured as one-step mergers or as tender offers followed by a back-end or short-form merger. Reverse stock splits can also be used to reduce the number of public shareholders in order to render the company eligible to delist and deregister under the Exchange Act. Going private transactions may involve negotiations with a special committee of the target company’s board, the issuance of fairness opinions, extensive public disclosures under Rule 13e-3 of the Exchange Act and a shareholder vote. Additional factors to consider in going private transactions include the timing and substance of the necessary disclosures, as well as the likelihood of litigation relating to the disclosure. Going private transactions tend to be more time consuming and costly than going dark transactions.
Listing in Hong Kong
Given the benefits of “going dark” under Rule 12h-6 of the Exchange Act as compared to other methods to terminate reporting obligations in the U.S., U.S.-listed Chinese companies are now actively exploring alternative listing venues prior to proceeding with the delisting and deregistration process in the U.S., preferably in another international financial centre that offers comparable ability to raise international capital, such as the HKEX. So far, Alibaba Group, JD.com and NetEase have all completed a secondary listing in Hong Kong, together with very large new equity issues to Hong Kong retail and institutional investors. In connection with this, we set out below a summary of the requirements for pursuing a dual-primary or secondary listing on the HKEX.
PRC-based issuers that are already listed in the United States (e.g., on the New York Stock Exchange (NYSE) or NASDAQ), have the option of pursuing either a dual-primary listing under Chapters 8 or 8A or a secondary listing under the concessionary route under Chapter 19C. In particular, Chapter 19C has attracted significant attention in recent months, as a number of high-profile PRC tech companies (including Alibaba Group, JD.com and NetEase) have completed or are in the process of completing a Hong Kong listing under Chapter 19C. The traditional secondary listing route is not available to PRC-based issuers, as the HKEX and the Securities and Futures Commission require an issuer pursuing a traditional secondary listing to have a “centre of gravity” outside of Greater China.
The concessionary secondary listing regime under Chapter 19C differentiates between PRC-based issuers that were listed on or before 15 December 2017 (Grandfathered Greater China Issuers) and those that were listed after 15 December 2017 (Non-Grandfathered Greater China Issuers). On the basis that Grandfathered Greater China Issuers were listed prior to the publication of the Exchange’s proposals for a concessionary secondary listing route (and therefore the risk of regulatory arbitrage is limited), a wider range of waivers are available to them to facilitate their listing in Hong Kong.
If after a PRC-based issuer has completed a secondary listing in Hong Kong, the bulk of trading in its shares moves to Hong Kong on a permanent basis, which means that at least 55% of the total worldwide trading volume, by dollar value, of those shares (including the volume of trading in repository receipts issued on those shares) over such issuer’s most recent financial year, take place on the Exchange’s market, then such issuer will be treated by the HKEX as having a dual-primary listing in Hong Kong.
A brief overview of the relevant listing requirements are set out in the Appendix of our pdf.