The ‘Holding Foreign Companies Accountable Act’: An arduous path for Chinese firms?

President Trump's Trade War with China led to the introduction of numerous new policy measures, among which the Holding Foreign Companies Accountable Act (HFCAA) is the latest and most discussed. The HFCAA has gained the attention of Chinese companies investing in the US stock exchange because it will have major repercussions for them if they don’t comply with its rulings.  These companies include some of China’s major economic giants such as Alibaba Group Holding Ltd., Baidu Inc., JD.com Inc., etc. They are among the 273 Chinese companies at risk of being delisted by 2024. Therefore, it is pertinent to unpick what the HFCAA stands for and why it is creating a disaster for Chinese companies registered on the US stock exchange.

What is the HFCAA?

The HFCAA is a law passed in 2020 to hold foreign companies accountable, especially targeting those that do not share their audit reports for financial scrutiny. The law requires foreign companies registered on US stock exchanges to declare that they are not owned by Chinese government officials. The HFCAA itself is an amendment to the previously passed Sarbanes–Oxley Act. As per the previous act, companies in foreign jurisdictions are required to disclose their data to the US Securities and Exchange Commission (SEC). Earlier, the Public Company Accounting Oversight Board (PCAOB) was prevented from conducting inspections outside the US. Following the HFCAA, however, the PCOAB is allowed to audit specified reports for a consecutive period of 3 years, a process that is required if a foreign company wishes to remain on the US stock exchange. If a company fails to comply with the aforementioned processes, it will be declared as a Commission-Identified Issuer and the legal process will work as prescribed in Release No. 34-93701.

How will the legal process work?

If Chinese companies do not comply, then the SEC is given the legal right to identify those companies as Commission-Identified Issuers and openly disclose the issuer’s details for public scrutiny so that transparency is ensured, but only if they remain part of the issuer list for 3 consecutive years.

To this end, the US has accelerated the rate of action against issuers. This has been done by the introduction of another bill in the US senate to reduce the previously mentioned three consecutive years' timeline under the HFCAA to two years. The development is alarming for Chinese companies as it means a speedy response to the trading ban is to be expected as early as 2023. The outcome is the delisting of Commission-Identified Issuers by stock exchanges once trading bans are implemented.

The reputation of the US stock exchange

The US capital market has drawn businesses from all over the world due to its reputation for honesty and integrity as well as its market breadth and liquidity, visibility, efficiency, and brand-name enhancement. The purpose of PCAOB inspections and investigations is to ensure that audit firms adhere to the necessary auditing standards and regulations to safeguard US investors and improve market integrity. In light of these claims, it follows that the current rise in Chinese purchases in the United States has resurrected earlier concerns about the political and economic effects of foreign investment. Chinese investments raise concerns that they may hurt rather than benefit local employment because state ownership and China's industrial policies may encourage its companies to buy assets abroad just to relocate employment and production back home.

Moreover, for any state, the protection of the data of its citizens is of vital interest, and if Chinese companies do business within the US and intend not to share the audit reports and working papers with the PCAOB, that raises eyebrows within security circles. Nevertheless, the US views Chinese ingress into the US market with scepticism. Although PCOAB views that audit reports do not contain anything that is a matter of national security, if a firm is reluctant to share based on the proposition that a foreign state does not permit the sharing of data then it raises the alarm for the home state.

Such steps are vital for the legitimacy and transparency of the US exchange system so that every listed company adheres to the standard protocols. However, Chinese firms have refrained from sharing audit reports based on their excuse that audit reports are part of "state secrets" that, as per China’s State Secret Laws, cannot be shared without the permission of the Chinese government.

China’s State Secret Laws and the reluctance of Chinese companies to share audit reports

China is one of the most rigid business societies in the world when it comes to secrecy, and traditionally information is revealed only on a need-to-know basis, which is why the US’s current approach towards data security has relevance in all areas of Chinese governance. In this regard, China has its own State Secret Laws to ensure that no Chinese firm can share data with any other country without the permission of the government, which were first instituted in 1951. If any company shared data without the approval of Chinese regulatory authorities, it could result in licence cancellation and other harsh measures. Therefore, Chinese firms find it difficult to maintain the secrecy of data at a time when foreign states are requiring the sharing of data for regulatory, transparency, and legitimacy measures.

The State Secrets Law prohibits sharing financial information about Chinese companies on foreign listings. For the sharing of data with foreign states or companies, the concerned authority needs prior authorization from the government. Furthermore, every individual is responsible, as per Article 398 of the Criminal Law, to “safeguard” state secrets from non-governmental personnel. An example from within China is the case study of Zheng Enchong, who was penalised for sharing an internal Xinhua news agency news report on Human Rights in China.

Following similar lines, in 1989, China implemented a new law known as the State Secret Laws. The law prohibits the disclosure of state secrets. The 1951 regulation didn’t define “state secrets," which made it easier for the government to question almost any instance of information that had implications for the government. With the 1989 updates this was updated. It is important to explain the term “neibu" (internal) which Chinese officials frequently invoke to clarify why they are unable to share any details with foreign parties about the regulations or details regarding any official document.

State secrets have been classified into 3 categories: top secret, highly secret, and secret. The categorization is based on the idea of how much harm the sharing of each would cause China’s national security. The idea is itself blurred as the law intends to name anything as a state secret for a particular period, but that time period is unspecified in the document. Similarly, it means that anything questioned by a foreign state may be named top secret or its duration will be extended. Certainly, the protection of state secrets remains a pertinent concern for any state, but claiming invoking the cause of national security - perhaps arbitrarily -  whenever China is concerned raises questions from within the international audience regarding how to find a middle way when conflicts arise. The recent example that has emerged is the questioning of compliance rates of Chinese firms according to HFCAA regulations.

Taking the example of the classification of audit papers as state secrets, Chinese firms that are operating outside China face challenges regarding how to read the HFCAA’s Article 21. Article 21 does not allow Chinese officials to invoke the ‘neibu excuse’ as a legitimate platform upon which to deny foreign access to official documents. The HFCAA would require a document to be specifically labelled a “State Secret” for it to forgo disclosure. This means that if the audit papers are not already declared by the state as state secrets, they can be legally shared with the US if asked by a Chinese firm working in the US. However, the lines remain blurred as states may designate a document a state secret at any time, raising legal questions.

To demonstrate the reality of this legal conundrum, if we return to China’s State Secrets Law, we see that Article 2 defines a state secret as a matter that is linked to the national interest of the state and should not be shared with anyone except the ones who are allowed by the Chinese government for a specific period. Given China’s long history of a peaceful, development driven rise it can be asserted that China may declare any economic matter a security matter to protect its economic interests — such as Chinese firms' access to foreign markets.The point to ponder, therefore, is that the law does not prescribe the procedure for the determination of state secrets, thus raising further legal ambiguity over sharing audit papers with US audit authorities.

What’s next?

The SEC of the US has already begun naming the Chinese companies that are at risk of delisting. Nonetheless, the delisting exacerbates political rhetoric on both sides, as Washington continues to insist on access to audit reports, while Beijing, citing national security concerns, prohibits foreign inspection of working papers from local accounting firms. Further countries, likely US allies, may follow this trend and begin questioning Chinese investors on similar grounds, especially given that China remains the only jurisdiction that has denied PCAOB "necessary access to conduct oversight."

For the US, Chinese investment has become a double-edged sword. As strategic competition between the US and China is challenging the US-led economic status-quo, so does Chinese investment remain an important part of the US market. As per the estimates from Goldman Sachs, U.S. institutional investors held around $200 billion of exposure to Chinese companies’ American depositary receipts (ADRs). It is therefore important to analyse how the HFCAA has shaped the existing trade war pattern that has impacted both states.

In retrospect, the emerging situation requires closer cooperation from both sides. China, despite its concerns about state secrets, is trying to find a way forward for Chinese investors who have come under the radar of PCAOB. Vice-Premier Liu He of China states that negotiations between Chinese and US regulators over companies listed in the US have advanced and that both parties are putting the finishing touches on specific cooperation arrangements. In other words, the HFCAA has weaponized access to the US capital markets to punish Chinese firms.

Furthermore, cases have been observed regarding potential accounting scandals, which is why the US has needed strict policy measures to maintain the trust of investors in US stock exchanges. A case under review is the US toll on the Luckin Coffee accounting scandal, in which executives at the Chinese coffee company fabricated more than $300 million in revenue. The actions are not just against Chinese firms but also several US companies such as HealthSouth, WorldCom, Enron, Lehman Brothers, Freddie Mac, and American International Group. Such actions are critical to sustaining sound capital-market governance, where trustful disclosure and punishment for noncompliance strengthen the foundations of the stock exchange.

Irrefutably, both states need to take steps to assist the firms that believe that the role of a state is to assist market participation, minimise disruptions to investors, and maintain order in the market. Both sides need to act mature, as they have done in the past. If China believes it can leave the US stock market and move to Hong Kong, then it needs to recalibrate such action as it would only be a temporary solution. Such steps would mean the introduction of a possible step by the US towards revoking Hong Kong’s preferential status as a customs and travel territory separate from China. Such a step means the Hong Kong stock exchange’s attractiveness would  decline. Similarly, the integration of US economic interests with China may require decoupling, as per US experts, yet a holistic reassessment of this option is needed as several US sectors have China as their biggest importing market or vice versa.

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