Topic No. 10: Disclosure Considerations for China-Based Issuers
Disclosure Considerations for China-Based Issuers
Date: November 23, 2020
Summary: This guidance provides the Division of Corporation Finance’s views
regarding certain disclosure considerations for companies based in or with the
majority of their operations in the People’s Republic of China (“PRC” or
Supplemental Information:The statements in this CF Disclosure Guidance represent the views of the Division
of Corporation Finance. This guidance is not a rule, regulation or statement of
the Securities and Exchange Commission. Further, the Commission has neither
approved nor disapproved its content. This guidance, like all staff guidance,
has no legal force or effect: it does not alter or amend applicable law, and it
creates no new or additional obligations for any person.
Over the past decade, U.S. investors have increased their exposure to companies
based in or with the majority of their operations in China (“China-based
Issuers”). China, while often viewed from an investing perspective as an emerging
market, is the world’s second largest economy and, through direct investment as
well as index-based investing, U.S. investors have increased their exposure to
China-based Issuers over the past decade.
High-quality, reliable disclosure, including financial reporting, is at the core
of the Commission’s mission to protect investors, maintain fair, orderly, and
efficient markets, and facilitate capital formation. Although China-based
Issuers that access the U.S. public capital markets generally have the same
disclosure obligations and legal responsibilities as other non-U.S. issuers, the
Commission’s ability to promote and enforce high-quality disclosure standards
for China-based Issuers may be materially limited. As a result, there is
substantially greater risk that their disclosures may be incomplete or
misleading. In addition, in the event of investor harm, investors generally will
have substantially less access to recourse, in comparison to U.S. domestic
companies and foreign issuers in other jurisdictions. Below we discuss some of the potential risks associated with investments
in China-based Issuers. We then highlight related disclosure considerations that
these issuers should consider as they seek to fulfill their disclosure
obligations under the federal securities laws.
We recognize that some of the risks and differences discussed below pertain to
issuers operating in emerging markets or foreign private issuers more generally.
However, we include these risks and differences because the limitations on U.S.
regulatory oversight of China-based Issuers can magnify these risks and
differences. Additionally, some of the risks and differences may amplify other
risks and differences, increasing the significance of their disclosure for
China-based Issuers. Thus, China-based Issuers should consider the cumulative
effects of these risks and differences as they consider their disclosure
obligations under the federal securities laws.
Risks Associated with China-based Issuers
>Risks Related to High-Quality and Reliable Financial Reporting
One of the most significant risks to high-quality, reliable disclosure and
financial reporting by China-based Issuers results from current restrictions
on the Public Company Accounting Oversight Board’s (“PCAOB”) ability to
inspect audit work and practices of PCAOB-registered public accounting firms
in China and on the PCAOB’s ability to inspect audit work with respect to
China-based Issuer audits by PCAOB-registered public accounting firms in
Hong Kong. Although the Sarbanes-Oxley Act of 2002 requires the PCAOB to
inspect registered accounting firms to assess their compliance with auditing
standards, to undertake investigations, and to bring enforcement actions for
non-compliance with these standards, China has not provided the PCAOB access
to inspect or investigate these registered public accounting firms with
respect to their audits of China-based Issuers.
As part of a continued regulatory focus in the United States on access to
audit information, both the U.S. House of Representatives and the U.S.
Senate have independently passed bills that, if enacted, could result in
delisting companies that use an auditor that the PCAOB is not able to
inspect. Furthermore, in its Report on Protecting United States Investors
from Significant Risks from Chinese Companies, the President’s
Working Group on Financial Markets recommended, among other things, that
U.S. exchanges require PCAOB access to work papers of the principal audit
firm as a condition to initial and continued exchange listing.1 While each of these initiatives contemplates a transition period for
currently listed issuers to comply in order to reduce market disruption, any
actions, proceedings, or new rules resulting from these efforts may have an
adverse impact on trading prices of securities or terminate the trading of
securities of China-based Issuers with PCAOB-registered public accounting
firms in China and Hong Kong.
>Risks Related to Access to Information and Regulatory Oversight
China has often restricted U.S. regulators’ access to information and limited
regulators’ ability to investigate or pursue remedies with respect to
China-based Issuers, generally citing to state secrecy and national security
laws, blocking statutes, or other laws or regulations. In addition,
according to Article 177 of the PRC Securities Law, which became effective
in March 2020, no overseas securities regulator can directly conduct
investigations or evidence collection activities within the PRC and no
entity or individual in China may provide documents and information relating
to securities business activities to overseas regulators without Chinese
government approval. The SEC, U.S. Department of Justice, and other U.S.
authorities face substantial challenges in bringing and enforcing actions
against China-based Issuers and their officers and directors. As a result,
investors in China-based Issuers may not benefit from a regulatory
environment that fosters effective enforcement of U.S. federal securities
>Risks Related to a Company’s Organizational Structure
Current regulations in China limit or prohibit foreign investment in Chinese
companies operating in certain industries. For example, there are
restrictions on foreign ownership of telecommunications companies and
prohibitions on ownership of educational institutions. To circumvent these restrictions, many China-based Issuers form
non-Chinese holding companies that enter into contractual arrangements,
intended to mimic direct ownership, with Chinese operating companies.
Through these contractual arrangements, the China-based Issuer is generally
able to consolidate the Chinese operating company, commonly referred to as a
variable interest entity or VIE, in its financial statements, although
whether the China-based Issuer maintains legal control of the Chinese
operating company is a matter of Chinese law. Under this structure, the
Chinese operating company, in which the China-based Issuer cannot hold an
equity interest, typically holds licenses and other assets that the
China-based Issuer cannot hold directly.
These China-based Issuer VIE structures pose risks to U.S. investors that are
not present in other organizational structures. For example, exerting
control through contractual arrangements may be less effective than direct
equity ownership, and a company may incur substantial costs to enforce the
terms of the arrangements, including those relating to the distribution of
funds among the entities. Further, the Chinese government could determine
that the agreements establishing the VIE structure do not comply with
Chinese law and regulations, including those related to restrictions on
foreign ownership, which could subject a China-based Issuer to penalties,
revocation of business and operating licenses, or forfeiture of ownership
interests. A China-based Issuer’s control over a VIE may also be jeopardized
if a natural person who holds the equity interest in the VIE breaches the
terms of the agreements, is subject to legal proceedings, or if any physical
instruments, such as chops and seals, are used without the China-based
Issuer’s authorization to enter into contractual arrangements in China.
>Risks Related to the Regulatory Environment
China’s legal system is substantially different from the legal system in the
United States and may raise risks and uncertainties concerning the intent,
effect, and enforcement of its laws, rules, and regulations, including those
that restrict the inflow and outflow of foreign capital or provide the
Chinese government with significant authority to exert influence on a
China-based Issuer’s ability to conduct business or raise capital. This lack
of certainty may result in the inconsistent and unpredictable interpretation
and enforcement of laws, rules, and regulations, which may change quickly.
For example, China-based Issuers face risks related to evolving laws and
regulations, which could impede their ability to obtain or maintain permits
or licenses required to conduct business in China. In the absence of
required permits or licenses, governmental authorities may impose material
sanctions or penalties on the company.
Differences in Shareholder Rights and Recourse, Governance, and Reporting Associated
with China-based Issuers
>Limitations on Shareholder Rights and Recours
Legal claims, including federal securities law claims, against China-based
Issuers, or their officers, directors, and gatekeepers, may be difficult or
impossible for investors to pursue in U.S. courts. Even if an investor
obtains a judgment in a U.S. court, the investor may be unable to enforce
such judgment, particularly in the case of a China-based Issuer, where the
related assets or persons are typically located outside of the United States
and in jurisdictions that may not recognize or enforce U.S. judgments. If an
investor is unable to bring a U.S. claim or collect on a U.S. judgment, the
investor may have to rely on legal claims and remedies available in China or
other overseas jurisdictions where the China-based Issuer may maintain
assets. The claims and remedies available in these jurisdictions are often
significantly different from those available in the United States and
difficult to pursue.
>Corporate Law and Corporate Governance Differences
China-based Issuers may be organized or incorporated in jurisdictions outside
of both China and the United States, such as the Cayman Islands and British
Virgin Islands. Differences between the corporate law and corporate
governance rules and practices of these jurisdictions and U.S. jurisdictions
may give rise to additional material risks and fewer shareholder
protections. For example, the fiduciary duties that directors owe investors
may be narrower in scope or less developed in these jurisdictions than in
Certain China-based Issuers qualify as foreign private issuers, which are exempt from certain rules of U.S. exchanges that are
applicable to U.S. domestic issuers. For example, U.S. stock exchanges often permit foreign private issuers
to rely on home country corporate governance practices, which means that these companies may not be required to:
have a majority of independent directors;
have independent audit committee members, compensation committee
members, and nominating committee members;
have independent board members meet in executive session;
hold annual meetings; or
obtain shareholder approval for certain issuances of
Foreign private issuers may be entitled to certain exemptions from the audit
committee independence requirements in Exchange Act Rule 10A-3.
To the extent that China-based Issuers qualify as foreign private issuers,
they are exempt from certain reporting requirements under the federal
securities laws applicable to U.S. domestic issuers. Foreign private issuers
are exempt from Exchange Act reporting requirements relating to quarterly
reports and quarterly certifications by the principal executive and
financial officers; current reports on Form 8-K that domestic issuers are
required to file upon the occurrence of specified events; the solicitations
of proxies, consents, or authorizations under Section 14 of the Exchange
Act; rules that require insiders to comply with Section 16 of the Exchange
Act; and Regulation FD. Foreign private issuers also have four months after
the end of the fiscal year to file their annual reports, as compared to 60
to 90 days for domestic companies.
Disclosure Considerations for China-based Issuers
China-based Issuers must fully disclose material risks related to their
operations in China. As companies assess these risks and related disclosure
obligations, questions to consider include:
Does the company provide clear and prominent disclosure of PCAOB
inspection limitations and lack of enforcement mechanisms, as well as
the risks relating to the quality of the financial statements? For
example, for China-based Issuers that engage audit firms based in China
or Hong Kong, does the company caution investors about:
the ongoing inability of the PCAOB to inspect the audit work of
its outside audit firm?
whether and how its audit committee has taken the lack of
inspection into account in connection with the oversight of the
outside audit firm and its procedures?
the difficulty regulators such as the SEC and PCAOB may have in
obtaining audit work papers from the company’s auditors and the
company and how that difficulty may impact the company and its
the possibility that SEC proceedings against the audit firm that
the issuer employs (whether in connection with an audit of the
issuer or other issuers operating in China) could result in the
imposition of penalties against the audit firm, such as
suspension of the auditor’s ability to practice before the
the possibility that legislative or other regulatory action in
the United States may result in listing standards or other
requirements that, if the company cannot meet, may result in
delisting and adversely affect the company’s liquidity or the
trading price of the company’s securities that are listed or
traded in the United States?
limits imposed by Chinese law on the ability of U.S.
authorities, including the SEC, PCAOB, and the Department of
Justice, to conduct investigations and bring actions, including
Does the company use VIEs in its organizational structure? If so, does
the company include sufficient disclosure about the related party
transactions in the VIE structure and caution investors about the risks
associated with the VIE structure employed in China, including that:
the VIE structure may be determined by Chinese authorities to be
inconsistent with the laws and regulations of China, including
those related to foreign investment in certain industries?
the VIE structure may be disregarded by PRC tax authorities
resulting in increased tax liabilities?
the VIE structure may not be as effective as direct ownership in
controlling entities organized in China, which often hold the
licenses necessary to conduct the company’s business in
control over, and funds due from, the VIE may be jeopardized if
the natural person or persons that hold the equity interest in
the VIE breach the terms of the agreement?
the VIE structure may result in unauthorized use of indicia of
corporate power or authority, such as chops and seals?
Does the company disclose risks relating to the regulatory environment
in China, including risks related to a less developed legal system,
which may result in inconsistent and unpredictable interpretation and
enforcement of laws and regulations? For example, does the company
caution investors that:
evolving laws and regulations and inconsistent enforcement
thereof could lead to failure to obtain or maintain licenses and
permits to do business in China?
intellectual property rights and protections may be insufficient
for companies with material intellectual property in China?
the increased global focus on environmental and social issues
and China’s potential adoption of more stringent standards in
these areas may adversely impact the operations of China-based
non-citizen shareholders may experience unfavorable tax
consequences, including for dividends payable and gains on sales
of securities for China-based companies if determined to be a
resident enterprise for PRC tax purposes?
uncertainties in China’s legal system could limit the
enforcement of contractual arrangements?
Chinese law restricts certain foreign investments in China and
these laws continue to evolve?
Chinese governmental authorities have significant discretion
that can be used to influence how the company conducts its
PRC law, and government control of currency conversion, may
restrict the ability to transfer funds into or out of
Does the company provide risk disclosure about differing shareholder
rights and remedies in the company’s country of organization and/or
based on where a company’s operations are located? For example, does the
company caution investors about:
the difficulties in effecting service of legal process,
enforcing judgments obtained in U.S. courts, and bringing claims
against the company or its directors and officers?
the lack of shareholder rights and protections if the company is
organized outside of the United States, particularly in
jurisdictions where the law is less developed?
If the company is a foreign private issuer, does it describe:
corporate governance differences pursuant to Item 16G of
differences in reporting requirements between U.S.
domestic issuers and foreign private issuers such as the
frequency of financial reporting, the exemption from
filing quarterly reports and proxy solicitation
materials, and the exemption from Regulation FD?
According to the PCAOB, “[i]n the 18-month period ended June 30, 2020, 17
PCAOB-registered firms in mainland China and Hong Kong signed audit
reports for 202 public companies with a combined global market
capitalization (U.S. and non-U.S. exchanges) of approximately $1.8
trillion.” See PCAOB, China-Related Access Challenges,
available at https://pcaobus.org/International/Pages/China-Related-Access-Challenges.aspx
(last visited Oct. 8, 2020). See also SEC Chairman Jay Clayton,
PCAOB Chairman William D. Duhnke III, SEC Chief Accountant Sagar Teotia,
SEC Division of Corporation Finance Director William Hinman and SEC
Division of Investment Management Director Dalia Blass, Emerging
Market Investments Entail Significant Disclosure, Financial
Reporting and Other Risks; Remedies are Limited (April 21,
2020), available at
In May 2020, the U.S. Senate unanimously passed S. 945, the Holding
Foreign Companies Accountable Act; and in July 2020, the U.S. House
of Representatives approved H.R. 6395, the National Defense
Authorization Act for Fiscal Year 2021, which contains provisions
comparable to the Holding Foreign Companies Accountable Act.
Additionally, in June 2019, a bipartisan group of lawmakers in the
U.S. House of Representatives introduced H.R. 3124, the Ensuring
Quality Information and Transparency for Abroad-Based Listings on
our Exchanges (EQUITABLE) Act. If any of these bills are enacted
into law, the SEC would be required to prohibit trading in a
company’s securities if the company’s auditor has not been subject
to PCAOB inspection for three consecutive years
A foreign private issuer is any foreign issuer other than a foreign
government, except for an issuer that (1) has more than 50% of its
outstanding voting securities directly or indirectly held of record
by U.S. residents; and (2) any of the following: (i) a majority of
its executive officers or directors are citizens or residents of the
United States; (ii) more than 50% of its assets are located in the
United States; or (iii) its business is principally administered in
the United States. See 17 CFR 230.405. See also 17 CFR
General Instruction F to Form 20-F defines “home country” as the
jurisdiction in which the company is legally organized,
incorporated, or established and, if different, the jurisdiction
where it has its principal listing.
One approach to providing this disclosure may be
a table comparing differences in corporate
governance practices between domestic issuers and
foreign private issuers and how those differences
Confidential and Proprietary — for Use Solely by Authorized Personnel