On December 20, 2021, the SEC's Division of Corporation Finance (the "Division") posted an illustrative letter containing sample comments that the Division may issue to companies based in, or with the majority of their operations in, the People's Republic of China ("PRC") or the Hong Kong Special Administrative Region of the PRC (collectively for purposes of this client alert, "China" and, such companies, "China-based companies"). The illustrative letter contains comments that are representative of comments the Division has been issuing during the past several months to China-based companies, as well as to companies that have a more attenuated connection to China. The posting of this sample comment letter has led some to speculate that the Division may now have settled on the scope of disclosure it expects from China-based companies and could begin clearing their offerings to proceed. The early weeks of 2022 may bring clarity to this situation and either see the SEC allow China-based companies to proceed with raising capital in U.S. securities markets or, if not, cause many such companies to abandon their efforts and seek to raise capital elsewhere.
The letter comes on the heels of final rules separately adopted by the SEC to implement congressionally mandated submission and disclosure requirements of the Holding Foreign Companies Accountable Act (the "HFCA Act"), which could result in trading prohibitions (as early as 2024) on an identified foreign issuer that the Public Company Accounting Oversight Board (the "PCAOB") has determined it is unable to inspect or investigate for three consecutive years. The HFCA Act was enacted in 2020 in response to the inability of the PCAOB to inspect the audits of China-based, U.S.-listed firms and could result in the delisting of China-based companies beginning in 2024.
SEC Illustrative Comments
The comments the Division has been issuing to China-based companies since mid-2021 seek more specific and prominent disclosure about their legal and operational risks and follow a series of statements and guidance posted on the SEC's website on disclosures that China-based companies should include in their SEC filings to highlight specific risks relating to investments in those China-based companies. In particular, the Division issued guidance in November 2020 on its views regarding certain disclosure considerations for China-based companies; additionally, in July 2021, SEC Chair Gary Gensler issued a Statement on Investor Protection Related to Recent Developments in China; and in August 2021, Mr. Gensler posted a video called "The SEC, China & Offshore Shell Companies" as part of his Office Hours series.
The new sample comment letter covers disclosure in the three areas of registration statements (and is applicable to corresponding sections of other filings):
- prospectus cover page
- prospectus summary
- risk factors
The comments focus on the need for "clear and prominent disclosure regarding the structure of the [China-based] company, including the relationship between the entity conducting the offering and the entities conducting the operating activities, risks associated with a company's use of a variable interest entity ("VIE") structure, and the potential impact on the company's operations and investors' interests if such structure were disallowed or the contracts were determined to be unenforceable." The comments also address the additional legal, regulatory, and enforcement risks that may apply to investments in China-based companies, such as the potential impact of the HFCA Act and related rules and any necessary PRC permissions a China-based company may need to operate its business or offer securities to foreign investors.
In its post regarding the sample letter, the Division also provided the following specific guidance for special purpose acquisition companies ("SPACs") and China-based registrants that have ongoing periodic SEC reporting obligations or are engaged in capital-raising transactions via takedowns from an effective SEC shelf registration statement:
- For SPACs with sponsors based in China, executive offices in China, or a majority of their executive officers and/or directors located in or having significant ties with China, or are contemplating merging with a company incorporated in China, the Division's view is that specific disclosure about these circumstances is warranted to meet the company's disclosure obligations even at the IPO stage when no specific target has been identified. Specifically, the Division expects their disclosure to address the risks associated with the SPAC's operations, as well as the challenges that investors in the SPAC might face in enforcing their rights under the SPAC's controlling agreements. Similarly, the disclosure should address any impact that a PRC law or regulation may have on the SPAC's ability to complete a merger transaction with an operating company in China, or the cash flows associated with the business combination, including shareholder redemption rights. Finally, the disclosure should cover the risks related to an investment in a China-based company after any subsequent business combination with an operating company, including any PRC government regulation of that entity's business or industry.
- For China-based companies that have ongoing periodic SEC reporting obligations or are engaged in capital-raising transactions via takedowns from an effective SEC shelf registration statement, the Division expects their prospectus supplements or incorporated periodic or current reports, and future periodic reports, to disclose the information and risks specified in the sample letter.
In providing the sample comment letter, the SEC also noted that the comments are illustrative and "do not constitute an exhaustive list of the issues that companies should consider," and urged companies to consider the sample comments along with additional regulatory developments relating to China-based companies as they prepare their disclosure documents. For example, China-based companies should consider whether disclosure is warranted relating to new draft rules recently announced by China's securities regulator, which would require Chinese companies seeking to sell shares abroad to follow domestic rules and file for local registration.7
The SEC also encouraged companies to contact the industry office responsible for the company's filings with any questions regarding the company's proposed disclosure.
As a result of the posting by the SEC of this sample letter, China-based companies making their initial filings with the SEC should ensure that their filings include applicable disclosure responsive to the comments in the sample letter. In addition, China-based companies currently engaged in an SEC review process should determine whether the sample letter contains comments applicable to them that they did not previously receive, as the Division may use this on a going-forward basis as a guidepost for issuing additional comments.