Sarbanes-Oxley Act - Impact on Hong Kong and China companies

Those who view corporate misconduct as one of the causes of the United States economy's downturn hope the Sarbanes-Oxley Act of 2002 (the "Act") will serve as s a bitter pill that might cure this presumed breakdown in the U.S. corporate governance environment. The objective of the Act is to enhance public trust in the integrity of financial reporting, partly through increased management accountability. The Act covers a broad range of governance matters, from financial statement certification to providing protection for whistleblowers. The Act's far-reaching implications to non-U.S. jurisdictions have raised concerns amongst government authorities, companies and certain industry groups.

Although many provisions of the Act still require further clarification, companies that are currently listed in the U.S., or those that intend to seek capital there, should begin assessing its impact. While much has already been written regarding the CEO, CFO and management certifications and attestations, several other provisions of the Act are equally relevant. In particular, provisions relating to additional requirements for audit committees, restrictions on director and officer loans and enhanced related party disclosure requirements warrant immediate analysis.

Audit committees

The Act will bring about fundamental changes in how audit committees, management and auditors carry out their respective responsibilities and interact with each other. The Act requires audit committees to be comprised of independent members of the board of directors. To be independent, a board member cannot receive any consulting, advisory or other compensation from the company, other than serving as a member of the board. In addition, the audit committee member should not be affiliated with the company or its subsidiaries.

In China and Hong Kong, independent is generally interpreted to mean that the members are not management, and do not have business or other relationships that could materially interfere with the exercise of their judgment. The independence rules in both these countries also look at the percentage of stock ownership, directly or indirectly held, in a company to determine if someone could be considered independent.

Although the definition of independence may be different between the US, Hong Kong and mainland China, the objectives are similar. They all reflect the principle that those charged with the responsibilities of corporate oversight should be truly objective. Because of the slightly different rules regarding audit committee composition and definition of independence, Hong Kong and mainland China companies who are thinking of selling stock in the U.S. will need to assess whether they are compliant with the Act.

Under the Act, the audit committee will become responsible for certain aspects of the Company's relationship with its auditor, such as the appointment, compensation and oversight of the work of the company's auditors. Auditors must report directly to the audit committees and the audit committee must approve any non-audit services provided by the auditors. In addition, the audit committee must establish procedures for receiving and addressing complaints received regarding accounting, internal controls and auditing. These provisions of the Act create fundamental differences in the responsibilities of audit committees as compared to audit committees currently operating in Hong Kong and China. These differences will require companies to change their mindset regarding the powers of the audit committees. The committees will have to be active in understanding the business and voicing their concerns to management.

In addition to independence and responsibilities of audit committees, requirements in US, Hong Kong and mainland China on composition of audit committees are slightly different. The below table generally illustrates this difference:

Composition of Audit Committee members

Hong Kong

China

U.S.

Number of Audit Committee members required

At least 3

At least 2*

At least 3

Percentage of independent members

> 50%**

100%

100%

Financial expert***

At least 1

At least 1

At least 1

* By 30 June, 2003, audit committee members must comprise at least one-third of board of directors.

** Chairperson must be independent

*** Definitions of æfinancial expert' differ. Generally encompasses education and experience in functioning as an accounting professional and possession of various degrees of financial and accounting knowledge.

While the Act does not drastically change the basic purpose of the audit committees, its ultimate effects on Hong Kong and Chinese companies are still being determined.

Currently, the Act requires national securities exchanges and associations to prohibit the listing of any security of an issuer that is not in compliant with the audit committee requirements within 270 days after enactment. The SEC has not granted an exemption to foreign companies and many Hong Kong and China companies will need to implement significant changes to comply.

Director and officer loans

The Act prohibits new loans to directors or executive officers unless made in the ordinary course of business, and on the same terms and conditions made to the general public. Hong Kong companies are allowed, under specific circumstances, to make loans to directors and executive officers. They are required under the Hong Kong Companies Ordinance, Stock Exchange listing rules and accounting rules to disclose loans made to directors, officers and employees.

Before the Act, loans to directors and officers were already subject to scrutiny. Loans are made to attract and retain executives, and are also viewed as a form of employee benefit. In some cases, the prohibition of these loans to directors and officers may create a conflict with their contractual entitlements. Whilst interpretations on the Act and its implementation is still evolving, companies should continue to review their compensation and benefit schemes to ascertain the potential impact of the Act.

Related parties

A key financial reporting requirement introduced by the Act is enhanced disclosure of transactions with related parties and all other unconsolidated entities that may have a material current or future effect on the financial condition of the issuer. The requirement on related party transactions should not pose a problem to companies here, as Hong Kong disclosure requirements for related party transactions are largely similar to those in the U.S. However, the Act may have introduced a new dimension to Hong Kong companies by requiring disclosure of transactions with entities that can have a material effect on the company's financial condition. Given that the business environment in Asia is closely knitted, and highly competitive markets create a tendency for companies to work closely with each other, the enhanced disclosure introduced by the Act is likely to be a sensitive issue.

Further interpretations to ascertain the kinds of transactions that will require additional disclosures by the Act are expected to be forthcoming. Companies will have to work with their advisors to study the impact of such disclosures and how they can minimize the potential conflicts and sensitivities that can be created by this disclosure requirement.

A final word

The Sarbanes-Oxley Act has introduced various new governance requirements. Some focus on increased accountability and some focus on increased transparency.The actual effects on Hong Kong and mainland China companies currently selling, or considering selling their stock, in the U.S. markets is far from clear. In a broad interpretation, companies will need to carefully assess the composition of their audit committees, adjust their mindset regarding how the relationship with its auditor is managed, re-evaluate their compensation and benefit schemes and reconsider the completeness of their related party disclosures vis-a-vis the expanded requirements of the Act. The impact of the Sarbanes-Oxley Act on any individual company will need to be carefully assessed by the company together with its U.S. legal counsel.

Rick Nurmi
Kenneth J Blomster

Richard A. Nurmi, Partner,
Global Capital Markets Group,
PricewaterhouseCoopers 

[email protected]

Kenneth J. Blomster, Partner,
Global Capital Markets Group,
PricewaterhouseCoopers

[email protected]

 

This article first appeared in the South China Morning Post

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