Potential Implications if Hong Kong’s Special Status Is Revoked

On May 29, 2020, US President Donald J. Trump announced in a news conference that Hong Kong is no longer sufficiently autonomous to warrant the special treatment that the United States has afforded Hong Kong since its handover to China.¹ Many of the initial concerns have focused on how the revocation will be implemented with respect to customs and other trade laws, but there other concerns that the financial services sector also should be paying attention to.² While it is unknown how far the consequences of the revocation will extend, we discuss some of the key issues to track over the coming months.

Public Company Audit Reports

Under US federal securities laws, the Public Company Accounting Oversight Board (“PCAOB”) is required to conduct regular inspections of all registered public accounting firms, both domestic and foreign, that issue audit reports for audits of US-listed public companies and broker-dealers registered with the US Securities and Exchange Commission (“SEC”) or that play a substantial role in the preparation of them.³ The PCAOB and the SEC historically have differentiated between audits performed in Hong Kong and audits performed in mainland China.⁴

Chinese authorities have not permitted the PCAOB to inspect the audit work and practices of PCAOB-registered auditing firms in China (including Hong Kong-based audit firms, to the extent their audit clients have operations in mainland China) with respect to their audit work of US-listed companies with operations in China. In contrast, the SEC has an arrangement with Hong Kong that allows the SEC to request and examine similar business books and records related to transactions and events occurring within Hong Kong and auditor’s documentation of work performed in Hong Kong.⁵

The SEC could revoke access to the US equity markets for public companies that use audit firms subject to the restrictions imposed by the Chinese authorities. In fact, President Trump specifically mentioned this issue in his May 29 speech when he instructed the Presidential Working Group on Financial Markets to study the practices of Chinese companies listed on the US financial markets. Given the proximity of this issue to the change in Hong Kong’s special status, any revocation of access to the US equity markets for mainland Chinese companies could be extended to public companies based in or with significant operations in Hong Kong.

Non-US Futures Activities

In 2015, the US Commodity Futures Trading Commission (“CFTC”) permitted certain approved firms in Hong Kong to solicit and accept orders from US customers for otherwise permitted futures and options transactions on Hong Kong exchanges without having to register in the United States.⁶ This relief extends only to approved firms regulated solely by the Hong Kong Securities and Futures Commission (“HKSFC”). No similar authorization has been issued to a regulator or exchange based in mainland China.

The CFTC recently finalized rules that would allow it to revoke prior authorizations, such as the 2015 authorization granted to firms regulated by the HKSFC.⁷ Among other items, these rules would allow the CFTC to revoke an authorization if there are any material changes in the HKSFC’s futures and options regulatory regime, including a lack of comity relating to the execution or clearing of any commodity interest subject to the CFTC’s exclusive jurisdiction, or if the CFTC determines that information-sharing arrangements with the HKSFC no longer adequately support the authorization.

Non-US Swaps Activities

In 2013, the CFTC issued a comparability determination with respect to the Hong Kong Monetary Authority’s (“HKMA’s”) swap dealer requirements for (i) chief compliance officers, (ii) risk management and (iii) swap data recordkeeping. No similar determination has been issued for a regulatory regime from mainland China.

The CFTC’s determination for Hong Kong allows CFTC-registered swap dealers that are located in Hong Kong to comply with the HKMA requirements as a reasonable substitute for compliance with the CFTC’s requirements. The CFTC has indicated that this determination may become invalid if there are material changes in HKMA’s regime.

International Capital Reporting

Under the Treasury International Capital Reporting System, US depository institutions, including US branches of non-US banks, and their US holding companies; US broker-dealers; and other US financial institutions must report certain claims on or liabilities owed to non-US residents on the Form B Reports.⁸ The thresholds for filing Form B Reports are if the claims or liabilities of the institution or its US customers exceed $50 million in total or exceed $25 million with respect to a single country.

Hong Kong and mainland China historically have been treated as separate countries for purposes of this reporting obligation. US financial institutions may need to begin filing Form B Reports if Hong Kong is treated as having been merged into mainland China and the aggregate activity exceeds the $25 million-per country threshold.

Takeaways

The true impact for the financial services sector will depend on how the United States moves forward with the revocation of its special treatment of Hong Kong. Therefore, financial institutions should start identifying and addressing the issues that are relevant to their operations. Looking at recent, similar situations, such as the exit of the United Kingdom from the European Union, we expect the industry will encounter issues like those discussed in this Legal Update, as well as unknown unknowns.

Proactive planning is particularly important for issues where the resolution may require engagement with US regulators. US regulators sometimes have limited bandwidth to address multiple issues simultaneously and may be slowed down by the requirements of the Administrative Procedures Act and other rulemaking requirements. Early engagement with regulators, often through outside counsel, can mean the difference between timely resolution and last-minute scrambling.