Holding Foreign Companies Accountable Act (HFCAA)

The Holding Foreign Companies Accountable Act (HFCAA) is a 2020 United States federal law designed to hold foreign companies listed on U.S. stock exchanges to the same auditing and transparency standards as their domestic counterparts. In a nutshell, it's America's regulatory sheriff telling foreign firms: “If you want to raise money from our investors, you have to play by our rules.” The law specifically targets a long-standing issue where the U.S. regulator, the Public Company Accounting Oversight Board (PCAOB), was blocked from inspecting the audit files of companies based in certain jurisdictions, most notably China and Hong Kong. For years, this created a massive blind spot for investors, who had to take the financial statements of these companies largely on faith. The HFCAA put an end to that, creating a powerful mechanism to delist companies that remain non-compliant, thereby protecting investors from potential accounting fraud and misrepresentation.

Imagine two bakeries selling pies. One lets health inspectors check its kitchen anytime, while the other keeps its kitchen doors locked, claiming “bakery secrets.” Which pie would you trust more? For years, U.S. investors faced a similar scenario. All companies listed in the U.S. are required to have their audits inspected by the PCAOB. This is a fundamental layer of investor protection, ensuring the numbers a company reports are credible. However, Chinese authorities, citing national security concerns, consistently blocked the PCAOB from inspecting the audit work of U.S.-listed Chinese firms. This meant that the financial health of hundreds of Chinese companies, from tech giants to emerging startups, could not be independently verified by U.S. regulators. High-profile scandals, like the massive fraud discovered at Luckin Coffee in 2020, underscored the very real risks. Investors were pouring billions into companies whose books were effectively a black box. The HFCAA was passed to pry that box open or, failing that, to remove it from the U.S. market entirely.

The HFCAA's enforcement mechanism is straightforward and potent, often described as a “two-strikes-and-you're-out” rule. Initially, the law operated on a three-year timeline, but this was accelerated to two years by subsequent legislation in late 2022, turning up the heat on non-compliant firms. Here is the process:

• Strike 1: The U.S. Securities and Exchange Commission (SEC) officially identifies a company as a “Commission-Identified Issuer.” This happens if the PCAOB certifies that it is unable to inspect the company's registered public accounting firm for the year.
• Strike 2: If the company is flagged for a second consecutive year, the clock runs out. The SEC is then required to prohibit trading of the company's securities on any U.S. exchange, which results in a delisting.

This threat of being kicked off the world's most liquid capital markets created immense pressure, forcing a resolution to the long-standing diplomatic and regulatory stalemate.

For a value investor, the HFCAA is more than just a piece of regulation; it's a powerful lesson in risk, trust, and the true meaning of value.

A core tenet of value investing is buying a wonderful business at a fair price. But what if that business could suddenly become inaccessible? Delisting risk is a major liability that must be factored into any valuation. A stock might look statistically cheap, but it's no bargain if it's at risk of being booted from the Nasdaq or NYSE. A delisting triggers a cascade of negative events:

• Forced Selling: Many institutional funds are prohibited from holding unlisted or over-the-counter (OTC) stocks, leading to massive selling pressure.
• Loss of Liquidity: Trading volume plummets, making it difficult to buy or sell shares at a fair price.
• Price Collapse: The combination of forced selling and illiquidity almost guarantees a significant drop in the stock's value.

Value investors like Warren Buffett and his mentor, Benjamin Graham, built their philosophies on a deep understanding of a company's financials. As Graham taught, a core principle is the margin of safety—the difference between a stock's market price and your estimate of its intrinsic value. The HFCAA highlights a critical flaw in analyzing companies from non-compliant jurisdictions: if their audits can't be inspected, how much can you trust their reported earnings, assets, and liabilities? The inability to verify the numbers fundamentally erodes your margin of safety. A cheap P/E ratio is meaningless if the “E” (Earnings) is potentially fabricated.

Interestingly, the HFCAA's biggest impact may have been in preventing the very outcome it threatened. The credible threat of mass delistings finally brought Chinese regulators to the negotiating table. In late 2022, the PCAOB announced it had, for the first time, secured complete access to inspect and investigate firms in mainland China and Hong Kong. This breakthrough dramatically lowered the immediate delisting risk for hundreds of Chinese companies. However, the law remains in place. If access is ever rescinded in the future, the two-strike clock can start ticking again.

The HFCAA is a landmark piece of investor protection that reinforces a timeless lesson: transparency is not a “nice-to-have”; it's essential. For the value investor, it serves as a stark reminder that geopolitical risk and regulatory standards are just as important as a balance sheet. While the immediate crisis for many Chinese stocks has been averted, the HFCAA's existence ensures that the “locked kitchen” problem won't be easily ignored again. When searching for value stocks globally, always ask yourself: can I trust the numbers, and who is verifying them?