On April 21, 2020, the SEC Chairman Jay Clayton and a group of senior SEC and PCAOB officials issued a joint statement warning about the risks of investing in emerging markets, especially China, including companies from those markets that are accessing the U.S. capital markets. On July 9, 2020, the SEC held an Emerging Markets Roundtable where Chair Clayton reiterated his concerns about emerging market investment risks. Previously, in December 2018, Chair Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III issued a similar cautionary statement, also focusing on China (see HERE).
SEC and PCAOB Joint Statement
On April 21, 2020, SEC Chair Clayton, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, and PCAOB Chairman William D. Duhnke III issued a joint public statement warning of the significant disclosure, financial and reporting risks of investing in emerging markets, and the limited remedies where such investments turn bad.
Over the past years, emerging markets have increased their access to U.S. capital markets with China becoming the largest emerging market economy and world’s second largest overall economy. The ability for regulators to enforce financial reporting and disclosure requirements for entities either based in, or with significant operations in, emerging markets is limited and dependent on the cooperation and assistance of local authorities. As a result, in many emerging markets, including China, there is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse, in comparison to U.S. domestic companies. The joint statement summarizes specific risks and considerations for market participants.
I have written about risk factors and the importance of company-specific risk disclosures in the past (see HERE). Companies that have significant operations in emerging markets often face greater risks and uncertainties, including idiosyncratic risks, than in more established markets. The operational risk disclosures for companies in emerging markets need to be robust including considering industry and jurisdiction-specific factors.
Likewise, the varying standards for financial reporting and oversight in different jurisdictions create unique risks that must be disclosed. Companies should discuss these matters with their independent auditors and where applicable, audit committees, and should disclose the related material risks.
Companies based in emerging markets should consider providing a U.S. domestic investor-oriented comparative discussion of matters such as (i) how the company has met the applicable financial reporting and disclosure obligations, including disclosure control procedures and internal controls over financial reporting and (ii) regulatory enforcement and investor-oriented remedies including, as a practical matter, in the event of a material disclosure violation or fraud or other financial misconduct.
Quality of Financial Information; Varying Requirements and Standards
The foundation of investor confidence in capital markets is high-quality, reliable financial statements. The SEC regulatory regime contains numerous rules and regulations to ensure these high-quality financial statements, including rules related to internal controls over financial statements (ICFR); auditor attestations; CEO and CFO attestations (see HERE); independent audit committees; auditor independence standards, PCAOB review and oversight and SEC review and enforcement.
While the form of disclosure may appear substantially the same as that provided by U.S. issuers and FPIs in many jurisdictions, it can often be quite different in scope and quality. Furthermore, that scope and quality of disclosure can significantly vary from company to company, industry to industry, and jurisdiction to jurisdiction.
In addition, if a foreign entity does not report to the SEC, the information and standards for preparing that information may be completely unreliable. Some jurisdictions have much lower regulatory, accounting, auditing or auditor oversight requirements or none at all.
The bottom line is that investors and financial professionals should carefully consider the nature and quality of financial information, including financial reporting and audit requirements, when making or recommending investments. Companies should ensure that relevant financial reporting matters are discussed with their independent auditors and, where applicable, audit committees.
PCAOB’s Inability to Inspect Audit Work Papers in China
The SEC and PCAOB’s first statement on this matter in December 2018 drilled down on the fact that China will not cooperate with their requests to review, investigate or audit local PCAOB member firms in China, thereby casting doubt and a lack of transparency on the quality and reliability of audits. The newest statement reiterates this situation and specifically notes a lack of improvement despite ongoing efforts. Investors should understand the potential impacts of the PCAOB’s lack of access when investing in companies whose auditor is based in China and public companies with operations in China must disclose these risks in SEC reports.
Limited Rights or Remedies
The SEC, U.S. Department of Justice (“DOJ”) and other authorities often have substantial difficulties in bringing and enforcing actions against non-U.S. companies and non-U.S. persons, including company directors and officers, in certain emerging markets, including China. Likewise, shareholder claims, including class action lawsuits, can be difficult or impossible to pursue in emerging markets. Even if investors successfully sue in the U.S., judgments may be impossible to enforce or collect upon.
Companies should clearly disclose the related material risks in their SEC reports.
Passive investing strategies, such as through or following an index fund, often fail to consider the increased and specific risks associated with emerging markets.
Investment Advisers, Broker-Dealers and Other Market Participants Should Consider Emerging Market Risks
The SEC reminds investment professionals to consider the risks discussed in their statement when making investment decisions or providing investment advice or recommendations involving emerging markets.