In this new Statement, a number of SEC and PCAOB officials—SEC Chair Jay Clayton, PCAOB Chair William D. Duhnke III, SEC Chief Accountant Sagar Teotia, Corp Fin Director William Hinman and Investment Management Director Dalia Blass—discuss the risks and exposures of companies based, or with significant operations, in emerging markets, for both U.S. issuers and foreign private issuers. Although the SEC is committed to high-quality disclosure standards, its ability to enforce these standards in emerging markets is limited and is “significantly dependent on the actions of local authorities” and the constraints of “national policy considerations.” As a result, in many emerging markets, “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 Statement is summarized below. The message is that, notwithstanding similarity in form and appearance between disclosures from U.S. domestic companies and disclosures from or related to emerging markets, disclosures from emerging markets may well differ in scope and quality and companies need to provide appropriate risk disclosure in that regard.
The Statement identifies some of these risks below:
- Emerging Market Risk Disclosures are Important. The officials first point out that companies with operations in emerging markets need to clearly disclose the “greater risks and uncertainties,” including “idiosyncratic risks,” that they face in those markets relative to more established markets. Among emerging market economies, China has become “the largest emerging market economy and the world’s second largest economy.” These risk disclosures should be industry- and jurisdiction-specific, as appropriate, and, in any event, should avoid boilerplate. For example, the environment in which the company operates could affect “whether the company has sufficient controls, processes and personnel to address its accounting or financial reporting issues. These potentially unique operating considerations also should be considered and reflected in financial and operational disclosures more generally, including disclosures of material risks, trends, uncertainties, accounting judgments and other items that are material to an investor.” While the form and appearance of disclosure may be substantially the same as in the U.S. and other more established markets, “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.”
- Quality of Financial Information, Requirements and Standards Vary Greatly. Companies should discuss relevant financial reporting matters with their independent auditors and audit committees. Notably, the officials highlight the fact that companies that trade on emerging market securities exchanges and do not file reports with the SEC are typically not subject to the same checks and controls that are provided under regulatory, accounting, auditing or auditor oversight requirements applicable to SEC reporting companies. For example, the officials believe that independent audit committees play a vital role through their oversight of financial reporting, including ICFR and the external, independent audit process, and that measures established under SOX “related to audit committees have proven to be some of the most effective financial reporting enhancements.” However, not all foreign jurisdictions require that companies have independent audit committees or have similar oversight. The officials suggest that investors and other stakeholders “should clearly understand how any limitations on the scope of these roles have an impact on the information provided.” The officials recommend that companies discuss with their independent auditors and audit committees the limitations (which may be more substantial in emerging markets) on the ability of U.S. authorities to bring actions for violations of SEC regulations in foreign jurisdictions and disclose the related material risks.
- The PCAOB’s Inability to Inspect Audit Work Papers in China Continues. Companies need to disclose the material risks related to the PCAOB’s lack of access to inspect audit work and practices of PCAOB-registered accounting firms in China with respect to their audit work for U.S. reporting companies. The caution applies even when the auditor signing the audit report is not based in China—so long as the company has operations in China, significant portions of the audit may have been performed by firms in China, and the PCAOB would not have had access to the firm’s audit work papers. The officials advise that companies “with operations in China should make clear disclosures regarding these risks, including highlighting these limitations as a risk factor.”
- The Ability of U.S. Authorities to Bring Actions in Emerging Markets May Be Limited. The ability of the SEC, DOJ and other authorities to bring and enforce actions against non-U.S. companies and non-U.S. persons, including company directors and officers, in certain emerging markets, including China, has been limited. These limitations—including limitations on access to information for investigations or litigation, constraints on assistance from local authorities and access to funds located in foreign countries—have had the effect of restricting the ability of these authorities to provide accountability for fraud or other wrongdoing, whether by companies, officers, directors or other gatekeepers. The officials advise that companies disclose the related material risks.
- Shareholders Have Limited Rights and Few Practical Remedies in Emerging Markets. The officials advise that shareholder litigation, such as class actions for securities fraud, which are commonplace in the United States, may face serious obstacles or be impossible to pursue from a practical perspective in many emerging markets. In addition, investors in emerging markets may be unable to pursue certain legal remedies in U.S. courts as private plaintiffs, and where the share purchase is made may affect whether remedies are available and where they may be pursued. What’s more, even investors that are successful in court may have difficulty realizing on a U.S. judgment in an emerging market, especially when funds are located in an emerging market. Legal remedies available in emerging markets may be inadequate, and international investors may have difficulty pursuing those remedies. The officials recommend that companies clearly disclose any material limitations on shareholder rights: “companies based in jurisdictions where there may be significant limitations on an investor’s ability to seek redress should make clear disclosures regarding these risks, including highlighting these limitations as a risk factor.”
- Drafting and Presenting Risk Disclosure: Disclosure Should be Prominent and Clear; Boilerplate Disclosure is Not Sufficient. The officials emphasize their expectation that companies will “present these risks prominently, in plain English and discuss them with specificity. Issuers based in emerging markets should consider providing a U.S. domestic investor-oriented comparative discussion of matters such as (1) how the company has met the applicable financial reporting and disclosure obligations, including those related to DCP and ICFR and (2) 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 more generally.”
The Statement also addresses a number of issues related to investors, funds and investment professionals not discussed in this post.