On July 9, 2020, the SEC hosted a virtual roundtable discussion on the risks of investing in emerging markets, including China.  The roundtable featured four separate panels that included representatives from the PCAOB, DOJ, NYSE, Nasdaq, MSCI, investor groups, auditing firms, academia and other market participants, with SEC staff members acting as moderators.

In his opening remarks, SEC Chair Jay Clayton stated that the roundtable is the latest in a series of efforts to highlight and discuss the various risks to investors that have accompanied the increased exposure by U.S. investors and the U.S. capital markets to companies with significant operations in emerging markets, including China.  He observed that the SEC has:  issued several joint statements with the PCAOB highlighting these risks, engaged with other regulators and Congressional leaders to address information barriers that impede access to the work of the PCAOB, and reminded U.S. auditing firms of the need for effective and consistent global oversight of member firms, including the need to supplement internal audit quality control procedures when regulatory oversight is more limited.  Chair Clayton said that the SEC’s staff focus, as the roundtable issues are discussed, will “continue to be on our core mission of ensuring continued investor choice and appropriate investor protection.”

SEC Commissioner Hester Peirce stated it is important to ensure that investors are able to build portfolios that achieve their objectives and manage risk, and that means investors should not be prevented from including emerging market investments in their portfolios.  However, investors should receive the information they need to understand associated risks, including an understanding of the standards that apply to companies in which they seek to invest and whether the applicable jurisdiction for any such companies are characterized by oversight or transparency challenges.

SEC Commissioner Elad Roisman stated that U.S. regulatory requirements in respect of accounting and audits provide essential investor safeguards against false and misleading financial data.  However, since issuers base their operations in many countries, including in emerging markets, this extraterritoriality poses serious challenges to effective due diligence and enforcement efforts.  He concluded by observing that being a public company listed in the United States is a privilege, and such companies enjoy access to U.S. retail investors and an association with the rigorous U.S. regulatory regime.

SEC Commissioner Allison Lee observed that U.S. investors have greater exposure to the risks and rewards associated with emerging market investments as capital markets have become increasingly global.  While the rewards are quantifiable and known, the risks, including challenges to investigating and enforcing legal violations by issuers in these markets and challenges with regulatory oversight of audit function, may be less clear to investors.  She highlighted that audited financial statements are a cornerstone of the U.S. public markets, driving investor confidence in the company’s reported results, and that confidence is critically enhanced by the PCAOB’s work.  She also pointed out that, aside from Chinese companies based in China with Chinese audit firms, there are a number of large U.S. issuers, domiciled in the U.S., that have significant operations in China and the audits of these issuers are conducted by large U.S. audit firms, who use Chinese affiliates who handle portions of the audit over Chinese operations. This could mean PCAOB limitations on inspections may apply to material portions of the audits of these U.S. companies. She said this raises a number of questions, including:  do investors really understand the risks with respect to such U.S. issuers?  How easy would it be for investors to divest these holdings should they decide the risks are too high or too opaque, given the prevalence of passive index investing? And how much has been, or should be, done to test whether the Chinese government would assert the same state secrets or other protection with respect to the audit work papers of these U.S. issuers? She encouraged discussion on the steps that regulators can take to address these risks.

The SEC’s press release announcing the agenda and panelists for the roundtable on emerging markets can be found here.  A webcast archive of the roundtable will be available on the SEC website soon.

We will follow up with a few blog posts discussing highlights from the panels.