US regulators are increasing their focus on US-listed companies based in or with significant operations in China. In a rare joint statement released on April 21, several top-level officials at the US Securities Exchange Commission (SEC) and the US Public Company Accounting Oversight Board (PCAOB), including both the SEC and the PCAOB chairs, expressed serious concerns regarding their ability to promote and enforce disclosure standards for US-listed companies who operate in emerging markets, including China (the “Statement”). While many of these concerns have been ongoing since at least 2010, China has since grown to become the largest emerging market economy and the second largest economy in the world, resulting in a much larger investment exposure for US capital markets. The Statement is a strong reminder of how seriously US regulators are viewing these issues and that Chinese companies remain a particular risk in the eyes of US regulators. Below are the key takeaways from the Statement for China-based US-listed companies (“issuers”).
The Statement emphasized that because risks are industry and jurisdiction specific, boilerplate disclosures are generally not useful or sufficient; furthermore, emerging market risk disclosures often are different in scope and quality despite appearing similar in form. The Statement also emphasizes that financial professionals and investment funds should consider the risks posed by issuers in emerging markets when constructing funds, making investments and providing investment recommendations. These professionals and funds should also make appropriate disclosures to investors based on the risks highlighted in the Statement. As outlined by the SEC and PCAOB in the Statement, issuers in emerging markets, including China-based issuers, should consider including in their risk disclosures such topics as:
- Different regulatory requirements related to financial statement quality
- Limitations on the ability of the SEC and PCAOB to inspect the quality of audits performed in China
- Limitations on the ability of the SEC to hold bad actors accountable and
- Limitations on shareholder rights and remedies.
We discuss these topics below.
1. Companies in emerging markets should work with independent auditors to evaluate quality of financial information, requirements, and standards
The Statement highlights the critical role that issuers, audit committees, auditors and regulators each play in the US financial reporting system, providing for a series of checks and controls that work together to promote high-quality, reliable financial information. The Statement warns investors that companies in emerging markets generally are not subject to the same requirements as apply within the US and that such differences impact the quality of information provided to investors.
Capital markets do not function well without high-quality, reliable financial information, and therefore, the Statement recommends that issuers ensure relevant financial reporting matters are discussed with independent auditors and, where applicable, audit committees. Taking steps to engage with auditors may help China-based US issuers or foreign private issuers (FPIs) alleviate both regulatory and investor concerns.
2. The PCAOB’s inability to inspect audit work papers in China is an ongoing concern which may lead to increased SEC scrutiny of China-based issuers
The PCAOB oversees the audits of all US-listed public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports. However, the PCAOB has been unable to inspect audit work and practices of PCAOB-registered accounting firms in China with respect to their audit work of US reporting companies.
The Statement emphasizes that investors should understand the potential impacts of the PCAOB’s lack of access when investing in companies whose auditor is based in China. Even when the auditor signing the audit report is not based in China, if the company has operations in China, investors should consider whether significant portions of the audit may have been performed by firms in China, and the potential impact of the PCAOB’s inability to access such audit work papers.
The Statement recommends that issuers with operations in China make clear disclosures regarding these risks, including highlighting these limitations as a risk factor. Failure to make such disclosure might trigger SEC regulatory action.
3. While US authorities may face limitations in their ability to hold bad actors accountable, they are not powerless
Accountability for issuers and gatekeepers, including individual accountability, is a key aspect of US securities law. The US SEC, US Department of Justice, and other US authorities often have substantial difficulties in bringing and enforcing actions against non-US companies and non-US persons, including company directors and officers, in certain emerging markets such as China.
As a result, US enforcement is severely limited when applied to individuals and companies based in emerging markets, creating further risk for investors. According to the Statement, issuers should clearly disclose the related material risks to investors. Again, failing to disclose such risks could trigger SEC action.
Despite the limitations discussed in the Statement, China-based issuers should recognize that the SEC still has the ability to act against companies that are subject to and violate US securities laws, including delisting a company’s securities and obtaining asset freezes that could tie up funds and other assets held in the US. Furthermore, US and Chinese authorities have also been known to take coordinated and/or simultaneous enforcement action against individuals and companies that have violated not just US securities laws but also PRC laws and regulations.
4. Issuers in emerging markets should disclose that shareholders may have limited rights and remedies
Shareholder claims that are common in the United States, including class action securities law and fraud claims, generally are difficult or impossible to pursue as a matter of law or practicality in many emerging markets. Issuers should clearly disclose any material limitations on shareholder rights. Failure to do so adequately might lead to scrutiny.
For further information, please contact the authors or your DLA Piper relationship partner.