SEC virtual roundtable provides insight on future direction of regulation for emerging market companies listed on US exchanges – continued focus on China

The US Securities Exchange Commission (SEC) held an all-day virtual roundtable on July 9 to gather the views of investors, exchanges and other market participants, regulators and industry experts on the risks of investing in emerging markets and potential regulatory approaches to mitigate those risks. Just a few days prior to the roundtable, the SEC’s Division of Economic and Risk Analysis published a report outlining the extent of US investor exposure to China-based companies and the risks related to that exposure. The risks outlined in the report were among the topics addressed during the roundtable sessions.

The roundtable presented a variety of perspectives and signaled possible directions of additional US regulation in this area. As noted in our May 4 and May 27 alerts, the primary focus of the SEC is on China, and other roundtable participants had a similar focus. It is clear that scrutiny of emerging market risks will continue to be an important issue, and the dialogue going forward will include consideration of the recommendations from the President’s Working Group on Financial Markets, which are due to be submitted early next month. A replay of the roundtable is available in two parts on the SEC’s website (Part 1) (Part 2).

Views of the Commissioners

In his opening statement, SEC Chairman Jay Clayton noted that the roundtable is the latest in a series of efforts on this important issue. The SEC and the Public Company Accounting Oversight Board (PCAOB) have issued several joint statements emphasizing risks for investors in emerging markets, including China, and worked with other regulators and Congress to highlight and address information barriers that impede access to audit work and practices of PCAOB-registered auditing firms. Chairman Clayton noted that the SEC was continuing to engage with US auditing firms to discuss audit quality and challenges in auditing public company operations in emerging markets, including China. This engagement has emphasized the need for supplemental internal audit quality control procedures when regulatory oversight is limited.

Of particular interest in Chairman Clayton’s remarks was his reference to the issuance of a June 4 memorandum by President Trump to the President’s Working Group on Financial Markets ordering the group to make recommendations to address the investor protection concerns arising from (i) the inability of US regulators to inspect audit workpapers of PCAOB-registered Chinese accounting firms that audit US issuers based in China or with significant operations in China, and (ii) the lack of compliance of such issuers with SEC financial transparency requirements. These recommendations must be provided to the President through the Assistant to the President for National Security Affairs and the Assistant to the President for Economic Policy in a written report by August 3 and address the following topics:

• Recommendations for actions the executive branch may take to protect investors in US financial markets from the failure of the Chinese government to allow PCAOB-registered audit firms to comply with US securities laws and investor protections
• Recommendations for actions the SEC or PCAOB should take, including inspection or enforcement actions, with respect to PCAOB-registered audit firms that fail to provide requested audit working papers or otherwise fail to comply with US securities laws, and
• Recommendations for additional actions the SEC or any other federal agency or department should take to protect investors in Chinese companies, or companies from other countries that do not comply with US securities laws and investor protections, including initiating a notice of proposed rulemaking that would set new listing rules or governance safeguards. Any such actions should account for the impact on investors and ensure the continued fair and orderly operation of US financial markets.

Following Chairman Clayton’s remarks, Commissioners Peirce, Roisman and Lee each acknowledged the benefits that can be realized from investing in emerging markets, including opportunities for diversification; however, each also warned of the risks of such investments. The Commissioners noted the wide variation in regulations relating to investor protection with a focus on the limitations presented by markets such as China, where financial reporting and disclosure are not subject to the oversight of the PCAOB. As Commissioner Lee stated, “audited financial statements are a cornerstone of US public markets, driving investor confidence in the companies’ reported results, and that confidence is critically supported by the PCAOB.”

A common theme of the SEC Commissioners and staff was a desire to focus on areas where the agency can act now to address the risks. Among the questions raised by the SEC for the panelists and the public to consider were:

• How much do investors understand about the risks of investing in emerging market companies, especially China?
• How easy is it for investors to divest themselves of these investments?
• How much has been or should be done to test whether the Chinese government would assert the same state secrets or other protections with respect to the audit workpapers of US-based issuers with significant operations in China?
• If the PCAOB finds violations in a jurisdiction where it has only limited access, should greater sanctions such as de-registration apply?
• Should there be heightened scrutiny of US issuers based in jurisdictions where the home country prevents full financial transparency?

The roundtable

To discuss these and other questions, the roundtable included four one-hour panels on the following topics:

• Investments in emerging markets by US retail investors
• Limitations on inspection and enforcement in emerging markets and auditors’ global oversight of member firms in emerging markets
• Disclosure and reporting considerations with respect to investments in emerging markets, and
• Improving emerging market investing for US retail investors and markets.

Panelists and moderators included representatives from the SEC, PCAOB, Justice Department, US securities exchanges, academia and the global investment community. A complete list and a link to public comments on the roundtable are available here.

Key takeaways

DLA Piper’s key takeaways from the roundtable discussion are:

1. Future regulation may require additional disclosures. There was almost unanimous concern about the quality of disclosure available with respect to emerging markets companies, especially Chinese companies. There was support for more disclosure in registration statements and other publicly available documents filed by issuers. Some panelists also called for greater SEC scrutiny of the risk disclosures in such documents. Of greatest concern were the quality of available financial information and the inability of the PCAOB to oversee the audit process of Chinese companies listed on US exchanges.
   
   Another important area of concern expressed was the lack of clear, easily available information about companies in China, including related party transactions. Limitations on the application of other US regulatory requirements, including Sarbanes-Oxley and Dodd-Frank, were also discussed, as was the close involvement of the Chinese government in the ownership, control and operations of some emerging markets companies.
   
   
2. Future regulation may focus on more diligence and additional disclosures for passive investors. The problem of limited or inaccurate financial and other information with respect to Chinese and other emerging markets companies was viewed as especially acute with respect to “passive” retail investors, who invest in emerging markets companies through mutual funds and exchange-traded funds (ETFs). It was noted that passive investing by retail investors now exceeds active investing (where investors perform individual analysis of the companies in which they invest). Many ETFs and mutual fund portfolios are primarily based on broad market and industry metrics rather than an assessment of individual component companies’ financials, corporate governance, and other details. This could result in the inclusion of emerging market companies for which little is really known about their financial condition.
   
   
3. There was limited support for the proposed legislation pending in Congress. Notwithstanding the concern about the lack of reliable financial information with respect to emerging market companies, the great majority of panelists viewed the legislation passed in the US Senate and pending in the House of Representatives as overly restrictive, unnecessary and potentially leading to unintended negative consequences, including significantly devaluing investors’ existing holdings of Chinese and other emerging market securities currently listed in the US. Nevertheless, the panelists generally took care not to take a position for or against the legislation. There was particular concern that the pending legislation was simply too blunt an instrument and could create ambiguities. Instead, panelists favored the use of other regulatory tools to achieve transparency, accountability and trust, with legislation only as a last resort. There also was a great deal of concern about overly prescriptive standards for emerging market issuers having potentially negative immediate and long-term impact on investor access to these companies.
   
   
4. Delisting may not be an effective solution. Several panelists expressed the view that measures leading to US delistings would not necessarily achieve their goals since many companies could simply relist in another market, such as Hong Kong, in which case they might well remain in one or more indices and thus continue to be included in funds and ETFs tracking such indices. And, while delisting may be an effective solution for companies listed on one market, some Chinese companies are already dually listed or preparing for dual listings to reduce the impact of any potential US action. There was also concern about pushing away innovative and higher quality companies and a desire to balance access to emerging markets with appropriate protections (although some disagreed that a wholesale flight of Chinese companies from the US market was likely, given the size and liquidity of the US market).
   
   
5. Expanding Chinese secrecy laws have increased US concerns. There was significant concern about the increased enactment of Chinese laws that restrict data and information, resulting in additional challenges to disclosure and transparency requirements for US-listed companies, including preventing auditors from making their audit work papers available for review by the PCAOB or SEC.
   
   
6. There are potential regulatory steps the SEC can seek to implement. A number of potential actions were suggested by panelists, including:
   
   a. Reorganizing risk disclosures so that risks are linked directly to the areas impacted by that risk
   
   b. Requiring clear columnar disclosure of differences in regulatory regimes with a separate column discussing the implication of those differences
   
   c. Requiring that global accounting firms stand as guarantors for the work of the Chinese audit firms that operate in their networks
   
   d. Imposing greater disclosure requirements on foreign private issuers that are only listed in the United States, and
   
   e. Requiring more robust disclosures about emerging market companies, including disclosures of national security related sanctions and human rights abuses, particularly in disclosures made to passive retail investors.

While discussions about these and other possible regulatory steps remain ongoing, the comment period for Nasdaq’s new listing rules relating to emerging market companies has ended, and those rules are now under consideration by the SEC.

We anticipate that the views expressed by the panelists will inform the SEC’s contributions to the August report of the President’s Working Group on Financial Markets, and the report should shed further light on the direction that regulators may take to address these concerns. We will alert our clients when the report becomes available.

If you have any questions regarding the SEC roundtable, or if you would like assistance in analyzing these issues, please contact the authors, a member of the DLA Piper Financial Services team or your DLA Piper relationship partner.

This information does not, and is not intended to, constitute legal advice.  All information, content, and materials are for general informational purposes only.  No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.