Emerging Market Investments Entail Significant Disclosure, Financial Reporting and Other Risks; Remedies are Limited

SEC Chairman Jay Clayton
PCAOB Chairman William D. Duhnke III
SEC Chief Accountant Sagar Teotia
SEC Division of Corporation Finance Director William Hinman
SEC Division of Investment Management Director Dalia Blass

The PCAOB's Inability to Inspect Audit Work Papers in China Continues

Introduction^[1]

Over the past several decades, the portfolios of U.S. investors have become increasingly exposed to companies that are based in emerging markets^[2] or that otherwise have significant operations in emerging markets.^[3] This exposure includes investments in both U.S. issuers and foreign private issuers ("FPIs") that are based in emerging markets or have significant operations in emerging markets. During this time, China has grown to be the largest emerging market economy and the world's second largest economy.^[4]

The SEC's mission is threefold: protect our investors, preserve market integrity and facilitate capital formation. Ensuring that investors and other market participants have access to high-quality, reliable disclosure, including financial reporting, is at the core of our efforts to promote each of those objectives. This commitment to high-quality disclosure standards—including meaningful, principled oversight and enforcement—has long been a focus of the SEC and, since its inception, the PCAOB.

Our ability to promote and enforce these standards in emerging markets is limited and is significantly dependent on the actions of local authorities—which, in turn, are constrained by national policy considerations in those countries. 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.^[5] This significant asymmetry holds true even though disclosures, price quotes and other investor-oriented information often are presented in substantially the same form as for U.S. domestic companies. Immediately below, we summarize some of these risks and related considerations specific to issuers, auditors, index providers and financial professionals. In the body of this statement, these matters are discussed in more detail.

• Emerging Market Risk Disclosures are Important. Companies that have operations in emerging markets, and investors in those companies, often face greater risks and uncertainties than in more established markets. Issuers reporting with the SEC should clearly disclose these matters to investors. Similarly, funds investing in emerging markets should ensure that their material risk disclosures are adequate and in compliance with federal securities laws. Many risks and uncertainties are industry- and jurisdiction-specific. Boilerplate disclosures generally are not useful or sufficient in these circumstances.

• Quality of Financial Information, Requirements and Standards Vary Greatly. 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. Issuers should ensure that relevant financial reporting matters are discussed with their independent auditors and, where applicable, audit committees.

• The PCAOB's Inability to Inspect Audit Work Papers in China Continues. Investors and financial professionals should consider the potential risks related to the PCAOB's lack of access to inspect PCAOB-registered accounting firms in China. Issuers should clearly disclose the resulting material risks. Auditors should have appropriate quality controls in place related to executing quality audits.

• The Ability of U.S. Authorities to Bring Actions in Emerging Markets May Be Limited. Accountability, for issuers and gatekeepers, including individual accountability, is a key aspect of U.S. securities law. 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. Issuers should clearly disclose the related material risks.

• Shareholders Have Limited Rights and Few Practical Remedies in Emerging Markets. 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.

• Passive Investing Strategies Do Not Take Account of These Risks. Investors should understand that an index fund tracking a specific emerging market index generally does not directly weight securities on the basis of investor protection limitations or differences in the quality of financial reporting and available oversight mechanisms.

• Investment Advisers, Broker-Dealers and Other Market Participants Should Consider Emerging Market Risks. Financial professionals generally should consider the limitations and other risks described above, when recommending investments in emerging markets.

Investors should recognize that these considerations (1) often are significant, (2) vary from jurisdiction to jurisdiction and company to company, and (3) are just some of the factors that may contribute to effective investment decision making, including portfolio and index construction.

This statement should not be viewed as an effort to restrict access to emerging market investments. Investor choice has long been a core component of our capital markets regulatory framework, and emerging market investments, including as a component of a diversified portfolio, have proven to be beneficial to many investors. The combination of (1) full and fair disclosure, (2) meaningful, principled oversight and enforcement and (3) broad investor choice, has made the U.S. capital markets the world's deepest and most vibrant, benefiting investors, issuers and economic welfare domestically and globally. This statement reflects our commitment to preserving and promoting each component of that important and powerful combination.

Disclosure Requirements of Companies Reporting with the SEC—Importance of High-Quality, Reliable Audited Financial Statements—Emerging Market Disclosures Often are Different in Scope and Quality Despite Appearing Similar in Form

Companies that have significant operations in emerging markets often face greater risks and uncertainties, including idiosyncratic risks, than in more established markets. Issuers reporting with the SEC should clearly disclose these matters to investors. Boilerplate disclosures generally are not useful or sufficient in these circumstances. For example, issuers should carefully consider the environment in which the company operates in assessing 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.

The bedrock of our globally interconnected capital market system has long been high-quality, reliable audited financial statements. Without high-quality, reliable financial information, capital markets do not function well, increasing capital costs and risks of misconduct, including the potential for investors to be defrauded.

Companies that file annual reports with the SEC, including FPIs (non-U.S. issuers that qualify as foreign private issuers under our rules), must file financial statements that have been audited by an independent, PCAOB-registered accounting firm. Management is responsible for the preparation of the financial statements, including responsibility for establishing and maintaining disclosure controls and procedures ("DCP") and internal control over financial reporting ("ICFR"), and for maintaining accountability for the company's assets, among other things.^[6] The auditor is responsible to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.^[7] Management for companies that file annual reports with the SEC, including FPIs, must determine that the financial statements, and other financial information included in the report filed with the SEC, fairly present in all material respects the financial condition, results of operations and cash flows of the company.^[8]

In addition to annual reports with audited financial statements, companies subject to the periodic reporting requirements under the Securities Exchange Act of 1934 ("Exchange Act"), other than FPIs, must file quarterly reports^[9] that include interim financial statements reviewed by an auditor and other disclosure items, and certifications by the principal executive and financial officers of the reporting company.^[10] By contrast, FPIs subject to the periodic reporting requirements of the Exchange Act are not required to file quarterly reports or quarterly certifications by the principal executive and financial officers of the FPI, but rather are only required to furnish certain interim information in specified circumstances.^[11]

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.

Financial Reporting and Other Disclosure Risk in Emerging Markets

Investors and financial professionals should carefully consider the nature and quality of financial information, including financial reporting and audit requirements, as well as other disclosure risk, when making investment decisions regarding companies that are based in, or have significant exposure to, emerging markets. These risks vary significantly depending on a variety of factors.

The frequency, availability and quality of financial information about potential investments in emerging markets may vary. For example, while a U.S. broker may be able to process an order for shares of a company that only trades on an emerging market securities exchange, these foreign-traded companies are not likely to file reports with the SEC. The information available about these companies, and its reliability, generally is significantly less than the information available about companies that file reports with the SEC, including because these companies generally are not subject to the same regulatory, accounting, auditing or auditor oversight requirements applicable to companies that file reports with the SEC.

In this regard, it is important to understand the critical role that issuers, audit committees, auditors and regulators each play in the U.S. financial reporting system. In other words, there are a series of checks and controls that work together to promote high-quality, reliable financial information. Similarly, investors and other stakeholders should clearly understand how any limitations on the scope of these roles have an impact on the information provided.

For example, audit committees of operating companies and funds reporting with the SEC play a vital role through their oversight of financial reporting, including ICFR and the external, independent audit process.^[12] In 2002, the Sarbanes-Oxley Act^[13] introduced a number of requirements to increase and strengthen the role of audit committees in financial reporting, including the independent audit committee requirement. We believe the measures related to audit committees have proven to be some of the most effective financial reporting enhancements included in the Sarbanes-Oxley Act.^[14] However, not all jurisdictions mandate independent audit committees or have similar requirements. Investors should consider the impact of a company's corporate governance structure, including the role of the audit committee or similar oversight, when making investment decisions in emerging markets.

In addition, while FPIs are generally subject to the SEC's reporting and oversight regulations discussed above, not all those regulations apply. Further, as discussed in more detail below, the ability of U.S. authorities to bring actions for violations of those regulations may be limited in foreign jurisdictions and particularly limited in emerging markets, including in China, the world's largest emerging market. Issuers should discuss these matters with their independent auditors (and where applicable, audit committees) and should disclose the related material risks.

To promote high-quality financial reporting and reliable audits for issuers reporting with the SEC, we continue to meet with those involved in the financial reporting system, including investors, preparers, audit committees and auditors to listen to stakeholder concerns, understand emerging issues and risks, answer questions and share views on current financial reporting matters. Investors, financial professionals and index providers should consider carefully that this type and level of engagement may not occur in emerging markets.

PCAOB's Inability to Inspect Audit Work Papers in China Continues

Investors and financial professionals should consider the potential risks related to the PCAOB's lack of access to the work of PCAOB-registered accounting firms in China. Issuers should clearly disclose the resulting risks to investors.

The Chairman of the SEC and the Chairman of the PCAOB, as well as staff from the SEC and the PCAOB, have on various occasions reminded investors of the significant risks related to investments in China due to the inability of the PCAOB to inspect^[15] audit work and practices of PCAOB-registered accounting firms in China (including Hong Kong, to the extent their audit clients have operations in China) with respect to their audit work of U.S. reporting companies.^[16]

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. Investors can access information about the PCAOB's lack of access on the PCAOB's website.^[17]

Given the importance to investors of understanding the potential material risks related to the PCAOB's lack of access related to PCAOB-registered accounting firms in China, issuers with operations in China should make clear disclosures regarding these risks, including highlighting these limitations as a risk factor.^[18]

In connection with our ongoing efforts to address a number of issues related to the quality of financial reporting and auditing in emerging markets, we have been meeting with senior representatives of the six largest U.S. audit firms and representatives of their global networks. To be clear, these discussions with the audit firms are not intended to be a substitute for the PCAOB inspecting audit work and practices of PCAOB-registered accounting firms in China with respect to their audit work of U.S.-listed companies. These meetings have included discussions regarding audit quality across their global networks and the importance of effective and consistent oversight of member firms globally, including those operating in China and other emerging markets.^[19] In each of these meetings, the audit firms have recognized their responsibilities as auditors and acknowledged the importance of consistent audit methodologies across their global networks. We were clear in sharing our expectations that they fulfill these responsibilities.

Enforcement Actions by the SEC, DOJ and Other U.S. Authorities May Be Limited

Accountability for issuers and gatekeepers, including individual accountability, is a key aspect of U.S. securities law. The SEC, 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. Issuers should clearly disclose the related risks.

Investors, including individual investors, funds and companies, should understand potential limitations on enforcement actions when making investment decisions in emerging markets. Due to jurisdictional limitations, matters of comity and various other factors, the SEC, DOJ and other U.S. authorities may be limited in their ability to pursue bad actors, including in instances of fraud, in emerging markets. For example, in China, there are significant legal and other obstacles to obtaining information needed for investigations or litigation.^[20] Similar limitations apply to the pursuit of actions against individuals, including officers, directors and individual gatekeepers, who may have engaged in fraud or other wrongdoing. In addition, local authorities often are constrained in their ability to assist U.S. authorities and overseas investors more generally. There are also legal or other obstacles to seeking access to funds in a foreign country. Issuers should clearly disclose the related material risks and financial professionals should consider these risks when making or recommending investment decisions.

Shareholder Rights; Shareholder Recourse

Shareholder claims that are common in the U.S., 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.

Investors should understand legal and practical differences affecting their ability to protect their interests when making investment decisions in emerging markets. Where investors purchase a security can affect whether they have, and where they can pursue, legal remedies against the foreign company or any other foreign-based entities involved in a transaction. Investors in emerging markets may not have the ability to seek certain legal remedies in U.S. courts as private plaintiffs. Moreover, even if investors sue successfully in a U.S. court, they may not be able to collect on a U.S. judgment against a company, entity or person, including company directors and officers, in an emerging market, particularly when the company's assets and those of its directors and officers are located in an emerging market. As a practical matter, investors may have to rely on domestic legal remedies that are available in the emerging market. These remedies often are limited and difficult for international investors to pursue.

Given the importance of a clear understanding of these risks to investors, management of 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 Insufficient

In light of both the significance and company-specific nature of the risks discussed in this statement, we expect issuers to present these risks prominently, in plain English and discuss them with specificity.^[21] 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. Similarly, as discussed further below, registered funds, including those investing in emerging markets, must disclose the principal risks of investing in the securities they hold in their prospectuses and summary prospectuses; this should also be presented in plain English and with specificity as to the fund's investments.^[22]

Passive Investing; Index Construction

Investors should understand that an index fund tracking a specific emerging market index generally does not consider or weigh investor protection considerations when investing in a particular security.

In addition to a number of considerations when investing in any fund, investors in index funds and other passively-managed funds should understand the potential impact of the fund's passive investing strategy on the investor's exposure to risks in emerging markets. For example, an emerging market index fund may seek to track a specific emerging market index, and therefore may invest in all of the securities included in that index or only a sample of those securities. However, the composition of the emerging market index itself generally would not weigh individual securities by investor protection considerations. That is, in index construction, decisions are made on a jurisdiction-wide basis. For example, once a jurisdiction is included, individual securities from that jurisdiction are included in the index based on the index provider's specific weighting methodology (e.g., based on market capitalization). The index may or may not weigh the jurisdiction as a whole on the basis of investor risk or other factors in addition to market capitalization.

Investors and financial professionals should consider these index construction decisions and the related risks when making or recommending investment decisions in such funds.

Considerations for Investment Advisers and Funds

Financial professionals generally should consider limitations on the quality or availability of information, as well as the other risks described above, when recommending investments in emerging markets. Funds investing in emerging markets should consider whether they have adequate risk disclosure about the unique risks and uncertainties that companies with significant operations in emerging markets often face. Boilerplate disclosures generally are not useful or sufficient in these circumstances.

In addition to the general considerations for investors above, investment advisers and funds should be mindful of their obligations under the Investment Advisers Act of 1940 ("Advisers Act") and Investment Company Act of 1940 with respect to investments in emerging markets.

Investment advisers, including advisers to funds, have a fiduciary duty to their clients under the Advisers Act, including a duty of loyalty and a duty of care.^[23] The duty of care includes a duty to provide investment advice that is in the best interest of the client. In order to provide such advice, an adviser must have a reasonable belief that the advice is in the client's best interest based on the client's objectives. For example, an adviser should consider whether investments are recommended only to those clients who can and are willing to tolerate the risks, and should conduct a reasonable investigation into the investment sufficient not to base its advice on materially inaccurate or incomplete information. Accordingly, investment advisers that are recommending investments in emerging markets may want to consider, as part of their due diligence, whether there are limitations on the quality or availability of financial information with respect to these investments, as well as possible limitations on investors' legal remedies along the lines of those discussed above. Investment advisers should also consider the effect of market closures on their clients' investments and ability to gain access to their assets.

In addition, mutual funds, exchange-traded funds and other registered investment companies are required to disclose their principal risks in the fund's prospectus and summary prospectus. These risks will depend on the fund's investment objective(s), holdings, investment strategies and structure.^[24] Private fund advisers also must state all material facts necessary to make the statements made to any investor or prospective investor in the fund not misleading.^[25] If a fund invests or may consider investing a significant portion of its assets in emerging markets, it should disclose those principal risks related to the quality or availability of the financial information of such investments, impact of any potential market closures and other related risks.

Closing

It is important that investors, funds, financial professionals and index providers consider carefully the issues, risks and uncertainties associated with investing in emerging markets, including China, the world's largest emerging market and second largest economy. In particular, protections similar to certain key elements of the U.S. regulatory regime may not exist in these markets and, as both a legal and practical matter, applicable regulations are more limited from an investor protection perspective. It is imperative that companies based in or with significant operations in these emerging markets, as well as their audit committees (if applicable) and auditors, each fulfill their responsibilities to (1) prepare and provide high-quality, reliable financial information and other disclosures, including through considerations of the circumstances and environment in which these companies operate and (2) provide accurate and complete risk disclosure, including with regard to the limited rights and remedies of U.S. authorities and investors.

This statement should not be viewed as an effort to restrict access to emerging market investments. Investor choice has long been a core component of our capital markets regulatory framework, and emerging market investments, including as a component of a diversified portfolio, have proven to be beneficial to many investors. The combination of (1) full and fair disclosure, (2) meaningful, principled oversight and enforcement and (3) broad investor choice, has made the U.S. capital markets the world's deepest and most vibrant, benefiting investors, issuers and economic welfare domestically and globally. This statement reflects our commitment to preserving and promoting each component of that important and powerful combination.