Monday, July 13, 2020

SEC roundtable explores disclosure issues in emerging markets

By Lene Powell, J.D.

At a recent SEC roundtable, panelists discussed issues that differing disclosure regimes in emerging markets may pose for investors. Although panelists were generally of the view that most companies provide sufficient disclosures and any deficiencies can be addressed through current SEC oversight, some had greater concerns, particularly whether there may be a "gaping hole" in the awareness of passive and retail investors of the risks of investing in emerging markets.

Disclosure. A panel on disclosure issues was moderated by Raquel Fox, director of the Office of International Affairs, and Bill Hinman, director of the Division of Corporation Finance.

In the view of Amy McGarrity, chief investment officer at the Public Employees’ Retirement Association of Colorado, a lot of very strong disclosure is already required, but U.S. regulators should be able to protect U.S. investors by engaging in inspections and examinations of companies making disclosures and their auditors. In general, she would favor more disclosures rather than less, and let the investor decide which they think is most important and relevant.

Sarah Payne, a partner at Sullivan & Cromwell, agreed that existing reporting requirements for foreign private issuers, including those primarily operating in China, provide a robust format for issuers to provide relevant disclosures. She believes that the "vast majority" of companies in China and other geographies do provide robust disclosure, and only a minority of companies provide little or no disclosure or boilerplate risks. In her view, this problem can "certainly" be addressed through the SEC's existing disclosure framework as well as the comment letter process and staff policy statements on areas where companies may be falling behind. Of course, in severe situations, enforcement actions can be used, she said.

According to Payne, common themes in disclosures include risks related to the regulatory environment in China and uncertainty regarding interpretations of existing regulations and the potential for adopting new regulations. Other areas of focus include foreign ownership restrictions, including in certain industries, as well as risks related to the big structures that many companies employ in China, as well as tax related matters. In addition, in recent years, it's become very common to have disclosure related to limitations on auditor inspections and work paper access and the like, said Payne.

John May, a partner and SEC services leader at PwC US, suggested that two particularly important areas of disclosure are related party transactions and the ability or inability of the SEC and DOJ to go in and do regulatory oversight and obtain work papers for investigation. The issue of regulatory access was explored in-depth in another panel at the roundtable, particularly regarding PCAOB oversight in China.

Paul Gillis, Ph. D., professor at Peking University’s Guanghua School of Management, expanded on the topic of oversight, explaining that the PCAOB has been blocked from doing inspections in China since its inception after the Sarbanes-Oxley Act was passed in the early 2000s. After the SEC sued the Big Four auditing firms over this issue and obtained penalties, companies have started disclosing the risk of not having PCAOB inspections. A bill, S. 945, which has passed the Senate, would ban firms from being listed and trading in the U.S. if their auditors are not inspected by the PCAOB. In addition, a company must disclose whether it is controlled by the state, whether any board members belong to the Communist party, and whether it has language from the Communist party or the government in its articles of incorporation. Gillis questions the relevance of some of this and thinks most investors already are aware that a company in China is likely to have a Communist on the board of directors.

On the question of how much investors actually examine and use disclosures, McGarrity believes that institutional investors, particularly fundamental investors, do look closely at disclosures and incorporate them into their analyses. McGarrity believes that the risks of investing in emerging markets, including China but also other emerging markets, are known by the investment community. Passive investors and retail investors, in contrast, may not examine disclosures as closely, and may not be fully aware of the risks of investing in emerging markets. McGarrity believes that lack of awareness by passive investors is a "gaping hole" and an increasingly relevant area to be reviewed.

According to Gillis, there may be too much generic risk disclosure. Many companies make so many disclosures of risk factors that investors can get burned out and stop taking them seriously. Gillis suggested that disclosures would be improved by getting rid of generic "sky is falling" kind of risks that every company is subject to. Payne agreed that too much disclosure can make it difficult for investors to get material information about a specific company.

Regarding possible enhancements to disclosure format, May thinks a columnar presentation can help investors digest information. For example, for corporate governance disclosures, the requirement applicable to a domestic company would be in the first column, the company practice would be in the second column, and a third column could explain the implications of the differences. McGarrity agreed that a columnar presentation is very helpful and relevant, and noted that it can be used not just for corporate governance disclosures but also for listing standards and other areas.

On the topic of whether the current balance of requirements is appropriate, Payne said in general the U.S. does strike the right balance, and if the U.S. started moving in a direction where companies outside of the U.S. find it less attractive to invest to list in the U.S., ultimately that would put U.S. investors at risk. For example, she is seeing companies being reluctant to undertake an IPO in the U.S., and that is to the detriment of U.S. investors. McGarrity agreed and said that if companies are delisted, some will find other ways to access U.S. capital markets and investors will still be potentially at risk there.

According to Gillis, the regulatory environment was developed to try not to make it a disadvantage for foreign companies to list get secondary listings in the U.S. without being subjected to additional onerous requirements. It was designed for, say, a German company like Daimler. But the difference with Chinese stocks, said Gillis, is that most of them do not have a listing anywhere else. Although they are listed in the U.S., they’re subject to a "much relaxed" corporate governance and disclosure regime because they're not subject to important rules like Reg FD or releasing ownership reports or quarterly audit reports. Gillis thinks this leads to a lot of insider trading on Chinese stocks. While some companies do disclose this information voluntarily, he’s not sure that the standard should be voluntary. He believes there has been a "race to the bottom" where unfortunately the U.S. is near the bottom. For example, Alibaba listed in New York only after it was unable to list in Hong Kong because of its corporate governance structure, he said.