Response Letter to Statement Announcing SEC Staff Roundtable on Emerging Markets

Jeffrey P. Mahoney is General Counsel at the Council of Institutional Investors. This post is based on a CII letter to the U.S. Securities and Exchange Commission.

Via Email
July 8, 2020

The Honorable Jay Clayton
Securities and Exchange Commission
100 F Street NE
Washington, DC 20549-1090

Re: July 9 Roundtable on Emerging Markets

Dear Mr. Chairman:

I am writing in response to the May 4 “Statement Announcing SEC Staff Roundtable on Emerging Markets” soliciting “views on the risks of investing in emerging markets, including China.”

The Council of Institutional Investors (CII) is a nonprofit, nonpartisan association of U.S. public, corporate and union employee benefit funds, other employee benefit plans, state and local entities charged with investing public assets, and foundations and endowments with combined assets under management of approximately $4 trillion. Our member funds include major long-term shareowners with a duty to protect the retirement savings of millions of workers and their families, including public pension funds with more than 15 million participants—true “Main Street” investors through their pension funds. Our associate members include non-U.S. asset owners with about $4 trillion in assets, and a range of asset managers with more than $35 trillion in assets under management.

As the leading voice for effective corporate governance and strong shareholder rights, CII believes that accurate and reliable audited financial statements are critical to investors in making informed decisions, and vital to the overall well-being of our capital markets. Consistent with our membership approved policies, we have long been troubled by the lack of cooperation of China’s regulators with United States (U.S.) Securities and Exchange Commission (SEC or Commission) and Public Company Accounting Oversight Board (PCAOB or Board) requirements, including efforts to promote high quality audits of financial reports of Chinese companies that are listed on U.S. exchanges. In recent years those concerns have grown as the number of Chinese companies listed on U.S. exchanges has increased significantly, and with many of those companies adopting variable interest entity and dual class stock structures, both of which include risks not fully understood by many market participants.

Since April, our concern has increased as the result of several significant events, including (1) on April 2 U.S.-listed Chinese coffeehouse chain Luckin Coffee Inc., whose PCAOB registered auditor has never been subject to a Board inspection, disclosing that it had fabricated as much as $310 million in sales from the second quarter of 2019; and (2) on April 21 the SEC/PCAOB public statement, “Emerging Market Investments Entail Significant Disclosure, Financial Reporting and Other Risks; Remedies are Limited,” warning investors that disclosures by SEC-registered companies from China may be incomplete and misleading and referencing a March 1 revision to the Peoples Republic of China Securities Law providing that “without the approval of its securities regulator and various components of the Chinese government, no entity or individual in China may provide documents and information relating to securities business activities of overseas regulators.”

To be clear, we are focused foremost on the quality and integrity of U.S. capital markets. Our members have a variety of investment strategies for emerging and frontier markets, and understand risk has to be calibrated to rewards. But we expect that U.S. capital markets should adhere to their articulated standards. This is not happening where U.S.-listed companies are audited by firms that are not inspected by PCAOB.

Potential Remedial Actions

CII’s preference is for PCAOB to inspect the audit work and practices of PCAOB-registered firms in China. However, after more than a decade of negotiations on this issue, it appears that China continues to refuse to permit such inspections. Moreover, as indicated, China recently amended its securities laws to explicitly impose a hurdle for those firms to share information with PCAOB, Commission, and other overseas regulators. As a result, we generally agree with the recent commentary in Barron’s that it appears that an agreement with China on PCAOB inspections may never be achievable “through conventional negotiations.”

We also agree the “status quo has become unacceptable.” And we welcome the pending recommendations of the President’s Working Group on Financial Markets. In the meantime, we offer our views on two potential remedial actions that have already been proposed and that with some qualifications we would generally support.

Nasdaq Proposals

In June, The Nasdaq Stock Market LLP (Nasdaq) issued three related proposals intended to tighten listing standards for Chinese companies and other companies from “Restrictive Markets” that have laws limiting access to information. One proposal would require companies to have management or advisors that understand regulatory and listing requirements, including controls over financial reporting.

A second proposal would require a minimum offering size or public float. A third proposal, which we view as addressing the essential element of an effective potential remedial action, would apply additional listing criteria when an auditor of an applicant or Nasdaq-listed company has not been or cannot be inspected by PCAOB.

In our view, the third proposal as drafted is flawed because it provides for far too much discretion for Nasdaq to approve the initial or continued listing of registrants from China or other restricted markets even when the company has a principal auditor that is located in a jurisdiction that prohibits PCAOB’s ability to inspect the auditor. As JP Gan, a Chinese venture investor and founding partner of Shanghai-based INCE Capital recently stated:

“The basic principle of capital markets is trust. The default assumption is everyone is good because the bad apples have been screened out, or it won’t be listed…

We believe the flaw in the third proposal can be repaired by revising the proposal to narrow the level of discretion along the lines of the following:

  • The proposed IM-5101-1(b)(1) and IM-5101-1(c) would be replaced by new rules that would require that listing applicants and listed companies from a Restrictive Market, including companies listed prior to the effectiveness of the new rules, be prohibited from having an auditor or an accounting firm engaged to assist with their company audit that is located in a jurisdiction that limits the PCAOB’s ability to inspect the auditor (New Auditor Inspection Rules).
  • [A] Nasdaq staff determination to deny the initial or continued listing of a company for lack of compliance with the New Auditor Inspection Rules would result in the issuance “of a denial or delisting letter to the company that will inform the company of the factual basis for Nasdaq’s determination and its right for review of the decision pursuant to the Rule 5800 Series.”

Subject to the adoption of the aforementioned revisions, we would agree with Secretary of State Michael R. Pompeo that Nasdaq’s action could “serve as a model for other exchanges in the United States, and around the world.”

Holding Foreign Companies Accountable Act (Accountable Act or S. 945)

In May, the U.S. Senate passed S. 945 by “unanimous consent.” The bipartisan bill would prohibit foreign companies from listing and trading their securities on any U.S. securities exchange or through any other method regulated by the SEC, including “over-the-counter” trading, if PCAOB is unable to inspect the issuer’s public accounting firm for three consecutive years.

The provisions of S. 945 would also provide that the Commission end the trading prohibition once the company certifies that it has retained a public accounting firm that PCAOB is able to inspect. The provisions would also require an issuer to disclose whether it (the issuer) is state-owned or government-controlled.

A companion bill, H.R. 7000, was introduced in the U.S. House of Representatives but has not yet been subject to a vote.

CII first took a public position on S. 945 in connection with a June 2019 hearing of the Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets of the Committee on Financial Services in which a draft companion bill was discussed. At that time, we stated:

We acknowledge that there are a number of possible alternative actions the SEC, the PCAOB, the stock exchanges, or Congress could potentially take to address, at least in part, the investor protection and general oversight issues that exist for U.S. Chinese listed companies. In our view, the provisions of the Accountab[le] Act are not an unreasonable response, particularly in light of the apparent increasing size, scope, and significance of those issues.

Since Senate passage of S. 945, some critics have indicated that its provisions are overly broad, particularly with respect to its application to U.S. multinational public companies with operations in China. We note that recent Congressional testimony appears to confirm SEC would have the authority to ensure that U.S. multinational corporations doing business in China in which auditors are not subject to PCAOB inspection would generally fall outside the scope of the Accountable Act. We support that view and believe it is generally consistent with the intent and the language of S. 945. More broadly, we agree that the Accountable Act is a “sensible way to approach a problem that’s been around for a while ”

****

We appreciate your consideration of our comments. Please let me know if you have any questions.

****

The complete publication, including footnotes, is available here.

Both comments and trackbacks are currently closed.