ADI 2020-11 Registered Funds’ Risk Disclosure Regarding Investments in Emerging Markets
Dec. 14, 2020
Ensuring that investors and other market participants have access to high quality, reliable disclosure of information material to an investment decision, including financial reporting, is at the core of the SEC’s mission.
The Division of Investment Management’s Disclosure Review and Accounting Office (DRAO) is responsible for, among other things, reviewing disclosures in registered investment company (fund) filings. DRAO focuses, in particular, on topics that have proven key to assessing investments, including risk disclosures. High quality risk disclosures both facilitate investment decisions and enhance investor protection.
Over the past decade, U.S. investors have experienced an increase in their exposure to companies with significant operations in emerging markets. The availability and reliability of information material to an investment decision, particularly financial information, from these companies may be limited in comparison to the scope and reliability of financial information provided by U.S. companies. Notably, regulatory authorities in some of these markets currently do not provide the Public Company Accounting Oversight Board (“PCAOB”) with the ability to inspect public accounting firms, including sufficient access to inspect audit work papers and practices, or otherwise do not cooperate with U.S. regulators.
A significant amount of U.S. investor exposure to emerging markets comes through funds investing in these markets. Accordingly, DRAO and other staff have closely reviewed filings of funds that invest significantly in emerging markets, identifying disclosure that notes the lack of publicly available information, restrictions on certain investments, the potentially higher risks for these investments than in companies subject to U.S. regulations, the lack of uniform disclosure, accounting and financial reporting and recordkeeping standards, and the limited investor protections applicable in other jurisdictions. This ADI is designed to highlight current findings from the staff’s ongoing review of funds’ emerging markets risk disclosure, bring more transparency to our disclosure program with respect to investments in emerging markets, and drive improved risk disclosure for investors.
Funds with Significant Exposure to Emerging Markets
The staff has been reviewing the disclosure of risks for both actively-managed funds with significant exposure to emerging markets and funds that track indices with significant exposure to emerging markets. Both types of funds may face emerging markets risks that should be disclosed to investors. For instance, in many emerging markets there is significantly less publicly available information about domestic companies due to differences in applicable regulatory, accounting, auditing, and financial reporting and recordkeeping standards. In addition, in some jurisdictions, foreign investments may be made through organizational structures that are necessary to address restrictions on foreign investments.
These structures may limit investor rights and recourse. More generally, there may be limited corporate governance standards and avenues of recourse as compared to U.S. companies. Additionally, shareholder claims that are common in the U.S. and are generally viewed as deterring misconduct, 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. Furthermore, with respect to index funds, lack of relevant data and reliable public information about portfolio companies in emerging markets can contribute to incorrect weightings and data and computational errors when an index provider selects companies for inclusion in an index.
Staff has observed a range of practice in the level and quality of risk disclosure provided by funds in this area. We encourage funds to provide tailored disclosures of risks in the emerging markets in which they invest, and related risks, so that investors are able to make informed investment decisions about and among funds. Funds may wish to consider the following factors and how the factors can impact the fund when drafting these disclosures:
- risks related to, but not limited to, lack of liquidity, market manipulation concerns, limited reliable access to capital, political risk, and foreign investment structures;
- whether and how emerging markets risks arising from differences in regulatory, accounting, auditing, and financial reporting and recordkeeping standards could impede an adviser’s ability to evaluate local companies or impact the fund’s performance. To this point, funds may wish to consider highlighting issues discussed in “Restrictions on PCAOB Audit Inspections” below;
- any limitations on the rights and remedies available to the fund, individually or in combination with other shareholders, against portfolio companies;
- if an index fund, whether the index provider will have less reliable or current information—e.g., due to issues associated with the regulatory, accounting, auditing, and financial reporting and recordkeeping standards in the relevant emerging market—when assessing if a company should be included in an index or determining a company’s weighting within the index;
- if an index fund, any limitations concerning the adviser’s ability to assess the index provider’s due diligence process over index data prior to its use in index computation, construction and/or rebalancing; and
- whether the limitations stated above could impact the stated investment objective of the fund.
As these factors, individually and collectively, point to potential risks related to the reliability and limitations of emerging market information that can meaningfully affect fund performance, the staff has heightened its review of these disclosures. 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.
Restrictions on PCAOB Audit Inspections
The Sarbanes-Oxley Act of 2002 requires that PCAOB-registered accounting firms, which prepare or issue audit opinions for U.S.-listed issuers, submit to PCAOB inspections and produce audit work papers. This requirement applies to audit opinions for all U.S.-listed issuers, regardless of the domicile of the issuer. Certain jurisdictions, however, do not currently provide the PCAOB with sufficient access to inspect audit work papers and practices, or otherwise do not cooperate with U.S. regulators, potentially exposing investors in U.S. capital markets to significant risks. In addition to the general risks of investing in jurisdictions that have different regulatory, accounting, auditing, and financial reporting and recordkeeping standards described above, funds must be mindful to assess their disclosure with regard to the unique risks associated with investments in jurisdictions that place material limitations on PCAOB inspection, investigation and enforcement. Funds should consider the potential risks related to the PCAOB’s lack of ability to inspect PCAOB-registered accounting firms, for example, in China. 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 audit work papers and practices of PCAOB-registered accounting firms in China (including Hong Kong-based firms, to the extent their audit clients have operations in mainland China) with respect to their audit work of U.S. reporting companies. Funds investing in emerging markets should carefully consider the regulatory environment in which a company operates in assessing whether the company has sufficient controls, processes, and personnel to address its accounting or financial reporting and recordkeeping issues. These potentially unique operating considerations and any material limitations on PCAOB oversight of companies’ auditors should be considered and reflected in risk disclosures of funds that have significant exposure to emerging markets.
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ADIs are recurring publications that summarize the staff’s views regarding various requirements of the federal securities laws.
This ADI represents the views of the Division of Investment Management. It is not a rule, regulation or statement of the Commission. The Commission has neither approved nor disapproved its content. This ADI, like all staff guidance, has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person. Future changes in rules, regulations, and/or staff no-action and interpretive positions may supersede some or all of the information in a particular ADI.
We hope that this ADI will assist registrants in preparing their filings. We also welcome feedback on this guidance and on any disclosure matters. If you have any questions or feedback, please contact:
Disclosure Review and Accounting Office
 See SEC Chairman Jay Clayton, PCAOB Chairman William D. Duhnke III, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman and SEC Division of Investment Management Director Dalia Blass, Statement on Emerging Market Investments Entail Significant Disclosure, Financial Reporting and Other Risks; Remedies are Limited (April 21, 2020) (“SEC and PCAOB Joint Statement”), available at https://www.sec.gov/news/public-statement/emerging-market-investments-disclosure-reporting.
 See SEC Emerging Markets Roundtable, Spotlight on Risks for Investors in Emerging Markets, available at https://www.sec.gov/page/emerging-markets-roundtable.
 See Secretary of the Treasury Steven T. Mnuchin, President’s Working Group on Financial Markets: Report on Protecting United States Investors from Significant Risks from Chinese Companies (July 24, 2020) (“PWG Report”), available at https://home.treasury.gov/system/files/136/PWG-Report-on-Protecting-United-States-Investors-from-Significant-Risks-from-Chinese-Companies.pdf.
 See SEC Division of Corporation Finance, CF Disclosure Guidance: Topic No. 10, Disclosure Considerations for China-Based Issuers (“CF Disclosure Guidance”), available at https://www.sec.gov/corpfin/disclosure-considerations-china-based-issuers.
 See SEC and PCAOB Joint Statement.
 See e.g., CF Disclosure Guidance (discussing risks related to a company’s organizational structure).
 See SEC and PCAOB Joint Statement (“Issuers should clearly disclose any material limitations on shareholder rights.”).
 See PWG Report.
 See Keynote Address – 2019 ICI Securities Law Developments Conference, Dalia Blass (December 3, 2019), available at https://www.sec.gov/news/speech/blass-keynote-address-2019-ici-securities-law-developments-conference.
 See SEC and PCAOB Joint Statement; see also, e.g., Form N-1A, Gen’l. Instr. B.4.(c)., Items 4(b) and 9(c) (the Fund should consider its specific exposures and risks of investing in the Fund, including the risks to which the Fund’s portfolio as a whole is subject and the circumstances reasonably likely to affect adversely the Fund’s net asset value, yield, and total return) available at https://www.sec.gov/files/formn-1a.pdf; and Rule 421 under the Securities Act of 1933 (17 CFR 230.421).
 See PWG Report.
 See PWG Report.
 See SEC and PCAOB Joint Statement.
 See, e.g., SEC Chairman Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III, Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally—Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China (December 7, 2018), available at https://www.sec.gov/news/public-statement/statement-vital-role-audit-quality-and-regulatory-access-audit-and-other.
 See, e.g., SEC and PCAOB Joint Statement.