Speech by SEC Staff:
Remarks at The Bond Market Association,
Corporate Credit Markets
Alan L. Beller
Director, Division of Corporation Finance
U.S. Securities & Exchange Commission
New York, New York
April 10, 2003
Thank you for that kind introduction. It is a pleasure and an honor to be addressing a group that has been so instrumental in enhancing the corporate fixed income market in this country and around the world. First, I must note that this morning I am speaking only for myself and that the views I express do not necessarily represent those of the Commission or any other member of the staff.
It is interesting that while the financial headlines focus on the equity markets, the debt markets provide the capital that more companies rely on more often to maintain their financial health, strengthen their financial structures and provide the fuel for the growth of their businesses. Many of the United States' largest companies go literally years without issuing common equity, but many issue large amounts of fixed income securities on a regular and frequent basis.
It probably surprises almost no one that in 2002 corporate debt issuance in the U.S. dwarfed equity issuance, with a total of more than $ 1.2 trillion of corporate debt issuance, compared to less than $ 120 billion of equity issuance.1 What may surprise a number of people outside this room is that even in the go-go days of the equity markets issuance in the debt markets was similarly much much larger than in the equity markets. In 2000 corporate debt issuance exceeded $ 1.2 trillion, while equity issuance was less than $ 200 billion.2 A healthy environment for capital formation thus depends crucially on successful conditions for debt issuance. And debt issuance depends on properly functioning trading markets and accurate information for valuation of companies and securities. While the equity market may get the public attention, the corporate debt market is often the engine that gets the job done. So we regulators must be cognizant of the importance of maintaining a healthy regulatory framework for debt issuance and trading.
Today I would like to focus on the need of markets and market participants for improved information regarding liquidity and cash flow. I would also suggest that it is important for market participants to better evaluate that information.
Again, the headlines have focused on the collapse of the equity prices of companies victimized by the accounting, disclosure and corporate governance scandals of the past 16 months. To be sure, these collapses have been spectacular, the losses suffered by innocent investors have been tragic and the need for reform to avoid repetition has prompted necessary and appropriate action by Congress, the SEC and other regulators, self-regulatory organizations and other branches of government.
But the actual implosions of the companies that have become the poster children for the breakdowns in our system did not occur because their equity prices fell near zero or because of the resulting colossal losses in equity market capitalization. Those events were nothing more than the consequences of the belated recognition that these companies had or were about to run out of cash and could not satisfy their obligations. Lack of liquidity was what put these companies into bankruptcy and endangered their continued existence.
There are two important factors here-- first the obvious importance of these companies' cash and liquidity positions; and second, the fact that so many participants in the market clearly had a seriously incorrect or incomplete understanding of some or all of the following cash and liquidity-related items for the companies that failed so spectacularly:
- the amount of these companies' obligations, including off-balance sheet obligations;
- the timing and other terms of those obligations;
- the availability of cash that was necessary to satisfy those obligations; and
- the access of those companies to capital resources or other sources of liquidity.
This summary would suggest that the market needs better and earlier analysis and warning of events that could materially impact a company's cash and liquidity position.
Before we get to a discussion of how that might happen, it is worth mentioning another reason that analysis of cash flows is so critical to a properly functioning market. As the financial types that fill this room know much better than I, proper valuation of companies depends on an evaluation of future performance, and particularly of future discounted free cash flow. While there is more forward-looking information available than there used to be, much of the information that the markets analyze is historical information. That information is useful in the valuation process principally insofar as the market is able to assess the degree to which the past predicts the future. So there's another reason for better and earlier analysis of events that could materially impact a company's cash flow.
How do we get that information? The good news is, first, that the rules of the SEC already contain provisions that, fairly interpreted, should require this information, and second, the SEC is focusing on how to use those rules to get better disclosure of this information. I am of course talking about Management's Discussion and Analysis of Financial Condition and Results of Operations, or MD&A for short. Too often in the recent past the words "Financial Condition" in the title to that item have gotten short shrift, but I think recent events, summarized above, have refocused both regulators and market participants on their importance.
The requirements of MD&A are well designed for this task. The Commission last year articulated three general purposes of MD&A. I have set them forth in many presentations over the last several months, but they bear repeating in the context of cash and liquidity:
- To provide a narrative explanation of a company's financial statements that enables investors to see the company through the eyes of management;
- To improve overall financial disclosure and provide the context within which financial statements should be analyzed; and
- To provide information about the quality of, and potential variability of, a company's earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.
These statements of general purpose focus nearly precisely on the enhancements that I think we need in the disclosure of cash flow and liquidity. How do we go about getting those enhancements?
First, there has to be a recognition of the importance in the framework of MD&A disclosure of cash flow and liquidity. From the time of original proposal and adoption of the MD&A requirements, the Commission and the staff recognized this importance. While MD&A has existed in some form since 1968, the current incarnation of MD&A was put into place in 1977 following the work of the Advisory Committee on Corporate Disclosure. The Advisory Committee recommended that the Commission require an analysis of the financial statements that "…will enable investors to relate the reported financial statements to assessments of the amounts, timing and uncertainties of future cash flows."3 The Committee also recommended voluntary disclosure in areas that affect cash flow and liquidity, such as:
- planned capital expenditures and financing;
- management plans and objectives;
- dividend policies; and
- capital structure policies.
In 1980, the Commission adopted the MD&A requirement to address, among other things, "a growing need… to analyze enterprise liquidity and capital resources."4 Soon after the adoption of the MD&A rules, the Commission issued a release clarifying that "the scope of the discussion should thus address liquidity in the broadest sense, encompassing internal as well as external sources, current conditions as well as future commitments and known trends, changes in circumstances and uncertainties."5 In addition, the release indicated that "…the Commission's concept of liquidity is comparable to the [FASB's] concept of financial flexibility or the ability of an enterprise to adjust its future cash flows to meet needs and opportunities, both expected and unexpected. Financial flexibility… includes potential internal and external sources of cash not directly associated with items shown on the balance sheet."6
Similarly, in its last comprehensive discussion of MD&A, in 1989, the Commission emphasized the importance of disclosure regarding cash flow and liquidity. The Commission reiterated the need to provide an analysis of both short-term and long-term liquidity and capital resources.7 The Commission stated that discussion about short-term liquidity should address a company's cash needs up to the next 12 months and that the discussion of long-term liquidity "…must address material capital expenditures, significant balloon payments or other payments due on long-term obligations, and other demands or commitments, including any off-balance sheet items, to be incurred beyond the next 12 months, as well as the proposed sources of funding required to satisfy such obligations."8 The 1989 Release also reminded registrants that the liquidity discussion should identify material deficiencies in short or long-term liquidity, as well as disclose either a proposed remedy, that the registrant has not decided on a remedy, or that it is currently unable to address the deficiency.9
Interestingly, in 1987 the accounting rules were amended to require a statement of cash flows as part of financial statements. Yet I think few people who have studied the subject would disagree with my assessment that the MD&A of too many companies is not informative when it comes to cash flow and liquidity. Too many companies merely repeat the information that is already apparent from the face of the statement of cash flows. There is clearly not enough analysis. The time has come to reverse that direction.
What specifically are we doing to improve disclosure in this area? First, as I noted above, the requirements of MD&A, fairly interpreted, should get us what we want. I would like to focus on forward-looking and trend information in particular. I spoke above of the importance of information about events that "could" materially impact cash flow and liquidity. MD&A addresses that subject specifically. Since its original adoption, MD&A has required disclosure of material trends and uncertainties that will or "are reasonably likely to" materially impact cash flow and liquidity. And it has been recognized that such disclosure could be required to be forward-looking.
Furthermore, the phrase "reasonably likely" has been interpreted by the Commission -- in particular, it is clear that an impact can be reasonably likely even if it is not "more likely than not". And the burden is on the issuer to conclude that an event is not reasonably likely, or that the reasonably likely impact will not be material. If the issuer cannot reach one of those conclusions, disclosure is required.
I apologize for the technical legal detail that I have just recited, but I wanted to set it out for a non-technical substantive reason. I believe that a fair reading of the requirements as I have just described them should produce more trend information regarding cash flow and liquidity than is currently being disclosed. In particular, management has much more information at its disposal, and has access to that information much more quickly than was even imaginable, say in 1989, when the Commission last comprehensively addressed these issues. The requirements of MD&A should be considered against the backdrop of the information currently available to management. I believe more trend disclosure will result.
The Division of Corporation Finance has been using the comment process to focus issuers on MD&A disclosure enhancement generally, including disclosure regarding cash flow and liquidity. In 2002 the Division undertook a screening of the Fortune 500, followed by a more thorough review where warranted. Most of the reviews were of financial disclosure, including financial statements and MD&A.
We issued nearly 400 letters seeking improved disclosure from the universe of America's largest 500 companies. We have posted on the Division website a report that summarizes the subjects on which we commented most frequently. In the areas of cash flow and liquidity, our most frequent comments included the following:
- General requests for more informative discussion of liquidity and cash flow, consistent with my remarks above. There is too much boilerplate and recitation of figures that can be taken or derived directly from the financial statements, and not enough analysis;
- Requests for more robust discussions of liquidity and capital resources - we saw too much disclosure along the lines of "we have sufficient resources to sustain us through the coming year";
- Requests to discuss main funding sources and any risks to their continued availability, including the availability of traditional financing and off-balance sheet financing such as securitization transactions;
- Requests for information regarding the impact on liquidity and cash flows of payments to fund pension plans; and
- Requests to provide information on the company's commercial commitments, as discussed in the Commission's January 2002 release.
In addition, the Division of Enforcement has been active in this area. For example, the Dynegy action included a transaction that was apparently engineered to increase operating cash flow, when in fact the transaction should have been recorded as a financing cash flow in accordance with it's substance. Interestingly, in the case of one of the transactions addressed in Dynegy, the Commission's claim was not that the company violated GAAP, but that its MD&A was inadequate to provide information necessary to give investors an understanding of the transaction and the company's cash flow.
This is another important general theme in analyzing and improving MD&A, consistent with the second general purpose I articulated earlier. There are circumstances where it is necessary for companies to use MD&A to fill in the gaps in GAAP. Accounting that violates GAAP is problematic without regard to disclosure. But accounting that conforms to GAAP can still leave out facts that are necessary for a proper material understanding of a company's financial condition or results of operations, and failure to provide those additional facts can make the overall disclosure misleading. The Commission has long been of that view and has brought enforcement actions accordingly, of which the leading example is probably the Caterpillar matter. In that case, the issuer failed to disclose in its MD&A that its GAAP results included a significant one-time gain from Latin American operations, and that omission was material in respect of an understanding of its results and made the overall disclosure misleading. There could be more actions to come in this area, involving both accounting and disclosure issues as company's seek to beef up operating cash flow, including in ways that may be inappropriate or are inadequately disclosed, just as some have done with revenue and performance measures in the past.
Some of the most important new SEC pronouncements and some of the most important new accounting requirements address accounting and disclosure regarding financial condition, cash flow and liquidity. The Commission in January 2002 addressed disclosure of off-balance sheet transactions, and Congress mandated additional rules in July 2002. Both the Commission and Congress saw a clear and vital need for improvement. A company's financial condition and the risks to its liquidity and cash flow simply cannot be assessed with any degree of accuracy or fairness if material obligations are not disclosed or are obfuscated. The Commission's position in January 2002 was clear-- disclosure of more information regarding off-balance sheet transactions was required under the then-existing rules. The rules the Commission adopted in response to the mandate of the Sarbanes-Oxley Act in January of this year went on to clarify and elaborate on disclosure in this area.
Beyond the Commission, the Financial Accounting Standards Board, the FASB, adopted two new important interpretations that impact accounting and disclosure of important matters regarding financial condition, cash flow and liquidity. First, in November 2002, the FASB adopted Interpretation No. 45, known as FIN 45, regarding accounting and disclosure for guarantees, which will require greater reflection of contingent obligations on the face of financial statements and additional disclosure in notes to financial statements. Second, in January 2003 the FASB adopted Interpretation No. 46, or FIN 46, regarding accounting and disclosure for a new creature defined as a "variable interest entity", which is the new term in the accounting literature for what we all used to call a "special purpose entity" or "special purpose vehicle". Again, the new interpretation is intended to require consolidation of more of these entities onto an issuer's balance sheet and additional footnote disclosure whether or not consolidation is required.
That completes a summary of some of the most significant things that the regulators and standard setters are talking and thinking about. And we are dedicated and serious about getting better disclosure in these areas. But everyone in this room knows that issuers often react much more quickly and much more dramatically to market pressures than to regulatory ones. And the principal actors in the corporate debt market include the people in this room.
Do you think that what you are currently receiving is sufficient? While disclosure may be improving, in light of the events of the last 16 months or so, I have a hard time believing that you are fully satisfied. If in fact further improvement is desirable, you who operate in the corporate fixed income market must demand better information regarding cash and liquidity than today's disclosure documents provide. And you should demand it on a timely basis, not after the crisis is apparent to all from the daily newspapers. Finally, because the fixed income market is dominated by the institutional investors and market intermediaries in this room, it is incumbent on you not only to demand better and more timely information, but also to do the necessary analysis to make your own independent determinations regarding a company's financial condition.
We are working overtime to enhance disclosure of important financial information. If market forces are also brought to bear, I am confident that you and we together will achieve that desirable objective, and markets will be better informed and more efficient as a result.
Thank you for your attention. I would be pleased to answer questions in the remaining time.
||Source: Thomson Financial Securities Data.|
||See Report of the Advisory Committee on Corporate Disclosure to the Securities and Exchange Commission, Committee Print 95-29, House Committee on Interstate and Foreign Commerce, 95th Cong., 1st sess., Nov. 3, 1977 at p. 368.|
||See Release No. 33-6231 (Sept. 2, 1980) [45 FR 63630].|
||See Release No. 33-6349 (Sept. 28, 1981) [Not published in Federal Register].|
||Id. at fn. 5.|
||See Release No. 33-6835 (May 18, 1989) [54 FR 22427] at Section III.C.|