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U.S. Securities and Exchange Commission

"Emerging Issues Under the Federal Securities Laws"


Commissioner Isaac C. Hunt, Jr.

U.S. Securities & Exchange Commission

DC Bar Corporation, Finance and Securities Section
Washington, D.C.

May 15, 2001

Good afternoon, it is a pleasure and an honor to address the members of the D.C. Bar Corporation, Finance and Securities Law Section.

But, before I begin speaking about what the SEC views as the critical, current issues involving the federal securities laws, I am obligated to state that the views that I express here today are my own and do not necessarily reflect the views of the Commission, other Commissioners, or the Commission's staff.

The SEC's mission, of course, is to protect investors and to promote efficient capital formation. What's historically curious is that, in some ways, the challenges facing the Commission in accomplishing its mission are no different today than the challenges that existed in 1933, when the U.S. federal government first began regulating the issuance of securities.

The House of Representatives report accompanying the new legislation described the market before the crash in eerily familiar terms:

"Alluring promises of easy wealth were freely made with little or no attempt to bring to the investor's attention those facts essential to estimating the worth of any security. High-pressure salesmanship rather than careful counsel was the rule in this most dangerous of enterprises . . .. Equally significant with these countless individual tragedies is the wastage that this irresponsible selling of securities has caused to the industry."

The comparison between the 1920s market and the recent dot.com offerings are extremely worrisome to any regulator. As Acting Chairman Laura Unger recently noticed: "[l]ast year, while the Nasdaq composite index was dropping 60%, less than 1% of analyst recommendations were "sell" or "strong sell" recommendations." In fact, as some companies moved towards bankruptcy and liquidation some analysts continued to recommend buying their stock.

With the past and current pictures firmly in mind, the two issues that I wish to focus attention on today are first, the importance of the quality of the financial reporting process and second, market fairness. First, in the area of accounting and financial reporting, the Commission has been extremely active. From our Division of Enforcement's financial fraud cases to recent rulemakings in the area of the role of audit committees and auditor independence, the Commission, I believe, has not only enhanced disclosure it has made such disclosures more reliable. The second area is market fairness. The Commission, with its adoption of Regulation Fair Disclosure (FD), has enhanced the integrity of our capital markets.

The Financial Reporting Process

When discussing financial reporting, it all begins and ends with a company's audited financial statements. Audited financial statements provide the foundation for our securities markets. Audited financial statements allow investors to make decisions on whether to buy, hold, or sell a particular security. If the numbers in the audited financial statements can't be trusted to provide relevant and reliable financial information about the company, investors might as well invest their money in lottery tickets. Because it will be by chance that their investments will be profitable. And based on some cases that I have seen, I have to believe that some shareholders would have received better odds in the lottery.

Current Trends

Unfortunately, the Commission has recently noticed certain worrisome trends relating to the integrity of financial information. Current market conditions have increased the pressure on companies to meet past or projected earnings levels. As a result, some managers have engaged in manipulation or "earnings management" to prop up their companies' profits and thereby their share prices, often with the approval of their accountants.

Another troubling trend on which we're keeping an eye is the increasing use of what has been called "pro forma" information. This is a tool that some companies use to disseminate an idealized version of their performance. It may exclude any cost or expense the company wants; yet it is presented in a format that suggests reliability and soundness. There's only one problem, pro forma statements are not audited and may not even be reconcilable with financial statements filed with the Commission.

Another practice that the staff has noted with increasing frequency is "channel stuffing." Some companies have announced that they will not meet their year-end earnings targets, apparently because they have been, in effect, reaching ahead into next quarter's sales to meet their quarterly targets. Using these techniques or offering deep discounts, companies motivate their customers to buy sooner rather than later. Unfortunately, while that may create the appearance of another successful quarter, it virtually guarantees that the company is starting in a hole the next quarter. At the end of the year, when the auditors discover what had been going on, the result is a shortfall for the fourth quarter and/or the year, as well as a shock to misled investors.

All of these practices move us away from a fair and accurate presentation of a company's financial situation. It creates a system where there is no transparency or comparability. Investors are unable to evaluate or compare companies when transactions, revenues, and earnings are manipulated in order to obtain some preconceived number. Companies must be expected to account for similar transactions and events in similar ways.

Recent Enforcement Actions Involving Financial Fraud

We have had many recent enforcement actions involving financial fraud. About 100 of the SEC's enforcement cases brought last year involved accounting or financial fraud. Charges were filed against 29 public companies, 19 CEOs, 19 CFOs, 16 Inside Directors and 1 Outside Director. As you know, SEC civil fraud charges can result in fines against companies and individuals and prohibitions against officials working again for public companies. Additionally, the Commission is making more criminal referrals, many of which have led to convictions and jail time.

Now, I'd like to summarize a number of points that are evident in recent enforcement cases. Remember, as you listen to this summary, that many of these frauds could have been avoided if companies had established effective internal controls, the oversight of the auditing committees had been more critical, or the auditors had been more demanding.

Revenue Recognition - Over half the cases brought by the Commission involved improper income recognition, including conditional and other non-GAAP sales; outright fictitious sales; improper "bill and hold" sales; failure to record expenses; and improper adjustments to revenue. Revenue timing was also a significant problem; indeed in one case [Sirena Apparel out of LA] senior managers reset a computer clock in order to hold a quarter open to meet a target. Employees of that company even placed bets with each other over how many additional days it would take to make the numbers!

Asset & Liability Valuation -- On the balance sheet side, about a quarter of the Commission's cases involved overvaluation of assets. Misuse of reserves, failure to record liabilities, and improper capitalization of expenses were also significant problems.

Accountants Charged

Let's not forget the accountants, both those inside the company as well as the outside auditors. In every financial fraud or reporting failure, the Commission always asks the question, "Where were the accountants?" All too often we find accountants and even outside auditors who, at best, closed their eyes to the problem, and in some cases were even complicit.

Commission Rulemaking

In addition to brining enforcement cases, the Commission has also used its rulemaking powers to enhance disclosure. Audit committees of public companies boards' of directors are now required to prepare a report, to be included in a company's proxy statement, stating whether the audit committee has reviewed and discussed the following matters:

  • the audited financial statement with management;

  • the methods used to account for significant unusual transactions;

  • the effect of significant accounting policies in controversial or emerging areas;

  • the process used by management in formulating particularly sensitive accounting estimates and the basis for the auditor's conclusions regarding the reasonableness of those estimates;

  • disagreements with management over the application of accounting principles, the basis for management's accounting estimates, and the disclosures in the financial statements; and

  • other matters required to be discussed set forth in Statement on Auditing Standards No. 61 (SAS 61), as that document may be modified or supplemented.

It is our hope that these additional disclosure requirements will result in audit committees becoming more engaged in the accounting of their companies.

Auditor Independence

The Commission also is concerned with the appearance of a lack independence of many accounting firms. Many auditing firms are obtaining additional fees from their client companies that dwarf the fees they received from these clients for their auditing services. Our concern is that these additional fees, at least at the margins, could affect an accountant's independent judgment. For example, how likely is it that an audit firm would tell a client company that their internal controls are insufficient with respect to their financial systems, if the audit firm itself had recommended and installed those financial systems for a significant fee? Our new rules now require disclosure in the proxy statement of audit and non-audit fees that the independent accountants received from their client companies. Accordingly, shareholders and market participants will now be able to decide for themselves whether receipt of these additional fees could perhaps impair an auditor's independence.

Regulation Fair Disclosure

The second area where the Commission took significant action recently is market fairness. Last year, as most of you know, the Commission adopted Regulation Fair Disclosure, or Regulation FD.

Regulation FD was designed to end the problem of selective disclosure. Selective disclosure occurs when a company's executive officers or other representatives provide material information to a selective few before disclosing such material information to the general public. Normally, our prohibition on insider trading would cover such situations, but because the information provided by the company's officers was not for the personal benefit of those officers, at least not monetarily, there is significant uncertainty as to whether our insider trading laws prohibit such disclosure. Most often, the privileged few that received the selected disclosure were analysts and market professionals who in turn often passed this information on to their favored clients.


Before I begin speaking about Regulation FD in detail I think it would be useful to discuss what we at the SEC consider "material" information. This question was raised repeatedly at the Roundtable on FD we held in New York on April 24th.

What do we mean when we say certain information is "material?" Does such information have to "move the market" in order for it to be considered "material?" How does one know for certain whether the disclosure of particular information would actually result in changes to the price of a security? Well in 1976, the Supreme Court, in TSC Industries, Inc. v. Northway, Inc., established the test for how we determine whether certain information is material under our federal securities laws. In this case, a shareholder brought suit against TSC Industries claiming that the company's proxy statement was incomplete and materially misleading in violation of the Securities and Exchange Act of 1934. The Court stated the following:

"The general standard of materiality . . . is as follows: An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote . . .. It does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote. What the standard does contemplate is a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder. Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available."

Today, this test is applied not only in determining whether the information is material with regard to a shareholder's vote, but also when securities are purchased or sold. Generally, the federal securities laws require that issuers disclose all material information when selling securities.

SAB 99

From time to time, the Commission and its staff have given companies and individuals additional guidance in accessing the materiality of certain items. Most recently, in August of 1999, the accounting staff of the Commission issued its Staff Accounting Bulletin No. 99 ("SAB 99"). This Bulletin alerted companies that, when assessing the materiality of an item, there is no magical monetary threshold below which an item would automatically be deemed immaterial. Rather, when assessing materially, one must take into account both the quantitative and qualitative elements of the disclosure.

For example, an overstatement of revenue by two percent could in some circumstances result in an increase in a company's earnings by a penny or two. To many this may seem insignificant, but in an environment where missing an analyst's earnings projection by a penny or two can send a stock tumbling, it is clear that the two percent overstatement of revenue could be material to the reasonable investor.

While our disclosure system requires companies to disclose material information upon the occurrence of certain events, it does not prohibit companies from disclosing material information at other times. Rather as a Commission, we have always, and continue to, encourage companies to disclose material information as soon as possible.

Consequently, companies often have disclosed material information to analysts before disclosing to the general public or before filing such information with the Commission. Generally, companies would disclose material information to analysts earlier as a means to better educate them in evaluating the company and its stock. It has long been the view that analysts would then evaluate and disseminate the material information to investors and the market in general. This has been the American model for almost 70 years.

But not too long ago things began to change. Analysts, while still playing an important role in the efficiency of the market, were slowly becoming less essential in the information dissemination process. The financial press and electronic financial media have proliferated in the last decades, and of course there has been the monumental impact of the Internet. Companies and investors no longer needed the analysts to disseminate material information to the market. Before 1990, it was difficult for many investors to even obtain a company's quarterly report. But with the SEC's EDGAR system and a slew of other Internet web sites, investors are only a click away from material financial information. This greater access by individual investors, combined with the appearance that some companies had released material information to an analyst or certain analysts in an attempt to curry favor, created the atmosphere and the need for Regulation FD.

The decision to adopt Regulation FD was not an easy. This regulation was very controversial. The Commission received nearly 6,000 comment letters when we first proposed it. We were changing the status quo; the analysts and corporate community were not exactly thrilled. I, myself, was critical of the initial proposal. I considered it much too broad for what was needed. For example, the initial proposal would have required a company to make public disclosure of any material information that it had disclosed in private. Thus, if a company provided material information regarding one of its products to one of its suppliers, such competitive material information would have had to be made public. The proposal also would have been extremely costly. The cost of reviewing every private communication to determine whether material information was being disclosed would have been prohibitively expensive, and, in my opinion, would have exceeded any benefits.

Thankfully, we were able to narrow Regulation FD. As the Regulation FD is adopted, it only applies to communications that the Commission felt were problematic. Regulation FD applies to communications of material information to those recipients of such material information who are likely to use this information to gain an unfair trading advantage over other investors.

Regulation FD thus applies whenever a company, or any person acting on its behalf, discloses any material nonpublic information regarding itself or its securities to: a broker, dealer, investment adviser, investment company, or shareholder, where it is reasonably foreseeable that such persons would trade on the nonpublic material information. Once applicable, Regulation FD requires the company to simultaneously disclose to the public the material nonpublic information. In the case of a non-intentional disclosure by the company, it is required to disclose such material information promptly: in no event, however, later than 24 hours.

Regulation FD changes the playing field. Hopefully, it will make our markets fairer and encourage investors to continue to participate in our capital markets. Concerns remain, however, that Regulation FD may chill communications. Companies may choose not to disclose material information that before it had disclosed only to the analyst community, in fear of violating Regulation FD. If this occurs, Regulation FD will need to be amended. At present, we are soliciting anecdotal comments and studying the situation closely.

In the meantime, I believe companies will continue to have the necessary incentives to disclose positive material nonpublic information to the broadest possible audience. However, I am most concerned about Regulation FD's chilling effect when the material information is negative. Companies may choose to hide behind Regulation FD and delay the disclosure of the material negative information. This would be most unfortunate. I am hopeful, however, that after companies get accustomed to their new responsibilities, Regulation FD will not chill communication but rather provide for more and fairer disclosure.


The Commission and the staff will continue to closely monitor the effect of our auditor independence rules, as well as Regulation FD.

I thank you for your time and attention today.



Modified: 06/06/2001