Speech by SEC Staff:
Alan B. Levenson Memorial Lecture
Alan L. Beller
Director, Division of Corporation Finance
U.S. Securities and Exchange Commission
Glasser LegalWorks: 6th Annual SEC Disclosure,
Accounting & Enforcement Conference
New York, New York
May 18, 2004
Thank you, Stan for that kind introduction.
I am honored to be giving the first Alan Levenson memorial lecture today and to do so after an introduction by Stan Sporkin. As most of you know, Stan Sporkin is a tough act to follow. And those of us who have been Director of the Division of Corporation Finance since Alan Levenson's tenure in the position from 1970 to 1976 (and I think there have been eight of us) know that Alan is also a tough act to follow. And it is a daunting prospect for me to do justice to Alan's accomplishments and memory, especially in this first lecture given here in his honor.
I think now would be a good time for me to say that, as a matter of policy, the SEC disclaims responsibility for remarks by members of its staff. My remarks represent my own views and not necessarily those of the Commission or other members of the staff.
This is a particularly fitting venue for this lecture, because Alan was a great supporter of continuing legal education. In an interview in the year before his death, he recalled that while he was at the Commission he felt "the private bar was essential to effective operations of the SEC, and the more that we could share information and do away with the mystery, it would result in the protection of investors, both from a disclosure standpoint and the raising of capital for our capital markets."1
While Alan recognized the important role the private bar could play in the protection of investors, he himself spent his early career entirely at the Commission. Alan joined the Commission as the first member of the SEC's Honors Program after graduating from Yale Law School. He worked his way from law clerk trainee in what is now the Division of Corporation Finance, to be the Director of the Division's enforcement unit, in the days before there was a separate Division of Enforcement. So Stan Sporkin and all the other Directors of Enforcement at the SEC also follow in Alan's footsteps.
After a brief sojourn in the private sector, Alan returned to the Commission from 1970 to 1976 to be the Director of the Division of Corporation Finance, which he described as one of the best jobs in the country.2 (I would add that I wholeheartedly agree with him.) After leaving the Commission, Alan was a leader in the securities bar for more than a quarter century until his death.
I feel a connection to Alan, not only because we shared a first name and a position, but also because, while the issues that Alan faced during his time as Director of the Division of Corporation Finance were of course different, many of the basic themes - governance, disclosure, controls - continue to resonate.
Students of history and the securities laws (as well as those of you who were there) will recall that the early 1970s saw its own market downturn and major bankruptcies. The early 1970s also saw its share of major corporate failures, most notably Penn Central Railroad. In the aftermath, then, as now, much attention was focused on corporate accountability, the accounting profession and the SEC's disclosure requirements.
As Director of the Division of Corporation Finance, Alan served under five Chairmen, and through many changes at the Commission, including the 1972 reorganization of the Commission that created a separate Division of Enforcement, the New York City financial and municipal bond crisis, and the implementation of the Williams Act rules (the initial ones of which Alan is reputed to have written over a weekend,3 which makes even the rapid rulemaking accomplishments of the Division in the six months after the enactment of Sarbanes-Oxley seem slow).
In an interview in the year before his death, conducted under the auspices of the SEC Historical Society, Alan counted among his most significant accomplishments while Director the development of the 140 series of rules (including Rule 144), advances in corporate governance and shareholder democracy, and the Commission's initiatives that ultimately lead to the Foreign Corrupt Practices Act of 1977.4
After the Watergate scandal, the use of "slush funds" for political contributions came to the attention of the SEC's relatively new Enforcement Division.5 Stan Sporkin was the architect of what followed at the SEC. As a result of its "questionable payments" enforcement program, between 1974 and 1976 the Commission obtained consent decrees against 13 companies related to falsification of corporate books and records relating to such funds. Eventually the Commission developed the related "voluntary disclosure" program, whereby a company could avoid SEC enforcement action by conducting its own investigation supervised by non-employee directors, and publicly disclosing any material findings in an SEC filing. Ultimately, more than 450 companies admitted to having, or were found to have, paid political or commercial bribes in the U.S. or abroad.6
These revelations led to a number of proposals for corporate governance and other reforms, including, ultimately, the Commission's recommendation for legislation prohibiting the falsification of corporate accounting records and requiring management to maintain a system of internal accounting controls. Congress enacted such legislation as part of the Foreign Corrupt Practices Act of 1977, and the requirements were embodied in Section 13 of the Exchange Act.
Following the more recent uncovering of major corporate accounting fraud and malfeasance, the Congress in the Sarbanes-Oxley Act and the SEC have adopted legislation and rules which recognize the importance of internal controls to good public financial reporting. The provisions are the most far-reaching and expansive of the Sarbanes-Oxley requirements for companies, but they also have the potential to provide the most substantial improvements.
From the beginning we have recognized that complying with these rules is no small undertaking for companies, especially small businesses. That is why we have been saying since the rules were adopted that companies should not delay in complying with these rules, even though we have imposed a later effective date than those for the other new Sarbanes-Oxley requirements - fiscal years ending November 15, 2004 for accelerated filers and July 15, 2005 for other issuers.
As I'm sure you are all aware, however, that does not leave much time, and I certainly hope that companies already are well on their way to developing the structure and systems and doing the other work necessary to have effective assessments of internal controls over financial reporting.
You will be discussing in a session this afternoon the PCAOB's Audit Standard 2, related to audits of companies' internal controls over financial reporting. The PCAOB has adopted and submitted this standard to the Commission for approval and the Commission's comment period on this standard ended yesterday. This standard makes clear that auditors cannot just attest to management's assessment but the scope of their audit must extend to the controls themselves. The Commission will be reviewing those comments and is sensitive to the issue of timing.
Management's Discussion and Analysis
While the modern form of the MD&A requirements were not adopted until 1980, during 1974 there were major developments in key areas that were forerunners in important ways of modern MD&A. In January 1974, the Commission released Accounting Series Release 151, which represented the first step towards allowing disclosure other than historical data.7 In December 1974 the Commission issued Accounting Series Release 166, which encouraged more detailed disclosure of uncertainties, especially related to the use of accounting estimates.8 These were two areas addressed again by the Commission in its interpretive release on MD&A in December 2003.
The Commission's decision to issue its December 2003 interpretive release grew out of its and the Division's conclusion that the quality of MD&A has not been as good as it should be. Among other things, this observation came from the review experiences of the Division, including our Fortune 500 review.
The Commission's guidance was timely, I believe, because companies have and use substantially more detailed and timely information about financial condition and operating performance than they did when the Commission last issued major guidance on this topic in 1989. Some of that information is financial, and some is non-financial but still bears on companies' financial condition and operating performance.
I know that there was a session this morning on MD&A, so I won't go through the release in detail with you, but, briefly, I think the release has a message in three main categories: the process by which registrant's draft their MD&A, the presentation of MD&A and the content of MD&A.
As for process, one of our goals was to spur each company and its management to take a fresh look at MD&A - not just mark-up last year's. Management is the "M" of MD&A and its unique perspective on its business and its early involvement in preparing MD&A is important if MD&A is going to achieve its objectives.
As for presentation, the Commission said that within the universe of material information, the most important information should be the most prominent. The Commission pointed out that duplicative disclosure can overwhelm readers and act as an obstacle to identifying and understanding material matters, and I believe for the first time, suggested it should be eliminated. Finally, the Commission suggested that many companies' MD&A would benefit from an executive-level overview that provides context for the remainder of the discussion. These are not the usual topics about which the Commission officially speaks, and I hope that companies and their advisors pay attention.
As for content, the Commission made clear that MD&A should not be a recitation of financial statements in narrative form or a series of technical responses to MD&A requirements. The "D" and "A" in MD&A make clear that discussion and analysis that explain management's view of the implications and significance of information in MD&A is paramount.
Following the lead of those, like Alan Levenson, who in the early 1970s recognized the importance of forward looking information in filings, the Commission emphasized the discussion of known trends and uncertainties that are reasonably likely to have a material effect on financial condition or operating performance.
The Commission devoted a separate section of the Release to liquidity and capital resources because it is so important and too often receives inadequate attention. Particularly, the Commission discussed the need for better disclosure of cash requirements and sources of cash.
The Commission also devoted a separate section to critical accounting estimates. As the release notes, the proposed rule on critical accounting estimates is still under consideration; the Division's recommendation to the Commission on that rule will be dependant in part on whether we see improved disclosure based on the Commission's guidance.
Quarterly Reporting and Form 8-K
One of the very important developments during Alan Levenson's tenure was the adoption of a quarterly filing requirement on Form 10-Q. It is clear that the Commission was well ahead of its time in moving toward more frequent reporting - even today the U.S. is still one of few countries that has a quarterly filing requirement.
The Commission's recently adopted amendments to Form 8-K represent the most significant move toward more current reporting since the adoption of Form 10-Q. I believe that you also had a session on these rules this morning, so I won't repeat all that detail, but there are some key ideas behind the Form 8-K revisions that I would like to touch upon.
The amendments are based on the idea that specified unquestionably or presumptively material events should be promptly disclosed to investors. These include entering into or terminating material non-ordinary course agreements, material events of default, financial restatements, delistings, resignations or appointments of directors or executive officers and incurrence of certain material accounting charges. The amendments also replace the current five business and 15 calendar day Form 8-K deadlines with a new four business day deadline.
Although proposed in 2002, before the adoption of the Sarbanes-Oxley Act, the amendments are responsive to Section 409 of the Act in that they require public companies to disclose, on a "rapid and current basis" material information regarding changes in a company's financial condition or operations.
The amendments include a limited safe harbor under Exchange Act Section 10(b) and Rule 10b-5 for failure to file timely certain of the new items on Form 8-K, where judgments about materiality and the occurrence of the events are most difficult. This safe harbor does not affect any duty to publicly disclose material information that is separate from the Form 8-K disclosure obligation (such as when the company is publicly selling or repurchasing its securities). And the safe harbor will not affect the Commission's ability to enforce its filing requirements under Exchange Act Sections 13(a) and 15(d).
In adopting the new Form 8-K requirements, the Commission decided not to follow the approach adopted in England and many provinces in Canada, which have requirements for current disclosure of material developments generally. Among the reasons for taking the approach we did were to take into account the U.S. enforcement scheme and concerns that a more general requirement would cause excessive compliance costs and burdens. In addition, such a rule might have to be accompanied by an explicit or implicit exception for non-disclosure for valid business purposes (such as ongoing material but preliminary merger negotiations).
While the U.S. has required quarterly reporting since 1970, the European Parliament recently chose not to follow the recommendation of the European Commission to adopt quarterly reporting in the EU. Even a more robust current reporting scheme does not necessarily capture important trends or developments, especially in the core business, that are more apparent in quarterly reports. While some argue that quarterly reports encourage short-termism on the part of investors, I would hazard to say that Alan Levenson would share my disappointment with the European Parliament's decision not to require disclosure of important financial and other information to investors on a quarterly basis.
Rule 144 and Securities Act Reform
Alan Levenson's work on Rule 144 is another example of his prescience. While Alan credited Frank Wheat with the idea behind the rule, it was Alan's work that brought it to fruition.9 Most of you probably don't remember that before the adoption of Rule 144, resales of privately placed securities were governed by a series of no action letters that required the showing of a "change in circumstances." I remember at a roundtable of Directors of the Division of Corporation Finance in March 2002, Alan joked with other panelists about whether death of the investor might not always be a sufficient change in circumstances.10
So this was a difficult test to apply and administer, to say the least, and Rule 144 gave badly needed bright lines in this area. Rule 144 also provided the basis for clear resale rules that, augmented fifteen years later by Rule 144A governing institutional resales, allowed the development of today's vibrant private offering market.
Since the adoption of Rule 144, there has been substantial growth in sophisticated financial strategies, including hedging, for restricted stock or stock held by affiliates. Technological developments, including new execution techniques, electronic trading platforms, the legal certainty given the treatment of over the counter derivatives, and the increase in stock option issuances to affiliates, have all contributed to that phenomenon.
In 1995, the Commission first sought input about the appropriate treatment under Rule 144 of restricted securities or securities held by affiliates in which the holder engaged in derivative and other hedging activities to either shift or hedge the economic risk of the investment. The Commission again sought comment on these issues in 1997. The issue has even greater importance today.
The changes in the markets and securities products require us to examine whether we can address these issues. As part of our Securities Act reform initiatives, we are looking at ways in which we can update Rule 144 and rationalize the treatment of new transactions and hedging strategies with Securities Act registration requirements and market realities, while maintaining appropriate investor protections.
Speaking of investor protection, we hear rumors from time to time that Section 16 insiders are engaging in derivative activities without reporting these under Section 16(a). Our rules are crystal clear - insiders must report transactions in derivatives. If we find these rumors are true, we will take vigorous action.
Alan Levenson pointed to Rule 144 as an early example of integrated disclosure, because it required good public information at the time of sale.11 This type of interaction between the Securities Act and the Exchange Act is more important than ever today. Our recent regulatory initiatives aimed at improving Exchange Act disclosure, including CEO and CFO certification requirements regarding disclosure controls and internal control over financial reporting, expanded current disclosure through Form 8-K, and our heightened attention to MD&A, are allowing us to focus again on modernizing the Securities Act.
Many of our thoughts are aimed at rationalizing the role of technology in informing today's investors, with the regulatory constraints on communications during a securities offering. Put simply - do the restrictions on communications during the offering process still make sense? We are looking at communications during offerings in different contexts, including expanding Rule 134 to allow more routine communications, freeing up written communications that are more clearly offers, addressing the age old question of road show communications and considering the newer question of the role of electronic road shows for retail investors as well as institutions.
We are also considering the question of what information investors should have at the time they make their investment decision. Regardless of the form or manner through which communications occur, we also are committed to ensuring that appropriate liability attaches to communicated information.
The strengthening of the Exchange Act reporting scheme provides a basis for procedural improvements in the securities offering area, at least for some classes of well-known seasoned issuers. We are also considering access versus delivery issues - with the most obvious being decoupling the final prospectus from confirmations.
Other areas we are considering addressing in Securities Act reform also recognize the significant role that technology plays in today's markets. We are reconsidering regulation of general solicitation and regulation of offers, at least in the institutional private offering context. Where we end up on any of these questions will, of course, depend on the Commission.
I'd like to return to Alan Levenson and the Division of Corporation Finance. In the SEC Historical Society interview, Alan said of his time as Director of the Division, "I considered it the most exciting job that I've held in terms of one, the nature of the issues; two, the people that I worked with; three, the opportunity, with a team, to make a contribution. And I emphasize 'a team.' I was very fortunate to have the opportunity to work with a group of people who, in my experience, in government and out of government, are as good as anywhere."12
First, I'd like to go on record as wholeheartedly subscribing to Alan's views regarding my job and the quality of the people I'm lucky enough to work with. Second, at Corp Fin, the Director is lucky enough to have great tradition and great predecessors. Each Director has the advantage of standing on the shoulders of his or her predecessor and on those of all the predecessor's predecessors. No one's shoulders were taller or broader than Alan Levenson's. We all benefit from his work and accomplishments at the Commission 30 years ago and as a critical member of the securities bar thereafter.
Thank you, and I'd be happy to take questions during the remaining time.