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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Recent Developments at the SEC

Remarks by

Commissioner Norman S. Johnson

U.S. Securities & Exchange Commission

Utah Bar Securities Section
Jackson, Wyoming

August 20, 1999

Thank you for the kind introduction. First, let me say that my comments are my own and do not necessarily reflect the views of my fellow commissioners or the Commission's staff.

It is always a pleasure to participate in Utah Bar activities, and to see so many friends. In my Salt Lake City practice, I had the opportunity to represent a number of Utah businesses, both large and small, just as you have. I have always been amazed by our state's entrepreneurial talent.

The continued growth of Utah's and our national economies depends in large measure on small businesses. Products and ideas that stem from small business are too vital to be hampered by excess regulation. These businesses cannot grow without money. When I started practicing, many small companies exhausted their credit and had limited, if any, access to equity and debt markets. Back then, it was believed that traditional lenders would only lend you money if you could prove that you didn't need it.

Today, the capital markets provide an increasingly important financing source for small business. At the same time, capital markets are attracting many new investors. These new investors, often with limited market experience, may have difficulty uncovering useful information on smaller companies that are not routinely followed by analysts and the financial press.

A number of entities are responsible for implementing and enforcing securities laws, including Congress, the SEC, the courts, self-regulatory and professional organizations. These entities must recognize these changes to the capital markets. Each of their policy decisions must strike a balance between our mandate to protect investors and small businesses' need for capital.

Striking this balance has been one of my highest priorities since joining the Commission. When balanced correctly, I believe both investors and small businesses gain. After all, the future performance of each depends in large measure on the success of the other.

A number of small business topics were well covered in the previous discussion. I will focus on a few legislative, regulatory and judicial developments that highlight this overall policy balance.

I. Issues Related to the “Year 2000” Computer Problem

First, I'd like to talk about Year 2000 regulatory and legislative developments. Since the SEC cannot require companies to fix their computer systems, we have focused on disclosure. Under a recent SEC interpretive release, all reporting companies must disclose management's assessment of any material Y2K issues. Public filings must contain "meaningful" disclosure in four areas: state of readiness, costs, risks, and contingency plans.

Although the Division of Corporation Finance reports some improvement in Y2K disclosure, many filings still contain incomplete and boilerplate language. With less than five months to go to the Year 2000, this is troubling. The staff found the least complete disclosure concerned contingency planning, worst case scenarios, and foreign exposure.

I suggest that practitioners and in-house counsel keep the following in mind:

  • Most companies will have material Y2K issues either from their own systems or those of suppliers and other third parties;

  • Use public filings to fully and fairly disclose both the problems and intended resolutions;

  • If Y2K information is important enough to be shared with the Board of Directors, it should be included in periodic reports.
Remember, that the safe harbor in the Private Securities Litigation Reform Act of 1995 may be available for forward-looking statements on Y2K.

We regulate the securities industry and our Y2K rulemaking in this area goes beyond disclosure. The Commission recently adopted a series of Year 2000 operational capability rules for broker-dealers and non-bank transfer agents. Under the rules:

  • Y2K problems are material if likely to impair a mission critical system;

  • Firms with material Y2K problems on or after August 31, 1999 are presumed not to be operationally capable and must notify the Commission immediately;

  • To remain in business until November 15, 1999, the CEO must certify that remedial work will be completed by November 15th.

The Commission recognizes that firms must continue to concentrate on their internal remediation and testing. Therefore, the Commission imposed a moratorium, from June 1, 1999 until March 31, 2000, on any new Commission rulemaking that would require major computer reprogramming by Commission-regulated entities.

The president recently signed the "Y2K Act" which applies to actions brought after January 1, 1999. Among its provisions, the law:

  • Gives companies 90 days to fix a Y2K problem before a plaintiff can sue;

  • Makes it harder to get class action status in federal courts;

  • Eliminates joint and several liability unless defendant had specific intent to injure plaintiff or knowingly committed fraud.

  • Limits defendant's liability towards third-parties in certain circumstances.

Two provisions are of particular interest to small businesses. First, the Act caps punitive damages at the lesser of three times actual damages or $250,000 for individual and business defendants with fewer than 50 employees. These caps apply unless the defendant had a "specific intent" to injure plaintiff. Second, the Act provides for a waiver of civil penalties for first-time small business violators of federally enforceable rules. However, this waiver requires "good faith efforts" at Y2K compliance and does not apply to securities market or investor protection rules.

Most of the Act's provisions do not apply to private securities litigation. The Act also generally does not restrict government enforcement and regulatory actions. Therefore, companies that have not satisfied their disclosure obligations may still face enforcement action in appropriate cases.

II. Rule 15c2-11

I'd now like to discuss recent proposals to amend Rule 15c2-11. This rule requires market makers for Bulletin Board and Pink Sheet stocks to review basic issuer information prior to publishing quotations for that issuer's securities. However, the so-called "piggyback" provision allows all market makers to publish quotations for a security without reviewing any information once one market maker has published quotations for the security for at least 30 days.

The proposed amendment to 15c2-11 would eliminate the piggyback provision. Instead, all broker dealers would have to review current issuer information before publishing priced quotations for certain smaller issuers. Broker dealers would be required to document their compliance with the rule.

The proposed amendment has a laudable goal: to prevent fraud by unscrupulous issuers and promoters. However, small companies are concerned that the amendments' additional requirements would cause many brokers to stop making markets in their stocks and impair their access to capital. Many market makers believe the proposed rule would expose them to serious liability risks. I share these concerns. In light of the public comments, we are re-examining the issue to determine what, if any, changes to 15c2-11 are appropriate.

III. Definition of “Accredited Investors” Under the Securities Act of 1933

Moving from the past to the future, I'd like to discuss a couple of policy issues that may result in SEC rule proposals in the near future. These proposals would change the criteria for "accredited investors" and strengthen the effectiveness of audit committees. Both are relevant to small businesses.

In my view, the Regulation D small offering safe harbors give small businesses a wonderful opportunity to raise capital with minimal red tape and cost. The amount of disclosure required in Reg. D offerings under Rule 504, 505 and 506, increases with the amount of money being raised. However, the Commission does not require standardized disclosure for more sophisticated investors. We call these investors "accredited investors."

We currently determine accreditation based on total assets and/or income. For example, an individual qualifies as an accredited investor if either:

  • The person and their spouse have a joint net worth exceeding $1 million; or

  • The person had an income exceeding $200,000, if single, or $300,000, if married, in each of the past two years, and is likely to make a similar amount this year.

The trouble is that assets may not be the best measure of sophistication. For example, a $1 million home would qualify the owner as an accredited investor, while a Certified Financial Analyst making less than $200,000 a year – if we could find one – would not.

The Commission is now studying different tests that might better measure financial sophistication. The test we will probably propose would be based on the person's or entities' investments. Cash and most securities, real estate and commodities would be included if held for investment purposes. Personal residences, family owned businesses and controlling interests in small businesses would not be counted towards the investment thresholds. The exact investment numbers we would require are still under discussion. I believe that we should expand the pool of potential investors to the extent consistent with our investor protection obligations.

IV. Strengthening the Audit Committees of Boards of Directors

Another area of interest is the current efforts to strengthen the audit committees of public companies. The impetus for this review comes in part from recent, high profile cases involving millions of dollars worth of "earnings management." Confidence in our capital markets may be undermined if investors begin to doubt the accuracy of financial information.

A properly functioning audit committee serves as an excellent deterrent to earnings management. However, this ideal is not always achieved. One commentator recently noted that, "[b]ehind most major corporate fraud cases lies an audit committee that was either loaded with close personal friends or asleep at the switch." This commentator detailed several conflicts involving audit committee members who were retired executives or outside counsel of the company. For example, a member of one audit committee was both a former CEO and the father of the current CEO.

Recently, a "blue ribbon" committee formed by the NYSE and the NASD issued a report on improving the effectiveness of audit committees. The report sets forth 10 recommendations that loosely fall into two categories. The first involve corporate governance issues under the primary jurisdiction of self-regulatory organizations like the NYSE and the NASD, subject to SEC oversight. I will call these "listing recommendations." The second group of recommendations involve disclosure and financial reporting issues under the SEC's jurisdiction. These I will call "disclosure recommendations."

The Blue Ribbon Committee recommended amending the NYSE and the NASD's listing requirements to require larger listed companies to have an audit committee composed of at least three members. All members of the audit committee would also have to be "independent" from the company's management under a new, stronger definition of "independence." In addition, all members of the audit committee would have to be what the report calls "financially literate" – meaning they have the ability to understand fundamental financial statements. And at least one member of the audit committee would have to have "accounting or related financial management expertise."

The Blue Ribbon Committee also made several recommendations concerning the operation and authority of audit committees. For example, audit committees of listed companies would be required to adopt a formal written charter detailing the scope of their responsibilities. The Blue Ribbon Committee also recommended that the accounting profession amend Generally Accepted Auditing Standards, or "GAAS." The change to GAAS would require the outside auditor to discuss with the audit committee the quality, not just the acceptability, of the company's accounting principles. Finally, the audit committee would have authority to select and, when appropriate, replace the outside auditor.

It is likely that the listing recommendations will be considered first. Of course, any proposals by the NYSE and NASD still would be subject to public notice-and-comment and SEC review.

In some ways, the disclosure recommendations are more complex and will require careful consideration by the SEC and the public during the comment period. The Blue Ribbon Committee recommended several changes to current disclosure requirements. Reporting companies would be required to make certain disclosures in the annual proxy statement about the audit committee's activities and charter. These disclosures would be covered by a new safe-harbor. Outside auditors also would be required to conduct interim reviews of the company's quarterly financial reporting.

A good deal of public attention has been focused on one recommendation. The Blue Ribbon Committee suggested that the audit committee indicate in annual filings that the audit committee believes the company's financial statements are fairly presented in accordance with General Accepted Accounting Principles, or "GAAP." Issuers and directors have expressed concern that this proposal would increase their liability and require detailed knowledge of GAAP. We are aware of these concerns.

Well-publicized recent cases involving large companies make clear that managed earnings and other financial shenanigans are not unique to small business. However, the costs of new regulations may disproportionately affect small businesses. For this reason, the Blue Ribbon Committee limited some recommendations, such as the size and financial expertise of audit committees, to companies with a market capitalization of at least $200 million.

There has been some speculation that the SROs and the SEC may want to eliminate the Blue Ribbon Committee's carve-out for smaller companies. While I do not want to prejudge any issues that the Commission will consider, I certainly would want to proceed with caution before eliminating the carve-out for small businesses. Rules that make sense for a Fortune 500 company may not always be appropriate for a start-up.

V. Private Securities Litigation Reform Act of 1995

No discussion of recent securities law developments would be complete without reference to litigation. While I'll leave the detailed discussion to other panels, there is one issue I'd like to cover: recklessness and the Private Securities Litigation Reform Act of 1995.

Cases requiring interpretation of the Reform Act are winding their way through the courts of appeal. One major issue several courts have decided is what level of conduct is actionable under the Act. To survive even a motion to dismiss, the Act requires plaintiffs to "state with particularity facts giving rise to a strong inference" of scienter. The SEC has consistently argued that scienter is satisfied if the corporate officer acted with recklessness – traditionally interpreted as "a highly unreasonable omission" or "extreme departure" from ordinary care. Four federal appellate courts have considered the scienter question. Three – the Second, Third and Sixth Circuits – agreed with us that the Act retains the recklessness standard for private securities litigation.

Last month, a divided panel of the Ninth Circuit in the Silicon Graphics case disagreed with its sister circuits and the SEC, which appeared as amicus curiae. Plaintiffs in this private litigation alleged that a public company and six of its officers fraudulently concealed bad news to artificially inflate the company's stock price. In determining what scienter standard to apply, the majority held that plaintiffs must show that defendants acted with a mental state beyond recklessness. Rather, the evidence must show at a minimum that the officers acted with "deliberate or conscious recklessness."

I respectfully disagree with the Ninth Circuit's conclusion on scienter. Nothing in the Act or its legislative history justifies overturning years of jurisprudence by various circuits – including the Ninth – applying the recklessness standard to securities fraud claims under Section 10(b). I recognize that many technology companies are concerned about class action law suits. In my view, however, the traditional recklessness standard – requiring an extreme departure from ordinary care – sufficiently protects companies and officers from well intentioned, even negligent mistakes. I do not believe that Congress intended to protect those whose actions are more egregious. In short, the court tipped the balance too far in one direction. Aside from the apparent contradiction in "deliberate recklessness," the Ninth Circuit has created a new and untested legal standard in an unwarranted attempt to raise the scienter standard.

It is important to recognize the limits of the Silicon Graphics holding. The decision applies only in the Ninth Circuit, may be reconsidered by the court en banc and conflicts with all other courts of appeal to consider the issue. In addition, the Act's pleading standard applies only to private litigation. The SEC will continue to monitor possible fraud and institute enforcement actions where appropriate. In short, this decision is not a license for corporations and their officers to abdicate their long-standing responsibilities to both the corporation and the investors who put their faith in them.

Striking the right balance to protect investors and accommodate small business is never easy. From the SEC's perspective, we are aided by our ongoing dialogue with the public. Every year the Commission hosts the only national forum on capital formation specifically for small business. This year's forum will be held September 13th and 14th in Washington. Although attendance is limited to insure open dialogue, I hope that some of you will be able to join us. Once the forum ends, the hard work will begin dealing with the issues raised. It's a necessary process so that there will be new topics to discuss at next year's Securities Section Seminar.

Thank you.