Speech by SEC Staff:
Current SEC Developments
Commissioner Isaac C. Hunt Jr.
U.S. Securities & Exchange Commission
at the American Society of Corporate Secretaries
San Francisco, California
June 30, 2000
Good afternoon, it is a pleasure and an honor to be here to address the American Society of Corporate Secretaries. The people in this room have a tremendous responsibility in assuring the importance of accurate corporate governance. The SEC and shareholders alike count on the vigilant oversight that the members of this group provide.
But, before I begin speaking about what the U.S. Securities and Exchange Commission ("SEC") views as critical, current issues in the securities markets, 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.
Let me start by talking briefly about the structural changes facing the securities industry and the challenges this creates for the Commission. As you know, we are in a very important transitional period in the securities markets, both for debt and equities. Most of these market changes have resulted from significant leaps in technology. Our goal at the Commission is to create a modern, flexible regulatory environment that recognizes technological innovation, while at the same time preserving our fundamental principles of transparency, competition, best execution, and, at the same time, ensuring the protection of investors.
As the securities markets become more global, with many stocks traded in multiple jurisdictions, the U.S. securities markets must adopt the international convention of decimal pricing to remain competitive. Unfortunately, the solution is not a simple one. The convention of quoting stock prices in fractions dates back more than two hundred years. Currently, the U.S. securities markets are the only major markets not able to price in decimals.
We believe that the time is right for the securities industry to convert to decimal pricing. The overall benefits of decimal pricing are likely to be significant. Investors may benefit from lower transaction costs due to narrower spreads. Moreover, the markets will be easier to understand for the average individual investor, who is used to dealing in dollars and cents for every-day transactions. And, in the global context, it will put U.S. markets in parity with the large foreign markets.
Nevertheless, it is critical that this conversion take place in a safe, orderly manner. The Commission has serious concerns about a full-scale conversion to decimal pricing in listed securities without an orderly phase-in. We are particularly concerned that making an immediate leap to decimal pricing could jeopardize market systems' capacities and capabilities. Without sufficient time for planning and system testing, an immediate full-scale conversion has the potential to create widespread operational problems, which in turn could adversely affect investors.
For these reasons, on June 13, the Commission ordered the exchanges and the Nasdaq market to submit a plan to phase in decimal pricing for listed stocks and certain options starting no later than September 5, 2000. The order also requires decimal pricing to be phased in for all Nasdaq securities beginning no later than March 12, 2001. Finally, all securities must be priced in decimals no later than April 9, 2001.
Another important challenge that the Commission is currently addressing is the conversion of markets such as Nasdaq to for-profit corporations, a process many refer to as "demutualization." In April, the NASD membership overwhelmingly approved spinning off the Nasdaq market into a for-profit market. This will be the first time that a currently registered self-regulatory organization converts to a for-profit status. In addition, the New York Stock Exchange has at various times discussed the possibility of becoming a for-profit exchange.
To a large extent, this trend to demutualize has been driven by the dynamic changes brought about by the technological revolution. For instance, the competitive pressures placed on our exchanges by the new market entrants, such as the ECNs, and global competitors, have caused our traditional exchanges to rethink their governance structures, as well as their capital structures, in order to be able to respond more quickly to the rapidly changing market place.
One example of this new thinking is the plan by the Pacific Exchange to link with the Archipelago ECN, which is a for-profit corporation. By way of background, Archipelago is an alternative trading system that disseminates the price and size of open orders and matches buyers and sellers of securities over an electronic network. In essence, the plan of these entities is to create the first fully electronic national stock exchange for New York Stock Exchange, American Stock Exchange and Nasdaq stocks.
The exchanges' plans to demutualize raise interesting issues for the Commission. As you may know, exchanges by law are also self-regulatory organizations responsible for carrying out the purposes of the federal securities laws. Among other things, we are grappling with the issue of how to ensure that the users of a for-profit exchange –i.e., the former members – have fair representation, or a say, in the way the exchange carries out it self-regulatory responsibilities. We are also looking for ways to minimize the conflicts of interest that arise between the for-profit motive and the self-regulatory role of the exchange. While many of these conflicts exist today, they are heightened when an exchange demutualizes.
In short, to borrow from a Chinese proverb, "may you live in interesting times." Some say that proverb is actually a curse, but at the Commission we think ourselves lucky to face challenging new issues every day.
Another key issue on the Commission's agenda is auditor independence. Investors in our markets rely on disclosures by public companies in making their investment decisions. Investors are more likely to invest, and pricing is more likely to be efficient, the greater the assurance to investors that the financial information that they receive is reliable. Independent auditors play a key role in the financial reporting process. The procedures followed by auditors enable them to express their opinions on whether financial statements are fairly presented and consistent with U.S. Generally Accepted Accounting Principles. Based on the independent auditor's opinion, investors have reason to believe that financial statements are materially accurate, fair and complete.
The capital formation process hinges on the willingness of investors to make investments in the securities of public companies. Investors commit their funds to companies relying, in part, on the independent public accountant's opinion that a particular company's financial statements fairly reflect the financial position, results of operations, and cash flows of the company.
The federal securities laws, to a significant extent, make the independent auditor the "gatekeeper" to the public securities markets. These laws require, or permit the Commission to require, that independent public accountants certify financial information filed with the SEC. Without an opinion from an independent auditor, a company cannot satisfy the statutory and regulatory requirements for audited financial statements and cannot sell its securities to the public.
In the fiscal year ending September 30, 1999, over 13,000 registrants filed annual reports with the Commission. During that same period, the dollar value of public offerings filed with the Commission totaled over $2 trillion dollars. While the Commission staff reviews filings, the staff is not able to review in detail all the financial statements filed with the Commission. Therefore, the Commission must rely heavily on the accounting profession to be primarily responsible for the large volume of financial information that forms the cornerstone of the Commission's full disclosure system.
The accounting profession has undergone profound changes in the last decade due to globalization, consolidation of the profession and the rapid growth of consulting services. For the largest firms, billings from audit work have dropped from 70% of total revenue in 1977 to 30% today. At the same time, consulting and other management advisory services now represent almost half of billings, up from a mere 12% in 1977. These changes are not without consequence. This shift in emphasis raises questions as to whether an accounting firm's advice is neutral or impartial, which in turn, threatens to erode reputations and undermine financial reporting standards.
Chairman Levitt proposed several measures to maintain the adequacy of auditor independence and accurate reporting, including: (i) SEC rulemaking to clarify activities that may be inconsistent for an independent auditor of financial statements to perform for audit clients; (ii) support for a plan by the Public Oversight Board to enhance its powers and responsibilities; and (iii) a self-evaluation by each of the major accounting firms of past compliance with the SEC's and the profession's financial investment rules and their systems of internal controls for monitoring those rules.
We at the SEC were very pleased when, on June 7, all of the Big Five accounting firms agreed to participate in a voluntary look-back program to report past violations of the auditor independence rules. In exchange, the program provides a safe harbor from enforcement and certain other staff actions, except in situations involving the most egregious violations or fraud.
With regard the Chairman's first initiative, on June 27 the Commission proposed new rules to strengthen independent audit provisions. As part of this rule proposal, the Commission is going to great lengths to ensure that those affected by the rule are given the opportunity to comment. The Commission plans to schedule public hearings around the country to engage in a dialog with the industry on this most important issue. We welcome your comments at that time.
Recent Enforcement Actions – Financial Fraud
In the meantime, to reinforce the importance of accurate financial disclosure, I'd like to run through a number of recent enforcement cases that have hinged on financial reporting fraud. Financial fraud cases constituted almost one fifth of the cases brought by the Division of Enforcement in the last year. These cases are a good advertisement for the need to employ vigilant auditors and auditing committees.
Intentional Misstatements -- The Division of Enforcement gives the closest scrutiny to intentional misstatements by senior managers. Last year, the Division brought 18 actions alleging that the purposes of these frauds was to engage in earnings management for the purpose of meeting projections and compensation benchmarks. In one particularly egregious case, the CEO of Unisom Healthcare handed the company comptroller a piece of paper and said "here's the numbers we need to get to" and "I don't care how we get there."
Obviously, the Commission does care how companies arrive at their numbers.
Revenue Recognition – Enforcement brought about one-third of its financial fraud actions – 32 of the 90 – for improper income recognition. Another 12 cases involved the booking of fictitious sales. The recent issuance of Staff Accounting Bulletin 101 ("SAB 101") on Revenue Recognition is particularly timely given the large number of these types of cases and, more importantly, provides guidance to accounting professionals on improving financial reporting. Please note that the effective date of SAB 101 has been extended for 90 days to allow the industry additional time to comply with the staff's provisions.
Asset Valuation -- On the balance sheet side, 17 cases involved fraudulent asset valuations. An additional 12 cases featured improper capitalization of expenses.
"Barter" Cases – In the high-technology arena, the Commission has seen some of the most creative methods of "cooking the books." Last year, we sued 4 such companies who greatly overvalued legal or other professional services received by paying out disproportionately large options or other equity interests. Simply put, these transactions were not accounted for on an arm's length or dollar-for-dollar basis.
Individuals Charged – Additionally, the Commission is increasing its sanctions against individuals who commit fraud on behalf of the corporation. Last year, 120 corporate officers and employees were charged with participating in financial fraud. Moreover, we have not limited ourselves to pursuing only senior officers. Because there are frequently multiple participants in fraudulent activity, we look up and down the chain of command. For example, in a recent action against Knowledge Ware, we charged 11 individuals ranging from the CEO down to 3 district sales managers. In the Livent theater fraud case, we charged 8 officers. Finally, in an action against W.R. Grace, we charged seven.
Accounting for Advertising Costs – Last, but not least, the Commission recently brought a case against AOL, which paid $3.5 million to settle financial reporting violations in connection with its accounting for certain advertising costs. Accounting rules do not allow a company to capitalize "direct response advertising costs" unless it can demonstrate from its past experience that future net revenues from customers obtained through advertising will exceed the amount of capitalized costs. The Commission found that AOL could not meet this requirement because of the volatile and unstable nature of the Internet marketplace (remember, this was 1995!) that precluded reliable forecasts of future revenues.
Fortunately for AOL and its investors, this story appears to have a happy ending. But not all companies and all investors have been so lucky. This is why it is critical that auditors and audit committees retain their objective and vigilant oversight of public disclosure filings made with the Commission. That way, investors have the reliable information necessary to make informed investment decisions. This continuing accurate reporting is essential to maintain the sanctity of today's markets.
The SEC also recently issued its long-awaited proposal on selective disclosure. Selective disclosure refers to the time honored practice of releasing material, non-public information about an issuer of public securities, made by the issuer or its agents, to selected persons, usually financial analysts, before disclosing the information to the public at large. The new SEC measure, Regulation FD -- for "fair disclosure" -- would prohibit companies from divulging information except through public disclosure. Regulation FD has generated considerable public comment and debate and, if enacted, would change the way most public companies release information to the market.
In my opinion, the proposal, if adopted, would be extremely costly to corporations and provide little benefit to investors. That's not to say that I do not believe selective disclosure to be a problem. I do, and I reiterate that as long as selective disclosure continues, our markets are not fair. However, I recognize that this is not an easy problem to solve and that, in adopting a solution, we should heed the advice of the medical profession: "first, do no harm!"
The proposed rule calls on issuers to disclose material information publicly and not selectively. It also directs an issuer to promptly disclose publicly any information that it inadvertently disclosed selectively. Regulation FD does not require issuers to disclose material developments when they occur. Nor does Regulation FD provide a definition of what is "material." However, the release provides that when an issuer "chooses to disclose material, non-public information, it must do so broadly to the investing public, not selectively to a favored few." But how exactly is this to be done? Two ways mentioned in the release are that the issuer may file the information with the SEC or they may disseminate it via a website.
Many companies are reluctant to engage in the wholesale sharing of information. The reasons are myriad and range from competitive concerns to the effects of "loose cannon" investors who may misunderstand the stream of information, react negatively and substantially harm the financial prospects of the company.
In the current process, which is undeniably flawed, financial analysts serve a useful function in ferreting out and evaluating information. This generally provides the market with a superior assessment of the issuer's performance and prospects. In turn, this promotes efficient markets and moderates market volatility that can result from uninformed investor reaction to news about issuers.
The comment period for this release has recently ended. Again, the SEC staff will begin the arduous process of assembling and weighing the commentary on this very important issue. Hopefully, with input and guidance from institutional and individual shareholders, the SEC will adopt rules that will limit selective disclosure while not unduly burdening companies or stopping the free flow of information.
In conclusion, I would like to thank the American Society of Corporate Secretaries for inviting me to speak this morning. I was very glad to have the opportunity to engage in a dialog to urge that we all work together to lay a strong but balanced framework of regulation to support our thriving markets. Please give us your comments on the recently issued release on Auditor Independence. We value your time and attention to these and other critical market development issues.