Speech by SEC Acting Chairman:
Protecting the Integrity of Financial Information in Today's Marketplace
Acting Chairman Laura S. Unger
U.S. Securities & Exchange Commission
Philadelphia Bar Association
March 30, 2001
Thank you and good afternoon. It's a pleasure to be here in the company of so many Philadelphia lawyers. Before I begin my remarks, I thought I would give you a pop quiz to see how much you know about current securities-related events. On Monday, February 26, 2001, shortly after 10:00 a.m., a Nasdaq listed company began trading at $10. Within 15 minutes, its price shot up to $93 per share. This is an example of:
(a) normal trading activity for a Nasdaq listed security;
(b) recent market volatility;
(c) what happened to your 401(k) plan that day
(d) an electronic communications network gone awry; or
(e) all of the above.
Those of you who answered (d) are correct, although for some, (e) may also be correct. The unusual trading activity was actually the result of human input into an electronic trading network or ECN. An ECN subscriber, reportedly a hedge fund trader, made a typographical error entering an order. Instead of entering an order to buy at $10 to $9.50, priced slightly below where the stock was trading, the subscriber entered an order for $10 to $95.
This situation is interesting for a number of reasons. To me, what is most intriguing is the insight it offers about technology and the marketplace. Pre-electronic markets, a trader would have known the order was wrong and could have corrected it before too much damage occurred. But the speed with which technology disseminated the erroneous information throughout the marketplace -- by electronic trading and communication systems -- greatly magnified the ripple effect of the error and approximately 1,500 trades occurred in the 15-minute period.
But I digress. As much as I enjoy talking about the electronic marketplace, I decided to discuss with you today how we are working at the Commission to protect the integrity of the information that investors rely on to make their investment decisions. It is more important than ever that investors have accurate, complete information to make decisions about their financial plans and portfolios.
Integrity of Investment Advice
The first area I will touch on involves the integrity of investment advice. Given current market conditions, issues of customer protection will become more important than ever. Online suitability is an especially important concern in today's markets as technology developments lead firms to offer a wider array of investment related tools and information. Current market conditions may also cause investors to seek more customized investment advice - online or offline.
Two years ago, investors flocked to online brokerage, drawn to the appeal of an infallible marketplace. Investors did not want advice, they wanted cheap access. Securities regulators were trying to figure out how best to protect these investors trading on their own, many of whom were first-time investors. Questions arose as to what - if anything - about online brokerage impacted the notion of suitability. In connection with my 1999 online brokerage report, I personally spent a lot of time thinking about online suitability, capacity and privacy issues, and how the industry disclosed the risks of online trading, the risks of initial public offerings, and the risks of margin trading.
The NASD recently issued some interpretive guidance on online suitability to help define when suitability applies online. Determining whether a broker or firm recommended that a customer purchase or sell a security -- triggering a suitability obligation -- has always required a "facts and circumstances" analysis. Although this remains true in the online environment, technology has added new variables to the analysis.
In addition to specific examples of communications that would and would not generally be considered a recommendation, the NASD set out two guiding principles as to whether a particular communication is a recommendation. First, and most notably, the more likely a communication could reasonably be perceived to a customer as a call to action to purchase a security, the more likely the communication is a recommendation. Second, the more individually tailored a communication is, the more likely it is a recommendation. The NASD guidance is probably not the final word on online suitability, but I think it will be helpful to broker-dealers as they introduce more and more technology into their client relationships.
Integrity of Online Investment Information
The second area I will touch on involves the integrity of investment information available online. As we all know, the Internet affords today's investors easy access to all kinds of information, both fact (such as real-time stock quotes, SEC filings, and corporate news releases) and opinion (such as communications from online message boards and Internet mailing lists, analysts' reports, website discussions, and online chat room conversation). Entire Internet communities have grown up around particular industries, technologies or issuers, providing incubators for investment ideas, and venues for the expression of competing viewpoints. But, again, as we've all seen, the Internet has also afforded easy access to fraudsters looking to hoodwink investors. "Stock gurus" may well redouble their efforts in the current investment climate to take advantage of investors seeking to recover from market declines.
Current market conditions aside, we have witnessed, over the past few years, a rise in the number of persons operating websites who pose as seasoned investment authorities. These "authorities" make baseless promises to investors not only about the stocks they pitch, but also about their own qualifications and accomplishments.
A recent example is the Commission's action against Mr. Yun Soo Oh Park, the owner of an Internet investing site that was once one of the hottest sources of stock picks on the Web. The defendant, known as "Tokyo Joe," recently settled a civil action filed last year by the Commission. Park neither admitted nor denied the S.E.C. charges, but agreed to pay $754,630 to settle the case. The SEC alleged that he not only engaged in unlawful touting and illegal stock scalping (that is, selling stock into the demand created by his own buy recommendations), but also the publication on his website of more than 200 misleading assertions, including false statements about his track record as a stock picker.
Another recent example of a case involving a stock-recommendation website came a few weeks ago as part of our fifth Internet fraud sweep. In that case, a former roofer-turned-online-stock-analyst claimed he had access to a proprietary computer trading system, had over 14 years of investing experience, and enjoyed an 85% success rate on trades he had previously made. The SEC's action against this individual alleges that, in reality, he had limited personal securities trading experience, never received any securities training, never worked for an investment firm, and used a publicly-available software program which could be readily accessed over the Internet.
I have asked the Enforcement Division to be especially watchful for online stock-picking sites, particularly those employing the sort of flamboyant advertising that could signal the use of inflated track records, misleading disclaimers, or other improper techniques calculated to bait investors.
The Integrity of Financial Information
The third area I will touch on involves the integrity of financial information. Current market conditions may increase the pressure on companies to meet past or projected earnings levels. As a result, management may be tempted to engage in "not so" generally accepted accounting principles.
We have already seen a number of NSGAAP trends. The first is a decreasing "quality of earnings" reported by companies. A lack of quality of earnings refers to distortions in financial statements resulting from undisclosed changes in underlying accounting assumptions. Such undisclosed changes are being used to improperly inflate operating results. For instance, management may change an accounting estimate (such as the life of an asset), which will have the effect of increasing earnings. If that change is not disclosed, investors may wrongly assume that the earnings increase reflects improved performance by the company instead of a change in an accounting estimate. Using this type of smoke-and-mirrors to mislead investors ultimately will harm a company, as well as investors' confidence in our financial reporting system as a whole.
A second troubling trend on which we're keeping an eye is the increasing use of pro forma information. Pro forma information is a tool companies have invented to disseminate an idealized version of their performance. It may exclude any cost or expense the company wants, yet it is presented in a form that suggests reliability and soundness. And that's the problem with pro forma financials. You don't really know what you're getting, except that it's what the company wants you to know. In fact, pro forma numbers are not audited and may not even be reconcilable with the financial statements companies have filed with the Commission.
Finally, I'll mention one more practice for which the staff will be on the lookout. Companies are announcing that they will not meet their year-end earnings targets, apparently because throughout the year they had been, in effect, reaching ahead into next quarter's sales to meet their quarterly targets. Using techniques such as "channel stuffing" 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 guarantees that the company is starting in a hole next quarter. When the end of the year comes, and the auditors discover what has been going on, the result is a shortfall for the fourth quarter and/or the year, and a shock to misled investors.
The Integrity of Fund Performance Advertising
The final area I will touch on involves the integrity of certain information included in mutual fund advertising. Twenty years ago, only 5.7% of Americans owned mutual funds. Today, some 88 million shareholders, representing 49% of U.S. households, hold mutual funds. These investors are entitled to rely on the integrity of the numbers included in the fund's advertising.
This is particularly important given current market conditions where performance information may change significantly from day to day. The Commission has seen instances where fund advertisements are in technical compliance with Securities Act requirements by disclosing the results of a fund's most recent calendar quarter, but where even more recent, but poorer, performance is not disclosed.
The staff is working on an interpretive bulletin to emphasize that technical compliance with Rule 482, the advertising rule, is not a safe harbor from the antifraud provisions. The bulletin will also point out that additional facts necessary to provide an investor with an accurate picture of the fund's performance may be necessary to avoid noncompliance with the antifraud rules.
The Commission always strives to maintain the integrity of financial and market information. Today I've shared with you how market conditions may impact where we devote resources to most effectively meet this challenge.
Thank you. I'd be happy to take your questions.