Remarks at "New Challenges Facing Capital Markets"
Commissioner Isaac C. Hunt, Jr.
U.S. Securities & Exchange Commission
Comissao do Mercado de Valores Mobiliàrios Conference
May 4, 2001
Good afternoon, it is an honor to be here with you today. I have been asked to speak to you about new challenges facing regulators in protecting investors. But before I begin my prepared remarks, I am obligated to give you the usual disclaimer that Commission members must make when speaking publicly; which is that the views I express here today are my own and do not necessarily reflect those of the Commission, other Commissioners, or the Commission's staff.
The U.S. Securities and Exchange Commission's mission is to protect investors and promote efficient capital formation. 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 issuance of securities. On March 20, 1933, President Franklin D. Roosevelt sent a letter to the U.S. Congress urging the enactment of federal securities regulation. In his letter he stated that:
"[t]here is . . . an obligation upon us to insist that every issue of new securities to be sold in interstate commerce shall be accompanied by full publicity and information, and that no essentially important element attending the issue shall be concealed from the buying public. . . . the purpose of the legislation I suggest is to protect the public with the least possible interference with honest business. . . ."
To give President Roosevelt's statement some context, the U.S. House of Representatives report that accompanied the enactment of the Securities Act of 1933, noted that during the previous decade (the 1920's) the U.S. securities markets saw some $50 billion of new securities issued, with fully half, or $25 billion of those securities, proving to be worthless.
Moreover, the House of Representatives report's description of the securities market of the 1920's may, to some, sound eerily familiar:
"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. Because of the deliberate overstimulation of the appetites of security buyers, underwriters had to manufacture securities to meet the demand that they themselves had created. . . . Such conduct ha[d] resulted . . . in the creation of false and unbalanced values for properties whose earnings cannot conceivably support them."
The comparison between the 1920s and the dot.com offerings of the new millennium 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.
There is, however, good news. While the problems and challenges today are not new, neither is the cure. I believe honest and fair disclosure is as prophylactic today as it was almost 70 years ago. The real difference today is the speed and scope of our markets. Before, fraudulent behavior was limited by geography and resources available to the fraudster. Today, with the Internet and globalization of our economies, the fraudster has an almost limitless market. But disclosure is as much the enemy of the fraudster today as it was almost 70 years ago.
In this regard I believe there are two areas where the Commission has made great strides in meeting the old challenges of this new millennium. First, in the area of accounting the Commission has been extremely active. From our Division of Enforcement's managed earnings 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.
When discussing accounting, 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.
In recent years the Commission has seen companies engage in the following practices, all with the approval of their accountants:
- "Big Bath" restructuring charges intended to encourage Wall Street to look beyond any one-time loss and focus only on future earnings;
- "Cookie Jar Reserves" created to protect the company in bad times by recognizing in good times extra accruals based upon unrealistic assumptions in estimating future liabilities;
- "Materiality" decisions that accept intentionally recorded errors on the basis of the supposed insignificance of one item of the financial statement; and
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.
- "Early Recognition" of revenue, such as before a sale is completed or at a time when the customer still has options to terminate, void, or delay the sale.
In America, the independent accountants, those who certify financial statements, are gatekeepers to our financial markets. The accounting profession must be aggressive in applying accounting standards objectively and uniformly. The Commission's Division of Enforcement has been and will continue to be aggressive in charging companies and accountants that fail to live up to their obligations under our federal securities laws.
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.
The Commission also is concerned with the appearance of a lack independence of many accounting firms. Many 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.
The second area where the Commission took significant action this past year is market fairness. Last year, as some of you may know, the Commission adopted Regulation Fair Disclosure, or Regulation FD as it is called.
Regulation FD was designed to end the problem of selective disclosure. Selective disclosure occurs when a company's executive officers 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.
As we all know, material information is the fuel that moves our markets. With access to material information an investor has the opportunity to drive the highway of profits and prosperity, without such access the investor may find him or herself on the detour of losses and bankruptcy. Consequently, some analysts, and therefore their clients, had a great advantage in our markets not because of their ability to evaluate or even to discover unknown facts about a company, but rather because their names appeared in the CEO's rolodex.
The U.S. securities laws are premised on the fact that investors should be treated fairly. The U.S. securities laws prohibit the use of insider information or misleading investors into selling or purchasing securities. As I noted earlier these laws were enacted in era when the standards of fairness, honesty, and prudent dealing was the exception rather than the rule. Therefore, rather than returning to such an era, I believed the Commission needed to address the issue of selective disclosure before it affected the integrity of our markets. After all, how many of you would return to a market that you believed did not treat you fairly?
Before I begin speaking about Regulation FD, I think it would be useful to discuss what we in America consider "material" information and our current reporting requirements.
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, our Supreme Court, in a case called 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 U.S. federal securities laws require that issuers disclose all material information when selling securities.
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.
Now that I have told you a little about what we in the U.S. would consider to be material information, let me begin to give you an overview of when and how such disclosure is made. Generally, whenever a corporation sells its securities publicly it must prepare and file a registration statement, registering the transaction with the Commission. This registration statement would contain a prospectus of the company's offering. The prospectus, which is required to be delivered to prospective investors, will contain certain required disclosures that the Commission, through its years of experience, has determined could be material to the reasonable investor. For example, among other items, the prospectus would contain the company's audited financial statements.
Once a company becomes a reporting company, it is required to file certain interim reports that could also contain material information. These reports are generally filed quarterly, with an annual report containing audited financials due 90 days after the end of a company's fiscal year. Companies also are required to file reports with the Commission on the occurrence of certain events. For example, a company must file a report with the Commission within 15 business days if there was a change in control at the company. Finally, whenever a company solicits voting proxies from its shareholders it must file its proxy statement with the Commission. The proxy statement, like the registration statement, prospectus, and interim reports, are required to disclose certain items that the Commission believes could be material to the reasonable investor.
That is a brief overview of the American disclosure system. While the U.S. 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 needed in the dissemination process. The financial press and electronic financial media have proliferated in the last decades, and of course along came the commercialization 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.
While analysts may not be needed as much in the dissemination process, the decision to adopt Regulation FD was not an easy decision. This regulation was very controversial. The Commission received nearly 6,000 comment letters. 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, Regulation FD was narrowed. Regulation FD, as adopted, 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 shareholder would trade on the nonpublic material information. Once applicable, Regulation FD would require 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 does not, however, apply to communications made in connection with a public offering or to communications made by foreign private issuers. The Commission decided not to apply Regulation FD to public offerings at this time because we needed to further consider the interplay between Regulation FD and specific disclosure requirements that exist when companies issue securities in a public offering. Theoretically, our disclosure requirements contained in Regulation S-K and S-X should be sufficient in obtaining disclosure of all material information for all investors. Accordingly, the need for Regulation FD in a public offering context is uncertain.
The decision not to apply Regulation FD to foreign private issuers was also made due to the uncertainty as to the effect that Regulation FD would have on foreign issuers. Because of the difference in disclosure obligations and disclosure customs in foreign jurisdictions, Regulation FD's impact may have been greater on foreign private issuers than on U.S. issuers. Our concern was that there might be unforeseen consequences to foreign issuers based on disclosures made in their home countries. This decision, however, will need to be re-examined as the globalization of our markets continues. Clearly, the effect of selective disclosure by foreign private issuers could be as significant to U.S. investors as selective disclosure made by U.S. companies.
Regulation FD changes the playing field. Hopefully, it will make our markets fairer and continue to encourage investors to participate in our capital markets. There are concerns, 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. We are studying the situation closely.
I believe companies will continue to have the necessary incentives to disclose positive material nonpublic information to the broadest possible audience. 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.
Well these are just some the ways the Commission has tried to answer those familiar challenges of this new millennium. Thank you for time and attention.