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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks Before the 31st Annual Institute on Securities Regulation

by Isaac C. Hunt Jr.

Commissioner, U.S. Securities & Exchange Commission

New York, New York

November 4, 1999

Good morning, itís a pleasure and honor to be here today. But before I begin 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 Commissionís staff.

As we prepare to enter into the new millennium, our capital markets are some of the most, if not the most, liquid and efficient in the world. But I am concerned that some recent practices may threaten our success. Specifically, I am concerned with the reliability and integrity of financial statements and the appearance of those who either ignore completely or circumvent the prohibitions of Section 5 of the Securities Act. The effect of these actions is to create an unleveled playing field. But before I discuss my concerns, let me remind you of a time when our markets were not as liquid or efficient as today, so that you can see just how far we have come and how much is at stake. Perhaps the best description of our early capital markets can be found in the House of Representatives Report that accompanied the passage of the Securities Act.

"During the post-war period some 50 billion of new securities were issued, approximately half, 25 billion, proved to be worthless. . . . Alluring promises of easy wealth were freely made with little or no attempt to bring to investorís attention those facts essential to estimating the worth of any security. . . . Such conduct [had] resulted . . . in the creation of false and unbalanced values for properties whose earnings cannot conceivably support them."

And to think this was all before the existence of dot.com offerings.

But in all seriousness, there are few pieces of legislation, in our countryís history, that can claim the success that the Securities Act and the Exchange Act have brought to our markets. With wisdom and forethought, Congress designed a registration and reporting system to provide investors with material information needed to make their investment decisions.

The heart of this system is the credibility of audited financial statements filed as part of the registration statement. As also noted by the House Report, the registration statement has "been designed to reach items of distribution profits, watered values and hidden interests that usually had not been revealed to the buyer despite their indispensable importance in appraising the soundness of a security." While today all reporting companies will file audited financial statements we have found that some do not meet the quality and integrity envisioned by Congress.

In fact, too often we find some creative accountings such as:

  • "Big Bath" restructuring charges intended to encourage Wall Street to look beyond the 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 insignificance to one item of the financial statement; and
  • The recognition of revenue too early, such as before a sale is completed or at a time when the customer still has options to terminate, void or delay the sale.

I understand the pressures placed on a company to meet an analystís projections. The pressure is intense when a projection missed by only a penny or two can send a companyís stock spiraling downward. But that does not excuse these practices.

What are we doing about it? Well, besides the well known enforcement cases, the Commission, the NASD, the New York Stock Exchange, and the American Stock Exchange have recently taken some important steps in returning "quality" to financial statements.

In August of this year, 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 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 companyís earnings by a penny or two. To many this may seem insignificant, but in an environment where missing an analystís 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 investors.

Among the considerations that may render material a quantitatively small misstatement of a financial statement item are the following:

  • whether the misstatement arises from an item capable of precise measurement
  • whether the misstatement masks a change in earnings or other trends
  • whether the misstatement changes a loss into income or vice-versa
  • whether the misstatement concerns a segment or other portion of the registrantís business that has been identified as playing a significant role in the registrantís operations or profitability;
  • whether the misstatement affects the registrantís compliance with regulatory requirements, loan covenants or contractual requirements; and
  • whether the misstatement involves the concealment of an unlawful transaction.

Finally, SAB 99 reminds the reader that an intentional misstatement made to manage earnings may be illegal. Section 13(b) of the Exchange Act requires that reporting companies keep books, records, and accounts, which in reasonable detail accurately and fairly reflect the transactions and disposition of assets.

The recent proposed rule changes, to their listing standards, by NASD, New York Stock Exchange, and American Stock Exchange, I believe will also help bring quality back. I think the two most significant aspects of these proposals are these:

  1. the requirement that audit committees include at least three members, comprised solely of "independent" directors who are "financially literate;" and
  2. the requirement that at least one member of the audit committee has accounting or related financial management expertise;

These changes, I believe, will help ensure that the audit committee members have the capability to ensure that a companyís financial statements are of the highest quality.

The Commissionís recent proposals for audit committees also should help provide additional safeguards. The two most significant aspects of our proposals might be these:

  1. the requirement to have an independent auditor perform a timely quarterly review; and
  2. the disclosure requirement of whether the audit committee has had discussions with the auditors regarding these ideas:
  • 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 auditorís conclusions regarding the reasonableness of those estimates;
  • disagreements with management over the application of accounting principles, the basis for managementís accounting estimates, and the disclosures in the financial statements; and
  • other matters required to be discussed set forth in SAS 61, as that document may be modified or supplemented.

Obviously, we are hoping that the disclosure requirements provide the incentive for audit committees to have these discussions.

I am, however, very interested in reading the comment letters. I am particularly interested in the cost/benefit implications that the quarterly review requirements may have for small businesses. I am also interested in whether companies will find it difficult to meet the 45-day filing requirement for Forms 10-Q, now that additional review and discussions would occur.

But most of all I am interested in what the comment letters will say on the so-called "certification" portion of the proposals, i.e., whether anything came to the attention of the members of the audit committee that caused the committee to believe that the audited financial statements included in the company's annual report for the year then ended contain an untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading. As you know, the Commission staff believes such a report will not change directors' liability. While such a report by the audit committee may not ultimately affect their liability, I am interested in your comments on how it might affect the evidentiary standards of proving such liability. I will be interested in your opinions on this matter.

Now many of you may be asking, how do any of these issues involve me? After all, Iím an attorney and these are accounting issues. Well first, if you represent audit committees they will surely be asking you for help on what their obligations are. But perhaps more importantly, we have been seeing a disturbing trend in the area of revenue recognition. Some companies have been entering into side agreements with customers in attempts to recognize revenue before any actual sale occurs. We also have seen contracts that allow for inappropriate "bill and hold" arrangements in attempt to recognize revenue early. While neither side agreements nor "bill and hold" contracts are illegal, it is how they are reflected in a companyís financial statements that is problematic.

As counsel you should be aware of these issues, especially when drafting these types of agreements near the end of a quarter. You should consider advising your clients that such revenue from these types of contracts may not be recognizable for purposes of GAAP. Additionally, when reviewing or writing a companyís Management Discussion and Analysis section of a filing, you must ensure that it is consistent with a companyís financial statements. As securities attorneys you must be familiar with financial statements. You also should know the business purpose for any transaction you are asked to work on by a company. Your advice will be more valuable to the client and you will be less likely to be involved in a fraudulent transaction if such is the case. So today, I am asking for your help in bring back quality to financial statements.

As I stated earlier, I am also concerned with what appears to me as offering practices that have disregarded Section 5 of the Securities Act. Many of you know last year at this time the Commission voted to issue a proposing release that would have reformed the offering process. This release is commonly referred to as the Aircraft Carrier.

At this conference last year, I expressed some of my concerns regarding those proposals. In later speeches, I have addressed aspects of the Aircraft Carrier that I believe to be promising. I recognize that the Internet offers benefits to issuers and investors alike. I also understand that to take further advantage of these benefits the Commission will have to consider allowing more communications during the quiet-period and the waiting-period. But in those speeches, I also saw the need to do these things prudently. I spoke of my desire to see a filing requirement for all free-writing and an earlier delivery of the prospectus, so that investors would receive a balanced picture, not just the latest hype.

As all you know, the Aircraft Carrier has not yet been adopted, the prohibitions of Section 5 remain. In fact, as many of you may have seen we recently brought three enforcement cases that deal with Section 5 violations. These are what I would call your typical Section 5 cases, they deal with unsophisticated issuers that had not realized the securities laws implications of their actions.

Until last week, I was under the impression that since the concepts of Section 5 are taught in every introductory securities course, that most violations occur out of ignorance. I am now worried that I may have been wrong. I wonít bore you with the benefits that Section 5 brings to investors, I will only say that if the financial statements are the heart of our system, Section 5 is the soul.

Recently, in the Wall Street Journal, former Commissioner Edward Fleischman is quoted as stating that we at the Commission may "have not been watching the gate to this particular corral." Moreover, the Journal stated that "[s]ome experts say the SEC has allowed gun jumping to flourish in the past yearís manic period of Internet-IPO mania." After reading more, I believe they may be correct.

I was further dismayed to read in the New York Post that a company attempted to include in their prospectus a disclaimer to the effect that statements made by the company's CEO to the press were not meant to be relied upon by potential investors. The first line of the story stated "Ignore our CEO Ėhe just runs the place." This is not how securities are sold in the U.S. If investors cannot rely on what a CEO says, we have problems.

I hope this trend ceases. There is no reason for it. We have over 60 years experience with Section 5 and the Internet does not change that. It is still the law, and I hope that all it takes is a speech to remind you of that.

In closing, today our capital markets are the envy of the world. We have those who came before us to thank, for it was their commitment to fairness and quality disclosure that brings us here today. I ask for your help in ensuring that we continue this commitment into the next millennium, so that those who come after us can also enjoy the fruits of the most liquid and efficient markets in the world.

Thank you.