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U.S. Securities and Exchange Commission

Testimony of
Laura S. Unger, SEC Commissioner

Before the Senate Subcommittee on Financial Service and Technology, Concerning Disclosure of Year 2000 Readiness

June 10, 1998

Chairman Bennett and Members of the Subcommittee:

I appreciate the opportunity to be here today to testify on behalf of the Securities and Exchange Commission ("Commission") regarding its efforts to improve public company disclosure of Year 2000 issues.

This testimony provides a brief description of the Commission’s efforts to promote Year 2000 preparedness by those industry participants directly regulated by the Commission, such as broker-dealers and investment companies. The testimony then describes the Commission’s efforts regarding the specific topic for today—the disclosure of Year 2000 issues by public companies.

The Commission’s Efforts to Promote Year 2000 Preparedness
by Regulated Entities

The Commission takes the Year 2000 issues faced by public companies, the securities industry, and the Commission itself very seriously. During the past year, the agency has intensified its efforts in this area.

For example, the Commission has focused much attention on monitoring the Year 2000 preparation of broker-dealers, as they are the primary intermediaries between investors and the securities markets. The Commission has proposed that broker-dealers and transfer agents provide the Commission with detailed reports on their Year 2000 readiness, 1 and will soon consider a request from the Division of Investment Management proposing that investment advisers make similar reports. We believe that requiring these reports will make clear to executives in the securities industry how seriously the Commission views Year 2000 problems. We will use the information obtained from these reports to focus our compliance examinations on firms posing the greatest risk, evaluate the adequacy of investor disclosure made by these firms, and, if necessary, take our concerns about Year 2000 to senior management and/or boards of directors of firms whose efforts to address the problem appear to us to be inadequate. The information will also help us advise Congress of the progress made by the securities industry in addressing Year 2000 problems.

We are supplementing our independent assessment of broker-dealer’s readiness with two sources of information. First, the self-regulatory organizations (SROs), as front-line supervisors of broker-dealers, have surveyed the broker-dealers that they regulate and are examining them to independently assess their progress. Second, the Securities Industry Association is also closely monitoring its members’ progress in remediating Year 2000 problems. Its members will participate in an unprecedented industry-wide testing of their computer systems.

The Division of Market Regulation has created a Year 2000 workplan for the 24 SROs it supervises. This workplan is designed to help SROs develop a thorough, realistic means of assessing the efficacy of their and their broker-dealer members’ remediation efforts. Further, the Division of Market Regulation has reviewed SROs’ Year 2000 efforts to date and will include a quantitative and qualitative analysis of its findings in an upcoming staff report on the Year 2000 readiness of the securities industry and public companies, as requested by Congressman Dingell. In general, the Division finds the progress made by the SROs to be encouraging so far.

In addition, the Commission’s examination program has been working on the Year 2000 problem since 1996. Examiners initially focused on getting the word out to registrants that there was a problem and that it needed to be fixed. They also conducted in-depth reviews of how the management at selected firms was addressing the problem. In the Spring of 1998, examiners began to collect quantitative data—such as the date by which a registrant expected to complete all corrections—that will enable the staff to monitor industry progress and provide reports to the Commission and Congress. Finally, in the coming months, the examination staff anticipates gathering quantitative information from a large number of registrants, and conducting examinations of firms that are showing unsatisfactory progress in addressing the problem.

To educate investors and assist them in conducting their own due diligence, the Office of Investor Education has posted on the Commission’s web site a series of questions that investors can use to assess their broker-dealers and money managers’ Year 2000 readiness. The Office of Investor Education will continue to take actions to further educate investors so they can prepare for the Year 2000.

The Divisions of Corporation Finance and Investment Management issued and later revised a joint Staff Legal Bulletin to heighten the general awareness and elicit meaningful disclosure from public and investment companies on Year 2000 issues. In addition, each Division instituted a Year 2000 Task Force to assess the frequency and quality of public and investment companies’ Year 2000 disclosure. Both Task Forces found a significant increase in the frequency of Year 2000 disclosure, particularly in light of the revised Staff Legal Bulletin. As discussed in greater detail below, the Task Forces found that many companies did not follow the specific guidance provided in revised Staff Legal Bulletin No. 5.

The agency as a whole has undertaken several simultaneous initiatives to promote Year 2000 readiness in the securities industry, the capital markets, and their underlying industries. The remainder of this testimony focuses on Year 2000 disclosure, particularly the efforts, findings, and conclusions of the Divisions of Corporation Finance and Investment Management.

The Disclosure Program

The Commission’s disclosure framework requires public companies to disclose material information about themselves to the public. This enables investors to make informed decisions. Although this disclosure framework requires all public companies to provide specific categories of information, it is flexible enough to enable companies to tailor disclosure to their particular circumstances.

In almost every case, the Commission relies on this general framework and does not provide specific guidance on any particular disclosure issue. The significance of the Year 2000 issue, however, caused the Commission and its staff to make an exception and provide specific guidance as to what public companies should consider when disclosing information about their Year 2000 readiness.

Commission Disclosure Efforts To Date

The Commission’s staff has been quite active with respect to the Year 2000 issue.

  • In May 1997, the Division of Corporation Finance updated its Current Issues and Rulemaking Projects outline to discuss the need for public companies to disclose the effect of Year 2000 technology problems. Corporate counsel pay particular attention to this outline. The update described generally the nature of these issues and the disclosures that public companies should make. The Division noted that the failure to address these issues successfully may materially affect public companies. Further, the Division noted that companies should be continually reassessing the need to disclose information concerning projected expenditures and uncertainties associated with Year 2000 consequences, particularly in connection with any upcoming obligations to file reports or registration statements with the Commission.

  • In October 1997, the Divisions of Corporation Finance and Investment Management issued Staff Legal Bulletin No. 5, which reminded those entities with reporting obligations of the significance of Year 2000 issues and the application of the Commission’s rules and regulations to those issues. The Divisions revised this bulletin in January 1998 to provide public and investment companies with more specific guidance. 2

  • Beginning in October 1997, the staff began to issue standard comments regarding Year 2000 disclosure in filings that it chooses for review. These comments raise awareness of Staff Legal Bulletin No. 5 and request companies to advise the staff that they have considered the need to disclose Year 2000 issues.

Staff Legal Bulletin No. 5

On October 8, 1997, the Divisions of Corporation Finance and Investment Management issued a joint Staff Legal Bulletin reminding those entities with disclosure obligations that the Commission’s rules and regulations apply to Year 2000 issues, just like any other significant issue.

Due to heightened awareness of the Year 2000 issue that resulted from greater media coverage and the efforts of Senator Bennett, 3 there were numerous requests that the Commission staff provide further guidance. On January 12, 1998, the Divisions revised the Staff Legal Bulletin to provide more specific guidance under existing Commission rules and regulations. 4 The staff intended this guidance to alleviate the uncertainty expressed by some members of the accounting and legal professions regarding what a company should disclose about its Year 2000 issues.

The revised Staff Legal Bulletin explains that public companies may have a Year 2000 disclosure obligation in their Commission filings because an applicable form or report requires the disclosure. 5 The most likely regulation triggering disclosure on a form or report is "Management’s Discussion and Analysis of Financial Condition and Results of Operations." 6 This is also known as "MD&A." In their MD&A, companies must discuss known trends, demands, commitments, events, or uncertainties that are likely to have a material impact on them. Companies may be required to disclose Year 2000 issues in their MD&A if:

  • the costs of addressing these issues is a material event or uncertainty that would cause reported financial information not to be necessarily indicative of future operating results or financial condition; or

  • the costs or consequences of incomplete or untimely resolution of these issues represent a known material event or uncertainty that is reasonably expected to affect their future results or cause their reported financial information not to be necessarily indicative of future operating results or future financial condition. 7

In the revised Staff Legal Bulletin, the staff provided guidance about the circumstances under which a company should consider its Year 2000 issues to be material. 8 If a company has not made an assessment of its Year 2000 issues or has not determined whether it has material Year 2000 issues, the staff states that the company must disclose this known uncertainty. In addition, the staff states that the determination as to whether a company should disclose its Year 2000 issues should be based on whether these issues would be material to a company’s business, operations, or financial condition irrespective of any remediation plans or insurance coverage. In other words, companies should determine materiality of their Year 2000 issues on a "gross" basis.

If a company determines that its Year 2000 issues are material, as described above, it should disclose the nature and potential impact of these issues as well as the countervailing circumstances. 9 As part of this disclosure, the staff expects a company to disclose, at a minimum, its general plans to address the Year 2000 issues that affect its business, operations (including operating systems) and, if material, relationships with customers, suppliers and other constituents, and the company’s timetable for carrying out those plans. A company also should disclose an estimate of its Year 2000 costs and any material impact it expects these expenditures to have on its results of operations, liquidity, and capital resources. Staff Legal Bulletin No. 5 specifically states that companies should avoid boilerplate disclosure.

Also, companies were advised to consider updating their Year 2000 disclosure at least quarterly when filing their periodic reports with the SEC. Any material changes in the company’s Year 2000 issues should be disclosed.

Staff Comments Regarding Year 2000 Disclosure

The Divisions of Corporation Finance and Investment Management request companies to confirm that they have considered the revised Staff Legal Bulletin. The staff includes this request in the comment letters it sends to companies whose registration statements or periodic filings have been selected for review. For example, since October 1997, the Division of Corporation Finance has issued the following comment to public companies as a standard part of its review of a filing:

Please see Staff Legal Bulletin No. 5 (CF/IM). In this bulletin, we explain what public companies should disclose about Year 2000 issues in their filings. Please supplementally confirm to us that you disclose in this filing all required information about Year 2000 issues.

The purpose of this comment is to increase companies’ awareness of the Year 2000 problem and assist them in meeting their disclosure obligations.

Impact of Commission Efforts to Date

The Commission’s efforts to date, together with the heightened public awareness of Year 2000 issues caused by the media and Congress, have significantly increased the number of companies that are addressing the Year 2000 issue in their filings with the Commission.

Only 10% of the annual reports filed by public companies for the first four months in 1997 contained the phrase "Year 2000." This percentage increased to 25% in the quarterly reports that followed Staff Legal Bulletin No. 5, published in October 1997. After the staff published revised Staff Legal Bulletin No. 5 in January 1998, 70% of the annual reports contained the phrase "Year 2000."

While the increase is easy to quantify, the staff continues to examine recent public company filings specifically to assess the quality of their Year 2000 disclosure.

Staff Task Force Reviews of Year 2000 Disclosure

The Divisions of Corporation Finance and Investment Management have each formed independent task forces to assess the current status of Year 2000 disclosure and propose steps that the Commission should take to remedy any deficiencies.

Division of Corporation Finance

The Division of Corporation Finance formed a Year 2000 Disclosure Task Force to review disclosure documents in selected industries.

The Task Force’s objective is to determine whether public companies are providing meaningful disclosure on their Year 2000 readiness, particularly in light of the interpretive guidance provided by the staff in revised Staff Legal Bulletin No. 5. The Task Force focused on the annual reports on Forms 10-K and 10-KSB that were filed after the staff issued revised Staff Legal Bulletin No. 5.

To evaluate the Year 2000 disclosure that companies have provided, the Task Force reviewed the annual reports of over 1,000 public companies. Each of the companies selected for review by the Task Force included some type of Year 2000 disclosure. The selected companies represent a cross-section of the companies that file periodic reports with the Commission, including the Fortune 100 companies and 66 small business issuers. As part of the review, the Task Force attempted to determine if these companies were following the guidance in the revised Staff Legal Bulletin. Many companies are not.

Specifically, the Task Force read the Year 2000 disclosure in the filings of 1,023 public companies to see if they disclosed certain information based on the specific guidance provided in revised Staff Legal Bulletin No. 5: 10

Assessment - the extent to which the company has assessed the seriousness of its Year 2000 technology problems if no corrective action is taken.

Assessment:

Percentage

About to be started

9%

Still in progress

56%

Completed

27%

No disclosure regarding assessment

8%


Plan - the extent to which a company described its plan to remedy its Year 2000 technology problems.

Plan:

Percentage

General description

44%

Detailed description

9%

Plan is fully implemented

4%

No disclosure regarding plan

43%


Timetable - the time frame within which a company intends to complete its assessment and/or its remediation plan. The Task Force considered disclosure such as "in time" or "by the year 2000" as "No disclosure."

Timetable:

Percentage

By the end of 1998

19%

Other than the end of 1998

17%

No disclosure regarding timetable

64%


Relationships - whether a company plans to evaluate or is evaluating the Year 2000 technology problems of those entities with which it has material relationships.

Relationships:

Percentage

Disclosure regarding evaluation of material relationships

49%

No disclosure regarding evaluation of material relationships

51%


Historical Costs - the amount of money a company has already spent on Year 2000 issues to date.

Historical costs:

Percentage

Disclosure regarding historical costs

8%

No disclosure regarding historical costs

92%


Estimated Costs - the amount of money a company estimates it will spend on Year 2000 issues.

Estimated costs:

Percentage

Disclosure regarding estimated costs

22%

No disclosure regarding estimated costs

78%


Materiality - whether a company disclosed that the Year 2000 issue is material to its business and, if so, the level of materiality.

Materiality:

Percentage

Year 2000 issues could be material

9%

Year 2000 materiality is unknown at this time

5%

Year 2000 issues are not material as to remediation costs or operations

67%

No disclosure regarding materiality of Year 2000 issues

19%

In many cases, the public companies disclosing that the estimated costs are not expected to be material also made cautionary disclosure that the company may be materially affected if third parties with whom it has material relationships are not Year 2000 ready. By including cautionary language, these companies may be seeking to protect themselves from liability for forward-looking disclosure, as provided by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. 11

Much of the disclosure regarding a company’s preparedness for the Year 2000 is, by its nature, forward-looking. Forward-looking statements concerning the Year 2000 issue may be covered by the safe harbor of the Litigation Reform Act if accompanied by meaningful cautionary language. The safe harbor requires the meaningful cautionary language to identify important factors that could cause actual results to differ materially from those in the forward-looking statement.

The Commission is concerned that while a greater number of companies mention Year 2000 in their annual reports, much of the disclosure is not informative. Perhaps many companies are not providing the type of disclosure specified in Staff Legal Bulletin No. 5 because companies are concerned that forward-looking disclosures would be a lightening rod for the plaintiffs’ bar. Several class-action lawsuits regarding Year 2000 issues have already been filed. 12 Companies, therefore, have every incentive to provide complete forward-looking information regarding their Year 2000 readiness.

The Task Force evaluated whether companies sought specifically to avail themselves of the safe harbor under the Private Securities Litigation Reform Act of 1995 or included general cautionary language. Because it was possible for companies to do both, and many did, the percentages for the categories below total more than 100%.

Cautionary language:

Percentage

Statutory safe harbor language;

  • specifically mentions Year 2000 issues; and

  • appears physically near the other Year 2000 disclosure

7%

Statutory safe harbor language:

  • specifically mentions Year 2000 issues: but

  • does not appear near to or in the same section as other Year 2000 disclosure

6%

Statutory safe harbor language:

  • does not:

    • mention Year 2000 issues; or

    • appear near to or in the same section as other Year 2000 disclosure

59%

Disclosure includes general cautionary language with the Year 2000 disclosure

43%

No disclosure regarding the statutory safe harbor or general cautionary language on Year 2000 issues

19%

Division of Investment Management

The Division of Investment Management formed a Task Force to review the Year 2000 disclosures made by investment companies and public utility holding companies.

First, the Task Force gauged the frequency of Year 2000 disclosure by investment companies. The Task Force reviewed disclosures made by the 25 largest investment company complexes. These complexes have assets in excess of $2.8 trillion and represent 59% of investment company assets. The Task Force found that almost all, 24, of these complexes have made Year 2000 disclosure to their shareholders. The Task Force then reviewed the 740 registration statements filed by investment companies since January 1, 1998. Based on this review, the Task Force found that 81% of these companies made Year 2000 disclosure.

Next, the Task Force evaluated the meaningfulness of the disclosure made by 50 investment company complexes. Based on this review, the Task Force reports:

  • 90% disclosed that they were still identifying their Year 2000 exposure;

  • 94% disclosed their Year 2000 issue in general terms;

  • 81% disclosed their reliance on service providers to be Year 2000 compliant; and

  • 88% do not make any disclosure of costs.

Typically, an investment company’s Year 2000 disclosure acknowledges the Year 2000 problem, states that the problems are being addressed and that the problems will be resolved, and that it cannot guarantee that its remediation efforts will prevent all problems. The general nature of the Year 2000 disclosure may be explained by investment companies’ reliance on external service providers (such as advisers, transfer agents, broker, custodians). Thus, the Year 2000 compliance of most investment companies largely is in the hands of other entities. As noted, the Commission has proposed and is considering proposing (see below) temporary rules that would require these service providers (brokers, transfer agents, and advisers) to file detailed reports on their Year 2000 readiness to the Commission.

After reviewing the results of the Task Force Survey, the Commission will soon consider a request from the Division of Investment Management to require investment advisers to provide detailed reports on their Year 2000 readiness to the Commission. These reports would enable the Commission to monitor the progress being made by registered entities. If the Commission determines to require such reports, we would use the information obtained from the reports to focus our compliance examinations on firms and areas in the industry where we perceive the greatest threat.

The Task Force reviewed the disclosure of all 19 registered holding companies under the Public Utility Holding Company Act of 1935. The staff found that all 19 companies, which represent 30% of the U.S. electric and gas industries, addressed Year 2000 in their disclosure. The Task Force’s review of these holding companies’ Year 2000 disclosures revealed:

  • All disclosed that they are aware of the Year 2000 issue, and most have completed their assessment phase and have initiated steps to address the Year 2000 issue;

  • Most disclosed that the Year 2000 would not have a material effect on their company’s results of operations or financial position given their corrective actions;

  • The companies indicated that their corrective actions depended, in part, on third party suppliers and contractors;

  • Many companies disclosed the effect of embedded microprocessors; and

  • Disclosure of estimated costs ranged from $2 million to $95 million.

The Division of Investment Management will continue to monitor disclosure made by public company holding companies as they continue to make corrections and perform testing of the generation, distribution systems, embedded microprocessors and computer software prior to the Year 2000.

The Commission’s Next Steps

The Commission and its staff continue their unprecedented efforts to increase the frequency and quality of Year 2000 disclosure made by public companies. The efforts to date have raised the consciousness of the public companies regarding this issue, but have not fully succeeded in obtaining the quality of disclosure that investors need.

The Commission has targeted the annual reports that public companies will file during the next year as the best opportunity to gain meaningful disclosure sufficiently in advance of the next millennium. In the near future, Chairman Arthur Levitt will mail a letter to chief executive officers of public companies to remind them of the significance of the Year 2000 issue and the Commission’s guidance regarding companies’ Year 2000 disclosure obligations.

The Commission also intends to publish an interpretive release in the near future that sets forth its views regarding the application of its disclosure requirements to the Year 2000 issue. The interpretive release would formalize current staff guidance and, among other things, remedy the apparent misconception that the Year 2000 issue is material, and therefore must be disclosed, only if the costs of remediation are material. The interpretive release will clarify that companies must, in addition to considering costs, determine materiality based on the potential consequences of inadequately resolving their Year 2000 issues. Further, the Commission’s interpretive release may form the basis of Commission enforcement actions against companies that fail to disclose material information regarding their Year 2000 issues. In addition, the Commission will soon consider a request from the Division of Investment Management to require investment advisers to provide detailed reports on their Year 2000 readiness to the Commission, including whether such reports be publicly available. These reports would enable the Commission to monitor the advisors’ Year 2000 readiness progress.

Again, thank you for the opportunity to appear today and testify about our Year 2000 efforts. We stand ready to provide you with any further assistance that you require.


FOOTNOTES

-[1]- Reports To Be Made by Certain Brokers and Dealers, Release No. 34-39724 (Mar. 12, 1998) and Year 2000 Readiness Reports To Be Made By Transfer Agents, Release No. 34-39726 (Mar. 12, 1998).

-[2]- The Staff Legal Bulletin contains the Divisionsí staffís guidance on good disclosure practices. It is not a rule, regulation, or statement of the Commission.

-[3]- On November 10, 1997, Senate Financial Services and Technology Subcommittee Chairman Robert Bennett introduced legislation, the Year 2000 Computer Remediation and Shareholder Protection Act of 1997 (S.1518), which would require public companies to disclose their Year 2000 issues.

-[4]- The revised bulletin supersedes the original bulletin and is located on the Commissionís web site at www.sec.gov/rules/othern/slbcf5.htm. The Commissionís home page, www.sec.gov, has a hyperlink entitled SEC & Year 2000 that contains a variety of Year 2000 related documents, including a Congressional Study, Congressional testimony, and investor education materials.

-[5]- In addition to the information that a company is specifically required to disclose, the disclosure rules require disclosure of any additional material information necessary to make the required disclosure not misleading. See Securities Act of 1933 Rule 408, Securities and Exchange Act of 1934 Rule 12b-20, and Securities and Exchange Act of 1934 Rule 14a-9.

-[6]- See Item 303 of Regulations S-K and S-B.

-[7]- If Year 2000 issues materially affect a companyís products, services or competitive conditions, a company also may need to disclose this in the "Description of Business." See Item 101 of Regulations S-K and S-B. In determining whether to include disclosure, companies should consider the effects of the Year 2000 issue on each of their reportable segments.

-[8]- This guidance is not exclusive. Compliance with the Staff Legal Bulletin does not necessarily constitute compliance with the disclosure requirements of the federal securities laws. Companies also need to consider these laws and the Commissionís rules and regulations in addition to the bulletin.

-[9]- The Emerging Issues Task Force of the Financial Accounting Standards Board considered how to reflect the costs of modifying computer software for Year 2000 projects properly in financial statements. In July 1996, the EITF concluded that these modifying costs should be charged to expenses as they are incurred. See Emerging Issues Task Force of the Financial Accounting Standards Board Issue No. 96-14: Accounting for the Costs Associated with Modifying Computer Software for the Year 2000, July 18, 1996.

-[10]- The Task Forceís findings, analyses, and conclusions are discussed in greater detail in the Division of Corporation Financeís Year 2000 Disclosure Task Force Survey, which accompanies this testimony.

-[11]- This safe harbor is in new Sections 27A of the Securities Act of 1933 and 21E of the Securities Exchange Act of 1934.

-[12]- The Information Technology Association of America has compiled a list of pending class-action lawsuits regarding Year 2000 issues. See www.itaa.org/Y2Klaw.htm#Lawsuit.

http://www.sec.gov/news/testimony/testarchive/1998/tsty0798.htm


Modified:06/11/98