TESTIMONY OF MICHAEL R. MCALEVEY, DEPUTY DIRECTOR DIVISION OF CORPORATION FINANCE U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING THE PROCEDURES OF THE DIVISION OF CORPORATION FINANCE IN REVIEWING MERGER FILINGS BEFORE THE SUBCOMMITTEE ON ENERGY AND POWER COMMITTEE ON COMMERCE U.S. HOUSE OF REPRESENTATIVES MARCH 10, 1999 U.S. SECURITIES AND EXCHANGE COMMISSION 450 FIFTH STREET, N.W. WASHINGTON, D.C. 20549 Mr. Chairman, Members of the Subcommittee: My name is Michael McAlevey. I am the Deputy Director of the Division of Corporation Finance at the Securities and Exchange Commission. I am pleased, on behalf of the Commission, to have the opportunity to discuss our role in regulating mergers of public companies. I want to state at the outset that the Commission does not, nor is it charged with, determining the merits of mergers or regulating the terms of transactions. In the context of the merger of two public companies, the federal securities laws require that the companies disclose all material information about the proposed merger so that investors can make a fully informed decision about the proposed transaction. In general, this disclosure appears in filings with the Commission and in a prospectus that is publicly available. I will outline the procedures that the SEC employs in reviewing merger filings. These procedures will apply to the proposed merger between Exxon Corporation and Mobil Corporation. 1. THE ROLE OF THE SECURITIES AND EXCHANGE COMMISSION IN REVIEWING FILINGS The Commission is responsible for administering the federal securities laws. These laws are designed to protect investors by requiring full and fair disclosure of all material information about publicly traded securities. Full disclosure ultimately benefits both investors and the capital markets. By enhancing investors' confidence in the completeness and accuracy of information about public companies, these full disclosure requirements encourage investor participation in the capital markets. The Commission's Division of Corporation Finance has primary responsibility for overseeing disclosures by issuers of securities. The Commission does not have authority to approve or disapprove a security or a transaction on its merits. If a transaction appears to involve a high degree of risk to investors or if a company involved in a transaction is experiencing financial difficulty, we do not, and we can not, stop the transaction from proceeding on that basis. Rather, the Commission's job is to ensure that the company fully discloses these risks and fully informs investors of its financial condition so that investors can make informed investment decisions. This system is designed to maintain market transparency. It allows market forces rather than regulatory controls to determine what transactions will proceed and at what prices a company's securities will trade. In this way, even small companies and companies with financial difficulties may have access to the public capital markets on an equal footing with larger, or more financially secure companies. Full and fair disclosure allows markets to assign an appropriate value for the securities of all public companies. Under the securities laws, public companies file registration statements, periodic reports and other disclosure documents with the Commission. All registration statements are subject to review by the staff of the Division of Corporation Finance. Given the volume of filings each year, we fulfill this obligation by selectively reviewing registration statements and other documents that companies file when they engage in public offerings and other transactions in publicly traded securities. These filings include documents concerning mergers and acquisitions. We also selectively review periodic reports that public companies are required to file with the Commission. These reports are designed to keep investors apprised of the companies' financial condition on a continuing basis. The Division's role in the registration process is to use reasonable means to encourage companies to make full and fair disclosure to investors of all material information. Our principal means of accomplishing this is through dialogue with the companies. This makes sense because the companies themselves possess the information that they are required to disclose. When we review a registration statement, we ask the company about any disclosures that are: * unclear, * incomplete, * inconsistent with disclosures elsewhere in the document or in other publicly available materials, or * do not comply with the specific disclosure standards in the federal securities laws and regulations. The company then responds to our questions by amending the document or supplying us with information to respond to our concerns. Registration statements will not be declared effective - permitting the sale of the securities - until we have no reason to believe that the disclosure is not materially complete, accurate and meaningful. I will discuss this process, which we call the "review and comment„ process, in greater detail below. We rely on the company's responses to our comments and on the company's legal obligations to respond to us in a truthful manner. In addition, the legal, financial and accounting professionals who are involved in preparing and/or auditing the company's disclosures have professional obligations and may be subject to legal liability if the disclosures contain material misstatements or omit material information. The Division of Corporation Finance does not independently audit the company or its operations. If we have significant concerns or become aware of information that suggests that a company may have violated the securities laws, we may refer the matter to the Division of Enforcement. The Division of Enforcement has broad authority to investigate possible violations of the securities laws and may bring actions against a company if information in its registration statement proves to have been materially false or misleading. 2. PROCEDURES THAT THE DIVISION OF CORPORATION FINANCE EMPLOYS IN REVIEWING MERGER FILINGS A. The companies file the proxy statement/prospectus with the SEC Ordinarily, when a company proposes to merge with another company, it is required to obtain shareholder approval of the transaction. Whether shareholder approval is required in a particular situation depends on the significance of the merger to the company and the requirements of the state of incorporation or the stock exchange or market on which the company's shares are traded. If shareholder approval is required, the federal securities laws require a public company to deliver a proxy statement to its shareholders. This document discloses the material terms of the transaction to shareholders so that they can make informed decisions when they vote on the transaction. In addition, when a public company proposes to issue stock in a merger transaction, it must register the offer and sale of that stock under the Securities Act. For example, assume that company A, a publicly traded company, proposes to merge with company B, also a publicly traded company. The companies have negotiated to exchange company A's stock for company B's stock. Before company A can offer its shares to company B's shareholders, it must file a registration statement with the SEC. The registration statement includes a prospectus that discloses material information about the companies and the proposed transaction. In addition to the prospectus, the registration statement contains exhibits, which include, among other things, the company's articles of incorporation and bylaws, opinions of counsel and material contracts to which the company is party. While the entire registration statement must be filed with the SEC and is publicly available, only the prospectus must actually be delivered to investors who will receive stock in the transaction.[1] The prospectus also serves as the proxy statement for the companies' solicitation of shareholder approval of the transaction.[2] As a result, we usually refer to the disclosure document that the companies distribute to shareholders as the proxy statement/prospectus. The disclosure about each company must include, among other things, a description of: * its business, * its property, * any material threatened or pending legal proceedings against the company, * historical financial results, and * a textual discussion of the company's financial condition and historical results of operations. If the companies have a reporting history with the Commission, are current in their reports, and have at least $75 million in market capitalization held by the public, they can incorporate their Exchange Act reports by referring to them in the registration statement.[3] These reports include quarterly and annual reports and special reports, which typically are used to announce unusual developments or events. Incorporation by reference can reduce the length of the document and the burden on the companies to disclose information that is already available in the companies' periodic reports. The reasoning behind this accommodation is that larger companies with reporting histories generally are followed sufficiently closely by the markets so that information about them is already publicly available. Further, the markets usually will have absorbed the public information about these companies and used it to establish a fair trading price in their securities. Therefore, receiving delivery of full information about such companies generally is not as important to investors as is information about smaller companies or companies without solid reporting histories. When companies incorporate their periodic reports by reference, they still are liable for the information in the reports that they incorporate by reference in the same manner as they would be if they included all of the information from the reports directly in the registration statement itself. In addition to this information about the companies, the disclosure in the proxy statement/prospectus also must include material information about the proposed merger including: * any material risks associated with the proposed transaction, * pro forma financial information for the combined company after giving effect to the merger, * the material terms of the proposed transaction, * a discussion of how the companies negotiated the transaction, * any material contracts between the two companies, * information about the proposed management of the combined company after the transaction is completed, and * a description of how shareholders' rights will change if the merger is completed. After drafting the registration statement, the companies file it with the Commission. The proxy rules allow companies to file preliminary proxy statements related to merger transactions confidentially, so the proxy statement/prospectus is not available to the public when it is initially filed.[4] The Commission's rationale when it adopted this position was that it wanted to allow companies to go through the review and comment process without prematurely disclosing confidential information to the market about merger transactions. The document only is made available to the public when the final proxy statement that will be delivered to shareholders is filed. Domestic companies are required to electronically make all of their non-confidential filings and, as a result, the final, or definitive, proxy statement/prospectus is available on the Internet in the SEC's EDGAR database generally within 24 hours after it is filed. Companies are required under state law to deliver the proxy statement to shareholders sufficiently in advance of the meeting to allow them time to consider the information before voting on it. The specific amount of time that the company must give shareholders varies by state. B. The staff's review of the filing 1. Routing to the appropriate industry group The Division of Corporation Finance is divided into 12 industry groups, each of which is headed by an Assistant Director. Each industry group is responsible for reviewing filings in one or more related industries.[5] This system allows members of the staff to develop expertise in their industries and to better identify issues that are of particular concern within an industry. When a filing is made with the Commission, it is routed to the appropriate industry group for processing. 2. Selective review process The Division does not have sufficient resources to review all registration statements and other filings that are made with the Commission. Therefore, in 1980, we implemented a "selective review„ program by which we review some, but not all, of the filings that are made with the Commission. When a filing is made and routed to the appropriate industry group, it is then "screened„ to determine if it will be subjected to a full financial and legal review, a partial review for specific issues only, or no review. We conduct a full review of all initial public offerings. In order to preserve the integrity of the selective review process, we do not publicly disclose our screening criteria for other filings. 3. Assignment of filing to staff If the filing is selected for full review, a staff attorney or financial analyst and an accountant are assigned to examine the filing. Senior level staff are assigned as a second level of scrutiny to review the filing and the comments drafted by the examining attorney or financial analyst and accountant. This second level of review helps us to ensure the thoroughness of our reviews and the consistency of our comments across filings. If necessary, the filing also is referred to special offices within the Division for an additional level of specialized review. For example, mining or oil and gas filings are referred to a mining or petroleum engineer, international filings may be referred to a separate international office in the Division of Corporation Finance, and some complex mergers, acquisitions and tender offers are referred to a separate mergers and acquisitions office within the Division. 4. Examination of filing The attorney or financial analyst and accountant who examine the filing review it to determine whether it complies with the requirements of the securities laws and regulations, that it fully discloses all required material information, and that the disclosure is meaningful to investors. Much of this review involves stepping into the shoes of a potential investor and asking questions that investors might ask on reading the document. As a result, some comments that we issue in the review and comment process are quite common and others are unique to the particular filing under review. For example, today, we commonly ask companies to expand their discussion of the risks associated with the Year 2000 problem. Often, companies make only generic disclosures indicating that they may have liability if their computer systems are non- compliant. We often ask companies to discuss specifically what they have done to evaluate and address their Year 2000 problem, what the costs associated with the Year 2000 problem are, what special risks are presented by the Year 2000 issue, and what contingency plans the company has established. Some other comments that we issue are unique to the company's industry, the company itself and the filing. In oil and gas filings, the petroleum engineer assigned to the filing typically will request from the company underlying documentation to support its calculation of reserve estimates. This documentation often includes detailed reserve reports prepared by the company's independent engineering experts. The staff engineer then will issue further comments if any disclosures in the proxy statement/prospectus are not materially consistent with the underlying reserve reports. Similarly, if a company is doing business in a politically unstable part of the world, we might ask it to disclose the risks associated with doing business there. If a company incurred a large, unexpected expense, we might ask for disclosure of the impact that expense has had on other planned capital expenditures. If the disclosure of the transaction or the companies is unclear or if important questions are left unanswered, we would ask the company to revise the document to clarify it. The range of possible comments is practically limitless and depends on the issues that arise in the particular filing. One important focus of the staff's review is in ensuring that the prospectus is clear and readable. As of October 1, 1998, our rules require that prospectuses be written in plain English. We want investors to be able to pick up the prospectus and understand the material information about the transaction on first reading. They should be able to do this without a legal dictionary, without diagramming the transaction, and without having to flip back and forth to different parts of the document to decipher the disclosure. We have made significant efforts to enforce this rule and are finding that prospectuses now are significantly more user friendly. 5. Issuance of comment letter All of the comments that the staff members generate on the filing are incorporated in one comment letter to the company. The company then responds to the letter by sending us a responsive letter and revising the document in accordance with our comments. The staff often also discusses any of the company's questions with the company and its legal, accounting, engineering and other advisors. 6. Comment clearance When we receive the company's response and revised filing, we review them to make sure that the company has complied with our comments. If we have further comments, we issue additional comment letters until all material concerns are resolved. 7. Declaring the registration statement effective The company then requests that the registration statement be declared effective so that the transaction can proceed. At that point, the Assistant Director of the group conducts a final review of the filing and makes a public interest finding that he or she has no reason to believe that the disclosure is not complete, accurate and meaningful. If the Assistant Director is unable to make such a finding, he or she will issue further comments. When all material concerns are resolved, the Commission, through delegated authority to the Division, issues an order declaring the registration statement effective. This allows the company to proceed with the transaction. 3. THE PROPOSED MERGER OF EXXON CORPORATION AND MOBIL CORPORATION The review of the Exxon/Mobil filings generally will focus on the same substantive issues outlined above. Our concern with respect to this transaction, as with any transaction, is that the companies make full and fair disclosure of all material information that they are required to disclose. We will not scrutinize the transaction to make an independent assessment of whether its terms are fair or whether the merger would benefit shareholders. That determination will be left to shareholders, after they have received full and meaningful disclosure of the material terms of the transaction. * * * **FOOTNOTES** [1]: The prospectus that is delivered to investors also includes the merger agreement as an appendix. [2]: Rule 14a-6(j) under the Securities Exchange Act allows companies to use the same document as the proxy statement for purposes of soliciting shareholder proxies, and the prospectus for purposes of offering and selling the securities in the transaction. [3]: A Company may also incorporate its Exchange Act reports by reference if it has been subject to the reporting requirements for three years, has been timely for the last year, and sends the incorporated Exchange Act reports with the prospectus. This option is rarely used. [4]: SEC Release No. 34-30849. 57 FR 29564 (June 24, 1992). [5]: The industry groups are: (1) health care and insurance, (2) consumer products, (3) computers, (4) natural resources, (5) transportation and leisure, (6) manufacturing and construction, (7) financial services, (8) real estate, (9) small business, (10) electronics and machinery, (11) telecommunications, and (12) new products and structured finance.