August 20, 2002

Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Attention: Jonathan G. Katz, Secretary

Re:   File No. S7-16-02
 Release No. 33-8098; 34-45907
 Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies

Ladies and Gentlemen:

We submit this letter in response to a request of the Securities and Exchange Commission (the "SEC" or "Commission") for comments on its May, 2002, Release No. 33-8098/34-45907, entitled "Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies" (the "Release").

The group submitting this letter consists of a Stanford Law School professor of securities law, securities lawyers practicing in the Silicon Valley area who work for private law firms, and lawyers from corporations with headquarters in Silicon Valley. The views reflected in this letter constitute a consensus of our individual perspectives. They do not reflect the official positions of the law firms or other organizations with which we are affiliated, or the clients of any of our law firms. Because this is a consensus document, we and our firms each reserve the right to express views that may not be fully reflected in this letter.1

The law firms with which we are affiliated primarily represent technology companies, and have been involved with a large majority of the capital formation activity in Silicon Valley. We are individually familiar with the issues that arise in the preparation and filing of reports by public companies and their insiders under the Securities Exchange Act of 1934 (the "Exchange Act"), and we believe that we have a broad insight into the workings of the public company reporting process in the high-technology industry, particularly as it has developed in Silicon Valley.



Our letter of August 6, 2002 describes serious limitations inherent in the Release's private litigation safe harbor proposals. We take this opportunity to reiterate those concerns. We further emphasize that the Commission should not adopt any new rules calling for quantitative or qualitative descriptions of probabilistic assessments, even along the lines of the approach described in this comment letter, unless and until the Commission adopts safe harbors as described in our prior correspondence.

The need to consider broader safe harbors suggests that a reproposal of the Proposed Rules may be appropriate. The occasion to repropose will also provide the Commission with an opportunity to consider a variety of comments contained in this and other comment letters.


A. The Proposed Rules, if adopted, herald a profound change in disclosure philosophy that warrants more careful consideration than is currently contemplated.

The Proposed Rules rank among the most profound changes ever contemplated to the Commission's disclosure philosophy. The Proposed Rules will, for the first time, require disclosure of detailed, quantitative, probabilistic assessments as a supplement to financial statements that are prepared in accordance with generally accepted accounting principles ("GAAP"). The Commission's proposal does not, however, appear to recognize the existence of a prior literature that addresses a range of issues that arise in connection with probabilistic financial statements. This literature dates back as far as the early 1970s and contains a variety of observations that could usefully inform the Commission's deliberations.2

We also believe that the Release fails to recognize the significant conceptual difficulties that it will impose on even the most honest and diligent of preparers. The problems associated with preparing quantitative probabilistic assessments differ in kind, not just in degree, from other forms of measurement challenges traditionally associated with the disclosure process. Indeed, commenters have observed that "no GAAP pronouncements quite match those that require probability assessments for evoking the ire of the accountants that must apply them."3 Equivalent "ire" will be evoked over time from issuers and counsel forced to comply with the Proposed Rules unless they are materially clarified. The cause of this "ire" is quite predictable and not unreasonable. Probability judgments can be very difficult to reach, particularly when there is limited information upon which to base those judgments or when the available information is of uncertain quality. Further, all such probabilistic judgments, if repeatedly made, as the Proposed Rules require, will eventually appear to be wrong. They will appear to be wrong even if they were made honestly, in good faith, and based upon the best information available at the time. This is the nature of quantitative probabilistic assessment, and the Commission should be aware that a material side-effect of its proposal is that it stands on the verge of adopting a requirement that issuers make statements that will, in hindsight, appear to be wrong, ill informed, inaccurate, or worse - despite the seemingly quantitative precision that was used to formulate these assessments at the time these assessments were originally made.

While we appreciate that the Commission is laboring under a tight timetable and is subject to significant pressure to respond to disclosures of fraud that have shaken public confidence in our markets, we believe that the Proposed Rules do not represent a measured policy response to these recent frauds. Given the decisions to defraud that appear to have occurred at Enron, WorldCom, Adelphia, and other issuers, it seems clear that the adoption of the Proposed Rules would not have deterred those wrongdoers from engaging in the violations that have been alleged. At most, the Proposed Rules would simply have added yet another disclosure obligation that would have been violated by these wrongdoers.

Sound public policy considerations therefore suggest that the Proposed Rules should be decoupled from initiatives designed to deter fraud of the sort recently disclosed at major corporations. The objective of the Proposed Rules is reasonable and laudable but the Proposed Rules are not rationally related to fast-track antifraud efforts. The Proposed Rules should, instead, be evaluated on a more measured timetable that reflects the fundamental nature of the changes contemplated by the Proposed Rules, addresses potential flaws in the proposals, and allows for more detailed analysis of other viable approaches, as described below.

B. Congress has considered many of the challenges addressed in the Release, and in Section 204 of Sarbanes-Oxley adopts an approach that differs dramatically from the Commission's proposal.

The Commission's proposals were released for comment on May 10, 2002. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"). Section 204 of Sarbanes-Oxley addresses many of the concerns that animate the Commission's proposals and suggests that Congress prefers an approach that differs quite dramatically from the one contemplated by the Commission. The Commission should recognize that its initial proposals could not have reflected the Congressional judgments reflected in Sarbanes-Oxley, and that superseding, intervening events reflected by that legislative action provide independent grounds for considering a reproposal.

As is evident from the plain text of Section 204, Congress has not concluded that the best response to the inevitable exercise of judgment inherent in the preparation of accounting statements is to require full disclosure to the public of the full range of alternative treatments and probabilistic assessments associated with the judgment ultimately selected by management. Congress has instead concluded that the appropriate step is to require detailed disclosure to the audit committee so that the audit committee can reach an appropriate judgment regarding the reasonableness of management's disclosures. Further, Congress has not required that the audit committee consider every conceivable accounting treatment or probabilistic set of judgments that management might or could have considered. Congress in Section 204 instead concluded that it was sufficient for the audit committee to consider:

"(1) all critical accounting policies and practices to be used;

"(2) all alternative treatments of financial information within generally accepted accounting principles that have been discussed with management officials of the issuer, ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the registered public accounting firm; and

"(3) other material written communications between the registered public accounting firm and the management of the issuer, such as any management letter or schedule of unadjusted differences."

Congress then leaves it to the audit committee to assure that public disclosures comply with relevant requirements. Congress thus struck a balance quite different from the one contemplated by the Commission when addressing the difficult policy challenges raised by critical accounting policies and the range of permissible alternative treatments under GAAP.

The Congressional approach reflected in Section 204 avoids the problems associated with disclosure of confidential information inherent in the Commission's proposal. The Congressional approach also raises far fewer implementation issues, will likely not foment as much questionable private party litigation, and will impose substantially lower compliance costs on the issuer community. There is much to commend the Congressional strategy.

We do not suggest that Section 204 precludes the Commission from adopting rules similar to those described in the Release. We do, however, suggest that the Commission should be informed by the very different approach that Congress has taken and that the Commission should consider modulating its proposals so that they are more consistent with the philosophy reflected by Section 204, as discussed below.

C. The probabilistic analysis required by the Proposed Rules is subject to fundamental ambiguities that will make good faith compliance difficult even for the most diligent of issuers.

The Proposed Rules rely extensively on qualitative descriptions of probabilistic assessments in order to mandate highly detailed quantitative presentations. For example, Proposed Item 303(c)(2)(ii)(A) defines a critical accounting estimate as one that "requires the registrant to make assumptions about matters that are highly uncertain at the time the accounting estimate is made." Proposed Item 303(c)(2)(ii)(B) refers to "different estimates that the registrant reasonably could have used" and changes that are "reasonably likely to occur from period to period..." Proposed Item 303(c)(2)(iv) defines the term "reasonably possible" as meaning "the chance of a future transaction or event occurring is more than remote but less than likely." Proposed Item 303(c)(3)(iii)(A)(2) refers to accounting estimates that are "changed to the upper end and the lower end of the range of reasonable possibilities...." Proposed Instruction 1 requires that certain changes "must be meaningful..." The underscored phrases are qualitative descriptions of quantitative probabilities. Similar locutions occur throughout the Release and in other proposed disclosure items.

These qualitative descriptions are highly problematic. They seek to elicit very specific quantitative disclosures and therefore inevitably raise a host of difficult implementation issues. For example, at what level of probability does a matter become "highly uncertain"? Hearkening back to the debate that preceded the Supreme Court's decision in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), what probability level distinguishes between estimates that registrants "could" have used and ones they "might" have used? What level of probability describes a "reasonably likely" event? Is a "reasonably likely" event more or less probable than a "reasonably possible" event? Is it "reasonably possible" to tell the difference among these various locutions and then apply these terms, subject to potential civil and criminal liability, in practice? How does one even begin to describe the upper or lower end of the "range of reasonable possibilities," particularly when there is no literature of which we are aware, and there is none cited by the agency, that gives operational substance to this qualitative description. Are issuers to assume that this range is defined by the 10%, 5% or 1% confidence interval tests commonly used in social science research? Or is some other standard to apply? If the social science literature is to be employed as a benchmark, which confidence level should be used? If that literature does not serve as a benchmark, to where should issuers look for guidance? Extensive research also indicates that reasonable persons can ascribe very different quantitative probability assessments to identical qualitative descriptions. Reasonable persons will therefore differ as to the proper quantitative application of the agency's quantitative standards.

If these qualitative descriptions of probabilities were meant to require corresponding qualitative forms of probabilistic disclosure, then issuers could rely on qualitative descriptions comparable to those employed by the Commission itself to comply with agency requirements. Part of the problem here, however, is that the Commission is relying on qualitative descriptions of probability to force very precise quantitative disclosures. The opportunity for good faith confusion is thus apparent. In particular, if the Commission believes that a matter is highly uncertain if its probability is less than 50 percent (or 30 percent), then the Commission should articulate its quantitative thresholds so that the reporting community is on fair notice of the standards the Commission seeks to apply. Similar quantitative guidance should be provided for every other qualitative standard upon which the Proposed Rules rely. On the other hand, if the Commission does not know how to ascribe quantitative probabilities that correspond to its qualitative assessments, or if the Commission is for any reason simply unwilling to describe the corresponding quantitative probabilities, then the proposal raises a question of fundamental fairness and basic notice. How can issuers be required to comply with complex new disclosure requirements at a level of precision that the Commission cannot itself even articulate or define? Moreover, is it reasonable to require that executives then certify these disclosures according to standards that are not articulated with a level of precision commensurate with that imposed on the reporting community?

Put another way, the Commission should not impose disclosure obligations that call for levels of precision more exacting than those the Commission itself knows how to specify.

The Proposed Rules raise another, more fundamental ambiguity. Not all probabilities are equally probable. A decision to assign a 50% probability can, in some instances, reflect a highly precise and well-informed judgment. However, in other contexts, the same probability can reflect the total, absolute, and utter lack of any information whatsoever. In other words, "50-50" can reflect a mathematically precise calculation or the assertion that "your guess is as good as mine."4

This distinction between "risk" which is measurable in an actuarial sense, and "uncertainty" which reflects a lack of knowledge rather than the existence of measurable randomness, is absent from the Release's analysis. Also absent is the fact that probability distribution can be highly unstable over time, and that projections based on precise historic calculations are often demonstrably poor guides as to future outcomes. Instead, the Release proceeds on the implicit assumption that all probabilities underlying the required disclosures reflect measurable forms of risk that are stable over time. This is not an accurate description of the business world, particularly as experienced by smaller issuers operating in highly competitive environments.

Accordingly, the ambiguities inherent in the Commission's proposals will likely create in the issuer community a strong preference for disclosures that look to the upper end and lower end of the range of reasonable possibilities, where the range is defined as broadly as possible. The result will be the disclosure of probabilities that are in and of themselves improbable because they are, by definition, the extremes of the range of reasonable probability assessments. The disclosures associated with these probabilities will be uninformative in the extreme, even though they will be in technical compliance with the Proposed Rules. The Commission should therefore expect many disclosures roughly along the lines of "if the worst reasonable probability happens our stock will be worth only a fraction of its current value" and "if the best reasonable probability happens, we should be worth much more than we are now."

We do not believe that this is the type of disclosure sought by the Commission, but there is a reasonable probability that this is the type of disclosure it will often get because of the fundamental ambiguities in the agency's proposal.

D. The Release's sample disclosures avoid the most difficult judgments required by the Proposed Rules.

The Release offers three examples as to how the Proposed Rules might be applied in practice. These examples are helpful to the extent that issuers encounter fact patterns that are analogous to those presented in the examples. These examples are, however, based on "easy" or overly simplistic fact patterns. These fact patterns fail to confront common difficulties that are certain to arise in practice, particularly for technology companies, and help underscore the fundamental limitations inherent in the agency's proposals.

Example 1 describes a warranty cost estimation problem. There, however, the issuer can rely on objectively observable market prices from which a range of potential future prices can be estimated. History also permits the issuer to estimate warranty costs as falling within a rather tight range of 19% to 22% of the cost of sales.

Example 2 describes a returned goods estimation problem. There, the issuer benefits from the fact that "a historical correlation exists between the amount of distributor inventory and the amount of returns that actually occur." The issuer's products in the example are sold in a "highly competitive marketplace" but "competitive factors have not, to date, materially impacted returns." Thus, the market is "highly competitive" only in a theoretical or abstract sense. Indeed, prior years' competition has caused the estimate of returns as a percentage of gross sales to decrease by only 1%, and the historical estimates here span a tight range of 11%, 12%, and 13% over a three-year period. In our experience, this is a comfortably stable market, not a highly competitive one.

Example 3 describes a situation in which the issuer has an established market position that generates a three-year product history that allows for relatively stable estimates of market trends. Indeed, the example discusses sales declines of approximately 2% per year during the past three years, and the data are sufficient to support direct quantification of an impairment analysis.

Actual application of these types of examples to technology companies would be much more complex and problematic than described in the examples set forth in the Proposed Rules. The examples relate to companies that have relatively stable sales, warranty returns and cash flows. Technology companies, however, can have very volatile earnings that change dramatically from period to period. This type of volatility in earnings and operating results can make the use of quantitative ranges highly problematic from an investor's perspective because these ranges would have to be set with a variance so large as to make the final disclosure meaningless. In addition, using historical information to set an upper or lower limit for any quantitative analysis could result in misleading disclosure because historical information for technology companies that is more than one or two quarters old may no longer be relevant or helpful in predicting future results or ranges of future results.

The volatility in earnings for technology companies makes any quantitative analysis that depends on estimating future cash flows quite difficult and problematic. Asset impairment and inventory valuation, for example, would likely be common critical accounting policies for a number of technology companies. Any discussion of a quantitative analysis for these two critical accounting policies would require these companies to offer ranges of outcomes for their future cash flows. With respect to evaluating the carrying value of long-lived assets, if the estimated future cash flows are less than the carrying amount of the assets, the assets will be required to be written down based on the excess of the carrying amount over the fair value of the assets. Determining these future cash flows and a quantitative sensitivity analysis for most technology companies will be much more complicated and difficult to disclose in a meaningful manner than what is set forth in Example 3 of the Proposed Rules. A typical technology company would have multiple configurations of any particular product at any existing technology generation or model, along with multiple generations of products in the market at the same time. Technology companies will often go through multiple technology changes or generations in products in one or two financial reporting periods. Accordingly, any attempt to do a quantitative analysis or establish ranges would require much more exhaustive and complex disclosure than that set forth in Example 3 of the Proposed Rules. Similar problems would occur in connection with any description of the impact of changes in average selling prices for semiconductor products, in any quantitative presentation by a company whose critical accounting policy was inventory valuation. Significant shared cost allocation issues could also arise.

In contrast to the three examples set forth in the Proposed Rules, many technology companies can find their sales declining by very large and essentially unpredictable amounts because of industry-wide declines in average selling prices or competitive or other factors over which they have no control and as to which they have little probabilistic insight. Many technology companies often find themselves dealing with new product or service offerings that have little quantitative history, particularly because of the limited product cycles of these products and the rapid technological change, and when such history exists, it can suggest variances far in excess of the tight ranges relied upon by the examples.

The three examples set forth in the Proposed Rules thus fail to provide guidance of the sort that would be useful to the large majority of issuers confronting realistic disclosure issues raised by the Proposed Rules. These three examples involve situations in which there are objective data or reliable data points that can be used to support any probabilistic inferences. All of these examples involve situations in which the expected variances are, because of competitive or other factors, relatively low. None involve situations that statisticians would describe as unstable distributions or jump processes. In other words, these are easy examples that do not describe the reality encountered by many publicly traded technology companies.

E. The Commission's own cost-benefit analysis illustrates the difficulties involved in making probabilistic judgments.

The difficulties presented by the Proposed Rules are better illustrated by the problems that arise in attempting to apply those rules to a real-world situation. The Release itself provides valuable insight as to these difficulties. In particular, the cost-benefit calculation relied upon by the Commission in evaluating its own proposal, as described in Section V of the Release, satisfies the definition of a "critical accounting policy" and can, for purposes of this analysis, be subject to the Commission's own Proposed Rules.

The Commission's analysis concludes that "the annual incremental paperwork burden for all companies to prepare the disclosure that would be required under our proposals to be approximately 781,911 hours and a cost of approximately $98,467,000." See the Release, at note 140. The Commission estimates that the average burden for each of the approximately 14,000 companies that would be subject to the rule is approximately $7,000 per company for in-house time and an additional $98 million, or $7,000 per company for outside professionals to comply with the disclosure. Id. at notes 153, 155, and 156. Total annual disclosure costs thus amount to approximately $696 million. The Release further states that the Commission believes that its "proposals would not substantially increase the costs to collect the information necessary to prepare the proposed disclosure." Id. at page 50.

The Release discloses that the Commission contacted "a few companies that voluntarily had provided information about critical accounting policies in 2001 Form 10-Ks. They indicated that preparation of the proposed disclosures would cost from approximately $5,000 to $500,000 per year." Id. at page 50. The Release fails to describe the number of companies contacted, whether the disclosures voluntarily made in connection with 2001 Form 10-Ks would have satisfied the requirements of the Proposed Rules, and the mean, median, or standard deviation of the cost estimates provided by the issuers. There is also no indication that the Commission inquired as to these registrants' estimates of the costs that would arise in connection with compliance with the rules as actually proposed.

If we apply Proposed Rule 303(c)(3)(iii)(A)(1) to the Commission's own cost estimate and treat the cost estimate as a critical accounting estimate, which it certainly is in the context of the statutorily mandated cost-benefit rule, then the Commission would have to assume and disclose the consequences of "reasonably possible near term changes... both positive and negative" in estimates used to define the calculated cost burden. The challenge here is obvious. The Release fails to describe an objective detailed set of data from which a probability distribution can be estimated. The Commission's own cost-benefit analysis is thereby distinguished from each of the Commission's three examples where the issuer is presumed to have objective historical data from which it can rather easily extract the information necessary to comply with the Proposed Rule.

The Commission could presumably collect more detailed information from its survey of filers that provided the estimates of $5,000 to $500,000 per year in costs. However, in order to comply with its own Proposed Rules, would the Commission be required to incur this additional expense in order to gather the data necessary for it to generate a reasonable probability distribution upon which to base its disclosures? If the Commission were instead simply to rely on the survey data described in the Release, those data would not seem to support the Commission's own analysis. For example, if one assumes that the midpoint of the $5,000 to $500,000 range, i.e., $252,500 per year, constitutes a reasonably possible near term change in the Commission's own estimates, then the annual compliance costs of the Proposed Rule for all 14,000 issuers climbs to $3.535 billion. If we more conservatively assume that only the 1,000 largest issuers incur this average cost of $252,5000, and that all other 13,000 issuers incur total costs of only $14,000 per company, as per the Commission's own calculations, then the total burden would amount to $434.5 million per year.

If, on the other hand, the Commission applies Proposed Rule 303(c)(3)(iii)(A)(2) and assumes that "the accounting estimate was changed to the upper end and the lower end of the range of reasonable possibilities" then dramatically different estimates will result. At the upper end of the Commission's own survey, an estimate of $500,000 of annual compliance costs for each issuer would suggest a burden of $7 billion per year. At the lower end, an estimate of $5,000 would suggest a burden of $70 million per year. The upper and lower ends of this range differ by a factor of 100. Would a range describing a factor of 100 in outcomes be considered meaningful disclosure for instant purposes?

Further, the Commission's analysis draws no distinction between the start-up costs that issuers are certain to incur in the early years of the Rule's application, while they and the Commission are both learning how to apply the Rule in practice, and the lower costs that will be incurred in a steady state once experienced participants in the process have reasonable guidance as to how to apply the new rules in practice. There are, we believe, two different sets of probability and cost estimates that apply to the "start-up" phase and to the "steady-state" phase, yet the Commission's analysis fails to address this distinction in any manner whatsoever.

Accordingly, we respectfully submit that the Commission should not rush to require issuers to comply with a rule that it itself would seem to have difficulty applying to its own disclosure proposals.

F. The Release demonstrates that qualitative disclosures can be informative.

The Release demonstrates that, although it can be difficult to articulate precise quantitative probabilistic assessments, it is often possible to provide meaningful qualitative language that usefully informs investors of a range of possibilities associated with an uncertain judgment or estimate. This observation is, we believe, highly salient to the Commission's inquiry. It also suggests that an alternative or supplemental approach could constructively address the objectives that the Release seeks to further.

In particular, the Commission could allow issuers to describe probability assessments using the same locutions upon which the agency itself relies in its own Release. Issuers could then provide a description of the consequences of alternative estimates that management views as highly likely, probable, less than probable, or remote, without having to ascribe artificial or false measures of precision, without having to make unrealistically precise judgments, without having to risk as great a potential disclosure of confidential information, and without having to incur as substantial a risk of litigation alleging fraud by hindsight.

Accordingly, to the extent that the Commission views it as desirable to require public disclosures of the uncertainties associated with accounting estimates, over and above the disclosure to audit committees now required by Section 204 of Sarbanes-Oxley, we respectfully suggest that the Commission's own Release demonstrates the desirability of a more qualitative approach than contemplated by the Proposed Rules. We therefore respectfully request that the Commission consider amending the contemplated rules so as to allow for more qualitative forms of disclosure, without precluding precise quantitative disclosures when such disclosures are feasible.

G. The Proposed Rules would effectively require the disclosure of sensitive confidential information that is not typically disclosed and the negative impact of such disclosure would disproportionately affect smaller issuers.

The quantitative and probabilistic disclosures required by the Proposed Rules would effectively require the release of confidential information that is not typically made public. For a number of technology companies, they would have to disclose confidential information regarding their estimates of reserves for intellectual property litigation or other patent prosecution matters - information that if disclosed could have deleterious impact on future results in these matters. The disclosure of product return or warranty reserves might also reveal an issuer's internal assessments of the relative values of their products. Sensitivity analysis would require disclosure of an issuer's business judgments about future market conditions, and that information could be extremely valuable to competitors who are privately held or foreign, and who therefore will not be required to make equivalent disclosures.

Indeed, in some circumstances, strict application of the Commission's requirements could create a tension between the issuer's fiduciary obligation aggressively to protect shareholder value and its obligation to abide by the Commission's disclosure requirements. As suggested above, this tension is most likely to arise in an obvious manner in a litigation context. An issuer may, for example, have a good faith claim in a commercial dispute or patent infringement action. The issuer can maximize the value of its claim, and promote shareholder value, only by zealously advocating its position before the court and strongly asserting the merits of its argument. A disclosure requirement that forces the issuer publicly to state that it believes its prospects of prevailing are, say 25% or 50%, can only detract from its ability to pursue its claim in good faith and in the best interests of its shareholders.

We do not believe that the Commission intends to create such pervasive and potentially profound tensions between a management's fiduciary obligation to promote shareholder value and its responsibility to comply with the agency's disclosure obligations. In the case of litigation, we observe that the market is generally able to discount litigants' courtroom claims even without quantitative disclosure of the sort contemplated by the Proposed Rules. Accordingly, we respectfully request that the Commission carefully reconsider the disclosure obligations it seeks to impose, whether quantitative or qualitative, so as to create safe harbors or other appropriate accommodations for situations that create a tension between the legal pursuit of strategies designed to promote shareholder value and overly precise disclosures that make it difficult or impossible to so serve shareholder interests.

In this regard, it is valuable to observe that issuers often go to great lengths to keep certain information confidential, including the filing of Confidential Treatment Requests. The Commission has often permitted issuers to avoid disclosure of very sensitive information, such as royalty rates in certain types of licensing agreements. Some of the disclosures required by the rules may require disclosure of some of this previously confidential information. Disclosure of such information could undermine existing Confidential Treatment Orders previously granted by the Commission.

It is further valuable to observe that all public companies would be put at a competitive disadvantage by having to disclose commercially sensitive information vis-à-vis privately-held companies and foreign issuers who are not subject to these more detailed disclosure requirements. Smaller public companies, and public companies in emerging industries would be at a particular disadvantage. Product loss reserve disclosures are problematic when a company has only a few products and, as suggested, litigation reserve disclosure for intellectual property or other matters could be catastrophic when a company has important litigation. Accordingly, in adopting the Proposed Rules, the Commission should not require any issuer to disclose information regarding any estimate that would place the issuer at a competitive disadvantage as a result of such disclosure.


The Commission has proposed disclosure in MD&A in the form of a "statement of whether or not a company's senior management has discussed the development and selection of the accounting estimate, and the MD&A disclosure regarding it, with the audit committee[.]" See the Release at page 13. The Commission has asked for a variety of input regarding this proposal. We submit the following responses on this issue, which is of critical importance to our clients.

As our specific comments below will demonstrate, we believe that the Commission's proposals in its request for comments will not help promote a productive, active dialogue between the audit committee and management, and also would result in inappropriate emphasis being given to the audit committee's role regarding preparation of financial statements and disclosure to the public, compared to that of a company's management. Our comments are consistent with the approach taken by Congress in the Sarbanes-Oxley Act of 2002. In the Act, Congress made the decision that discussions between the audit committee and the auditors need not be publicly disclosed. Section 204 of the Act does not require public disclosure of the auditor reports to the audit committee, including reports on critical accounting policies and alternative treatments of financial information. Although Section 302(a)(5) of the Act requires a certification that the management has discussed with the auditors and the audit committee significant internal control deficiencies and any fraud, the Act does not require public disclosure of the actual discussions between management and the audit committee. The staff's suggestion that the audit committee's unresolved concerns be disclosed takes a directly contrary view of the need for such disclosure. If adopted, such a requirement will certainly result in chilling the very honest and frank dialogue stockholders want to foster between management and the audit committee. Moreover, Sarbanes-Oxley places squarely on management the responsibility of certifying financial disclosure under Sections 302 and 906. In contrast, the staff's requests for comments which suggest that the audit committee be required to state whether it recommends either the disclosure regarding critical accounting policies or MD&A would, in our view, implicate the audit committee for disclosures for which it is simply not equipped to be the final arbiter. We strongly oppose these proposals for the reasons set forth below.

A. Item 306 should be amended to require disclosure as to whether senior management has discussed critical accounting policies with the audit committee.

We believe, based on our experience, that some proportion of public companies' managements discussed the selection and application of critical accounting policies with the audit committee prior to the Commission's recent disclosure initiatives. This dialogue regarding critical accounting policies has undoubtedly become more focused, and most audit committees have in our experience engaged in such discussions, as a result of the Commission's prior Critical Accounting Policy Release (Securities Act Release No. 8040, December 12, 2001), and the Item 306 requirement that the Audit Committee recommend the inclusion of the financial statements in the registrant's annual report. An audit committee would typically consider management's judgments applied to the preparation of such financial statements in evaluating the recommendation required by Item 306. The audit committee would, as part of this evaluation, typically consider whether management's accounting was in accordance with GAAP, whether management's judgments in applying critical accounting policies were unduly conservative or aggressive, and the possible impact of a change in assumptions on future reported results. Further, as you have noted, SAS No. 61 requires the auditor to inform the committee about formulation of sensitive accounting estimates, and the auditor's conclusions as to the reasonableness of such estimates, as well as the auditor's judgments about the quality of the entities accounting principles as applied. Section 204 of Sarbanes-Oxley also requires registered public accountants to discuss critical accounting policies with the audit committee.

Accordingly, we believe that the proposed disclosure (as to whether such discussions about the selection and application of critical accounting policies have taken place) will inform investors as to whether the audit committee has the appropriate basis for its recommendation regarding the inclusion of financial statements in the annual report. We therefore also support an amendment of Item 306 to include the discussions regarding critical accounting policies as a basis for the audit committee's recommendation that the financial statements be included in the annual report. We believe that this new disclosure will not require a significant change in the existing interaction between senior management and the audit committee.

We respectfully submit, however, that the MD&A disclosure relating to the critical accounting estimate would not ordinarily be reviewed with the audit committee, as it would not necessarily have been prepared at the time the audit committee is discussing the financial statements with the auditor and management. We recommend that the proposed disclosure requirement be modified to require a registrant to state only whether the senior management has discussed with the audit committee the selection and development of the critical accounting policies, not the MD&A disclosure. We discuss further the Commission's requests for comments relating to the audit committee's function in the review of MD&A in Section C below.

We also strongly recommend that the disclosure as to whether the senior management has discussed the critical accounting policies with the audit committee be required as part of the audit committee report required pursuant to Item 306 of Regulations S-K and S-B, (the "Audit Committee Report") and not as of part of MD&A. See the Release at page 23. In this regard we note that the Audit Committee Report serves a similar function to the compensation committee report required under Item 402 of Regulations S-K and S-B. The compensation committee report institutionalized practices which many registrants had previously adopted, while encouraging other companies with less active compensation committees to modify behavior to avoid disclosure which stockholders would view as a lack of oversight by the committee charged with these important issues. Compensation committees became more active in setting policies and reviewing CEO compensation and performance. Stockholders were free to draw their own conclusion about those disclosures, consistent with the Commission's approach to disclosure generally. The disclosure of whether senior management is discussing the selection and development of critical accounting policies with the audit committee creates the same potential for positive behavior modification regarding corporate governance.

The Audit Committee Report, not MD&A, is the right place for this disclosure. The disclosure is similar to the other disclosure matters covered under Item 306. In contrast, the disclosure is not management's analysis of results or financial condition, and accordingly, does not belong in MD&A. From an investor's point of view, this disclosure is extraneous to the main mission of MD&A, which is to allow investors to understand the registrants' financial results and conditions "through management's eyes." Most importantly, Item 306 provides significant protections for the Audit Committee Report, including the fact that the Audit Committee Report is not deemed to be soliciting material or filed with the Commission, nor is the Audit Committee Report incorporated by reference into a registrant's filings under the Securities Act of 1933 ("1933 Act Filings") without an express statement to such effect by the registrant, Regulation S-K, Item 306 (c) and (d). It is appropriate that those same protections be extended to the proposed new disclosure relating to the audit committee's discussions relating to critical accounting policies.

B. There should be no required disclosure relating to unresolved concerns held or procedures employed by the audit committee.

The Commission has requested comments on whether the disclosure of discussions between the audit committee and senior management should disclose "any unresolved concerns of the audit committee about the critical accounting estimates or the related MD&A disclosure." See the Release at page 22. The Commission also requests comments about whether disclosure should be required of "specific procedures employed by the audit committee to ensure that the company's response to the disclosure requirements is complete and fair." Id.

We respectfully submit that any requirement for disclosure relating to "unresolved concerns" the audit committee may have about estimates will likely have the undesirable effect of chilling communications between the audit committee and senior management, without materially aiding investors. We believe that the corporate governance goal to be furthered by more detailed communications between senior management and the audit committee, including those about critical accounting policies, is the fostering of a full and frank exchange about the application of management's judgment in applying the critical accounting policies. This would include discussions about management's assumptions, judgments as to the likelihood of certain occurrences and relative ranges. If the audit committee and senior management believe that these discussions may result in disclosure of the audit committee's concerns, management's discussion will likely be less candid, and the dialogue between the committee and management concerning the judgments will likely be truncated.

Moreover, the very disclosure requirement proposed is so vague, that companies will have great difficulty knowing whether they have complied. What is an "unresolved concern?" Must it be a unanimous concern or one held by one director? If management has promised a review and report, and reasonable corrective measures are being implemented but are not yet complete, is the concern still unresolved?

In addition, particularly given the ambiguity in the proposed disclosure, it is not at all clear that investors will benefit from disclosure of an audit committee's unresolved concerns. These will not likely be proven out until later periods and could be proven baseless or at least not materialized. Various participants may have different views of the relative merits of the concern, there may be ranges of "prescribed fixes" and the passage of time and later developments may render the concern moot or less critical. If the audit committee's discussion with management create concerns in the members of the committee that management are not applying appropriate assumptions or otherwise not exercising good judgment, the committee's role is to monitor, report to the Board and ultimately recommend management changes. This process would typically require more than one period to demonstrate validity of the committee's concern and/or modification of management's judgment, as a result of further consultation with the audit committee. It is not a process that necessarily benefits from early public disclosure, while review is ongoing, and management may be exploring or implementing corrective action. We are concerned that the proposed disclosure may likely chill otherwise healthy dialogue with the very committee whose counsel and judgment management would otherwise be induced to seek.

The proposed disclosure of specific procedures is also unduly invasive as to the operation and exercise of business judgment by the audit committee. Each audit committee should be free to develop its own procedures to test the disclosure prepared by management. The proposed disclosure may instead drive audit committees to adopt practices chosen by those registrants who are first faced with the disclosure requirement. These procedures may not be well suited to the particular corporate culture of the registrant, nor sufficiently focused on the types of disclosure issues the particular audit committee is confronting.

In discussions between senior management and the audit committee concerning critical accounting policies, the audit committee is called upon to exercise its business judgment as to the application of the policies. Accordingly, the audit committee is called upon to determine what procedures would assist the exercise of the Committee's business judgment. Any detailed description of how the audit committee exercises its business judgment, by implementing procedures or otherwise, is beyond the appropriate scope of the Audit Committee Report. The disclosure of specific procedures may suggest to investors more or less trust of management than in fact is the case, or may disclose concerns that the audit committee is appropriately monitoring but which are not ripe for disclosure. The Commission has mandated other disclosure of board activities (e.g., the compensation committee report under Item 402 and the Background and Reasons for the Merger under Regulation MA). These disclosures are not typically required to include the specific processes by which policies are developed or decisions on a transaction are reached. Such procedures should be kept within the boardroom to promote the audit committee's ability to accommodate a broad range of views and diligence activities without fear of investors reading into such activities unwarranted concerns.

We further observe that Section 401(a) of the Sarbanes-Oxley requires that all financial reports filed with the Commission "shall reflect all material correcting adjustments that have been identified by a registered public accounting firm in accordance with the generally accepted accounting principles and the rules and regulations of the Commission." It follows that the additional disclosures of audit committee discussions contemplated by the Proposed Rules would be of matters that would not rise to the level of "material correcting adjustments." This fact further calls into question the need and desirability of the additional disclosures requested by the Commission.

C. Disclosure relating to the audit committee's review of MD&A puts the audit committee in a role for when the audit committee is not equipped.

The Commission has sought comment on a variety of issues relating to MD&A:

See the Release at page 23. The Commission's proposal, as we noted earlier, also required disclosure as to whether management discussed MD&A disclosure regarding critical accounting policies. We view these as related proposals and we address them here.

We do not support a disclosure about whether management has discussed MD&A, whether only the section on critical accounting policies, or the entire MD&A, with the audit committee. We even more strongly oppose requiring disclosure that the audit committee recommends the MD&A disclosure (whether simply for critical accounting policies or for the entire MD&A). We have several reasons for our objections.

We believe the audit committee is called upon to provide a critical oversight function for management regarding its accounting policies and financial presentation of registrant's business. The discussion with management concerning the selection and development of critical accounting policies furthers this important function. The audit committee is not, however, management. It does not have access to the full range of day-to-day experiences (discussions with customers, suppliers and competitors, reports from subordinates, site visits and contract negotiations, to name a few) which together form the grist for management's judgments. The audit committee can test the reasonableness of management's assumptions, compared to the business experience of the members. The audit committee can determine if there is a material misstatement or omission based on its collective knowledge. The audit committee cannot, however, substitute its judgments for those of management. It should not therefore be held to report to stockholders about matters properly the responsibility of management.

Requiring the audit committee to recommend inclusion of the disclosure regarding critical accounting policies or the entire MD&A is to suggest to investors that the audit committee's judgment should be substituted for that of management. We do not believe that such inference is fair, nor is it consistent with the audit committee's role. Regulations S-K and S-B Item 303 is entitled "Management's Discussion and Analysis" for good reason. It is not appropriate to imply that it should be the "Audit Committee's Discussion and Analysis." Recommendations by the audit committee as to the inclusion of such disclosure simply implies more operational insights than an investor can fairly expect from a committee member, since the member is not the manager. Accordingly, we submit that the audit committee will be held to a standard inconsistent with the information reasonably in its possession if the committee is required to recommend inclusion of MD&A or any part of it.

A requirement that the audit committee disclose whether it has discussed MD&A with senior management creates an implication that the audit committee has sufficiently detailed operational information derived from its oversight of the registrant's operations to comment meaningfully on management's analysis and disclosure judgments. Although this is not as problematic as the inference created by a recommendation, we are still concerned that if the committee is required to disclose that MD&A was discussed by the audit committee, the audit committee would be unfairly promoted as a body that can pass a fully informed judgment on MD&A. We do not of course contend that audit committees should not, as a matter of good corporate governance, discuss the judgments made in applying critical accounting policies in order to allow the committee to assess the quality of management's judgment. See our discussion in Sections A and B above. By the same token, we do not suggest that an audit committee should not review the major trends of the business with management on a quarterly basis. We do, however, strongly believe that the detailed analysis contained in MD&A, whether relating to the application of critical accounting policies, financial results or financial condition, are properly the role of management.

Discussions between management and the audit committee relating the MD&A disclosure are perfectly appropriate and are to be encouraged. However, the key discussions to be had between the audit committee and management are regular discussions about trends in operations and financial condition. These are the discussions that allow the audit committee to perform its critical oversight function. This function does not depend on the audit committee's review of the proposed disclosure in MD&A as to trends, whether with management or the outside auditor. The Commission's proposal that audit committees disclose whether it had discussed the disclosure in MD&A, or any part of it, with management therefore appears to us to place undue weight on the audit committee discussions of the disclosure, as opposed to the committee's review of management's operational judgments. To be clear, in our view, preparation of such disclosure is the job of management, not the audit committee. To remain clear about the respective roles of the audit committee and management, we respectfully recommend that there be no mandated disclosure as to any discussions between management and the audit committee, regarding MD&A.

In summary, we submit that there be no requirement that the company disclose unresolved concerns or its procedures for review, that the audit committee not be required to disclose any recommendations regarding the inclusion of disclosure on critical accounting policies or MD&A, and that there be no required disclosure regarding discussions between management and the audit committee regarding MD&A.


For the reasons stated above, we respectfully suggest that the Commission not adopt the Proposed Rules in the form currently pending. Instead, we suggest that the Commission consider proposing a set of rules that:

  1. provide for a more effective safe harbor from private party litigation;
  2. allow for reliance on qualitative forms of disclosure consistent with the forms of qualitative disclosure relied on by the Commission itself in its proposing release, particularly when quantitative probabilistic assessments are difficult to articulate;
  3. provide accommodations in situations that create a tension between a management's fiduciary obligation to promote shareholder value and its obligation to comply with the Commission's disclosure requirements; and
  4. not mandate audit committee disclosures that could only chill legitimate discussions and impede the objectives sought by the Commission.


Thank you for your consideration of the foregoing.

Respectfully yours,


Joseph A. Grundfest
William A. Franke Professor of Law and Business
Stanford Law School
Stanford, CA 94305

Drafting Committee Members

Gray Cary Ware & Freidenrich LLP
Wilson Sonsini Goodrich & Rosati Professional Corporation
Venture Law Group LLP
Bingham McCutchen LLP
Fenwick & West LLP

1 We have commented on numerous Commission proposals in the past, including most recently the proposal to require company reporting on insider transactions (Rel. No. 33-8090; Comment Letter dated July 2, 2002) and the proposal to accelerate Form 10-Q and Form 10-K filing dates (Rel. No. 33-8089; Comment Letter dated May 30, 2002). Previously, we submitted comments on the "aircraft carrier" proposal (Rel. No. 33-7606; Comment Letter dated October 8, 1999); the proposal to amend Form S-8 (Rel. No. 33-7506; Comment Letter dated April 23, 1998); and the executive compensation disclosure rules (Rel. No. 33-6940; Comment Letter dated August 24, 1992). We have also requested and received a number of interpretive letters, including three letters regarding the application of the Section 16 rules (Interpretive Letters to Joseph A. Grundfest et al. dated April 25, 1991, August 19, 1991 and March 4, 1992). We are often referred to as the "Grundfest Group."

2 See, e.g., B. L. Oliver, A Study of Confidence Interval Financial Statements, 10 J. Acct. Res. 154 (1982); J. Birnberg and D. Slevin, A Note on the Use of Confidence Interval Statements in Financial Reporting, 14 J. Acct. Res. 153 (1976); D.E. Keys, Confidence Interval Financial Statements: An Empirical Investigation, 16 J. Acct. Res. 389 (1978); W. H. Beaver, Problems and Paradoxes in the Financial Reporting of Future Events, 5 Acct. Horizons 122 (1991); L. T. Johnson, B. P. Robbins, R. J. Swieringa, and R. L. Weil, Expected Values in Financial Reporting, 7 Acct. Horizons 77 (1993).

3 R. Price and W. A. Wallace, Probability and Materiality, CPA Journal (June 2001) at 19.

4 Consider, for example, the simple case of a coin that we know to be fair. We therefore know with 100% certainty that the probability that the coin will land heads is 50% on any given toss. Now consider a barrel of coins in a casino in Las Vegas. We know that the coins in the barrel are loaded, but we do not know how these coins are loaded. Some might be loaded to land heads all the time, others to land tails, and others to have varying probabilities of landing heads or tails. Because we have no information about how these coins are loaded, we might reason, through the application of what Keynes called the "principle of indifference," and what Bernoulli much earlier called the "principle of insufficient reason," that the probability that a coin randomly selected from this barrel will land heads is also 50%, but we are absolutely not certain that this 50% probability is correct for any repeated trial. In fact, we know that it is correct because any coin drawn will be loaded. See, e.g., D. S. Sivia, Data Analysis: A Bayesian Tutorial (1996) at 106, citing J. Bernoulli, Ars Conjectandi (1713) and J. M. Keynes, A Treatise on Probability (1921).