I am pleased to respond to the Chairmanís request for guidance as to specific steps that might be taken to facilitate an adaptation of our 1930s financial reporting system to the needs of the 21st Century. In particular, Iíd like to address steps directed to an evolution of financial reporting from the present "periodic" (i.e., annual and quarterly) system of transmission to a "real-time" transmission system.
At present, there appear to be two regulatory impediments to such an evolution in financial reporting. The first is regulatory reluctance to the acceptance of Internet transmission as full-fledged "public" disclosure under the federal securities laws. The second (earlier identified by the Chairman) involves the likelihood of concern about the liability environment by those who would seek to report financial information on a more frequent basis than once a quarter.
Let me address first the regulatory reluctance to accept Internet transmission as public disclosure and then the liability concern.
Internet Transmission as Public Disclosure
Like the rest of us, regulators are working hard to come to grips with the applicability of old rules to new information dissemination technologies. The SEC in particular is struggling to put in place a regulatory system that takes advantage of new technologies but, at the same time, continues to ensure that all investors share access to available information.
While the SEC has yet to speak precisely to the issue of real-time financial reporting, one consequence of its struggle with new technologies is the reluctance -- perhaps understandable in the contexts in which the issue has arisen -- to accept the electronic transmission of financial information as fulfilling a companyís public disclosure obligations under the securities laws. Thus, the SECís interpretive release on "Use of Electronic Media" provides:
Various commentators have suggested that additional regulatory changes may be warranted in the use of electronic media for delivery purposes. [An earlier release] stated that issuers and market intermediaries with delivery obligations would need to continue to make information available in paper form until such time as electronic media became more universally accessible and accepted. Some believe that this time has come and, therefore, that we should shift from the present delivery model to an "access-equals-delivery" model. Under the latter model, investors would be assumed to have access to the Internet, thereby allowing delivery to be accomplished solely by an issuer posting a document on the issuer's or a third-party's web site.
We believe that the time for an "access-equals-delivery" model has not arrived yet. Internet access is more prevalent than in 1995, but many people in this country still do not enjoy the benefits of ready access to electronic media. Moreover, even investors who are online are unlikely to rely on the Internet as their sole means of obtaining information from issuers or intermediaries with delivery obligations. Some investors decline electronic delivery because they do not wish to review a large document on their computer screens. Others decline electronic delivery because of the time that it takes to download and print a document.
In substance, the SEC -- while acknowledging the usefulness of Internet transmission as a complement to traditional transmission vehicles -- declines to accept Internet transmission in isolation as a substitute for more traditional forms of disclosure.
The rules of the National Association of Securities Dealers and the New York Stock Exchange, as approved by the SEC, in substance adopt the same approach. In a section dealing with "Use of the Internet in the Disclosure of Material Information," the NASD rules provide:
While Nasdaq requires that its listed issuers disseminate material press releases over one of the major news wires, Nasdaq recognizes the increased utilization of the Internet as a vehicle for additional news dissemination. The Internet is a valuable disclosure resource that can enhance the orderly dissemination of material information for all shareholders and market participants.
Issuers can and should provide shareholders direct access to corporate disclosures via their Internet home pages and web sites.
To ensure a level playing field for all investors in Nasdaq companies, however, this policy on disclosure of corporate information requires that the use of the Internet to disseminate material press releases is appropriate provided the information is not made available over the Internet before the same information is transmitted to, and received by, the traditional news vendor services. Issuers must still notify Nasdaq at least ten minutes prior to the release of any information that would reasonably be expected to affect the value of securities or influence investorsí decisions, as indicated in this policy.
Similarly, the rules of the New York Stock Exchange provide, "Any release of information that could reasonably be expected to have an impact on the market for a companyís securities should be given to the wire services and the press." Here, too, the regulators decline to accept as adequate public disclosure Internet transmission in isolation.
As suggested a moment ago, regulatory reluctance to accept Internet transmission as fulfilling a companyís public disclosure obligations in the context of these regulations may be understandable. It is a legitimate regulatory concern that investors, unaware of Internet postings or not possessing the means of access, may fail to receive new information transmitted only electronically that is relevant to their investment decisions.
However, at the core of an evolution of financial reporting to a real-time system would be the regular electronic transmission of financial information with a frequency that would likely make any form of transmission other than electronic transmission infeasible. Therefore, a first step in facilitating such an evolution would be acceptance of regularly-reported financial information exclusively on the Internet as adequate public disclosure under the securities laws.
The Legal Liability Environment
The Chairman was correct to draw attention to the litigation environment as a potential impediment to a real-time financial reporting system. Today, each time a company issues a Form 10-Q or 10-K, it runs the risk that even a seemingly inconsequential inaccuracy will trigger potentially debilitating shareholder litigation. It is highly questionable whether any company would embrace the concept of real-time financial reporting when the increased frequency of financial reporting could potentially increase the risk of litigation many times over.
It is therefore important to ask whether a new system of financial reporting may justify complementary innovation in our system of legal liability. To address one critical point at the outset, this is not to suggest that free rein be given to unscrupulous individuals to deliberately misreport financial results over the Internet. Rather, the need to consider the liability environment is in recognition of the importance of accommodating two separate interests. One involves the preservation of integrity in financial reporting. The other involves the recognition that the absence of innovation in liability systems may operate as a substantial impediment to adoption of an updated financial reporting system.
The critical point here, however, is that use of the Internet to disseminate financial information may result in the availability of risk management devices that simultaneously accommodate both of these objectives. For example, use of the Internet as a vehicle to transmit financial information would potentially allow senders and recipients to interact -- thereby providing to both the opportunity to allocate between themselves the risks inherent in real-time financial information transmission. At the same time (or as an alternative), senders might make access to information conditioned upon the recipientís electronically-transmitted acknowledgment of an understanding of its limitations. One could even envision a "safe harbor" for companies whose financial reporting system had received appropriate assurance of reliability from their outside auditor.
These thoughts are not intended to be definitive, but merely to recognize the potential availability of innovative liability systems. One point, though, should be paramount. Evolution of financial reporting beyond the system of the 1930s is too important to allow unaddressed concerns regarding legal liability to constitute a show-stopping impediment.
The Next Step
What logically follows is the usefulness of additional examination of these issues and, potentially, the formulation of discrete legislation. At root, such legislation -- for the moment letís call it the "Securities and Financial Reporting Act of 2001" -- would seek to accomplish two objectives. First, it would provide a framework in which the Internet transmission of regularly-reported financial information would constitute full-fledged public disclosure under the federal securities laws. Second, it would make available a system of legal liability applicable to the Internet transmission of financial data such that investors would be adequately protected, while companies would not be unduly discouraged from accepting the risks inherent in increased frequency in financial reporting.
The dislocations resulting from continued reliance on a 1930s-era system of financial reporting to serve 21st Century needs are exceedingly unfortunate. They include the recent upsurge in reported instances of accounting irregularities, legitimate concerns about earnings management, operational inefficiencies, significant volatility in securities markets, and an increase in the cost of capital. The subcommittee has correctly acknowledged that these problems warrant attention. The subcommittee is to be commended for its willingness to embrace the task.
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