Chairman Bennett, Senator Boxer, and members of the Subcommittee:
I appreciate this opportunity to testify on behalf of the U.S. Securities and Exchange Commission ("Commission") on disclosure obligations of public companies presented by the Year 2000.
It has become increasingly apparent that a large percentage of the world's computer systems must be modified to reflect the imminent change in millennium. This includes not only internal systems of public companies, but also systems governing electronic interactions between those companies and other entities, both domestic and foreign, including suppliers, customers, creditors, borrowers, and financial service organizations.
The Commission previously reported to Congress on many aspects of the Year 2000 issues faced by public companies, the securities industry, and the Commission itself. As Chairman Levitt previously testified before this Subcommittee, the Commission takes this issue very seriously, and is working, internally and with industry, to address it. This testimony will discuss just one aspect of the issue, but a very important one--disclosure by public companies.
Under the federal securities laws, disclosure is one of the principal means of protecting investors. Investors need sufficient information to make informed investment decisions--whether to buy or sell, or in some cases, whether to tender shares or how to vote. Public companies are not directly regulated by the Commission, but they must file information with the Commission on a regular basis to provide the trading markets with detailed information about their business and financial condition. In the case of the Year 2000 issue, just as with any other important issue facing a company, investors need to know if there is likely to be a material financial impact on the company.
As Year 2000 began to surface as an important issue, the Commission's staff began to receive questions about the nature of public companies' disclosure obligations. Initially, the staff gave oral guidance, both to individual callers and to groups of attorneys, accountants, and business executives at conferences. As discussed below, this staff guidance emphasized the fact that disclosure of material issues was required under the Commission's current rules, and Year 2000 issues should be analyzed in the same manner as any other significant issue facing companies. This guidance was put in written form and added to the Division of Corporation Finance's Current Issues Outline, which is widely published in connection with conferences and available on the Commission's web site. On October 8, 1997, this guidance was formalized as Staff Legal Bulletin No. 5, which applies both to companies making filings with the Division of Corporation Finance and to investment companies and investment advisers filing with the Division of Investment Management. Like all Staff Legal Bulletins, it is available on the Commission's web site. In addition to written guidance, staff from the Divisions of Corporation Finance and Investment Management also emphasize the importance of considering the materiality of Year 2000 compliance when speaking before business people and securities practitioners.
Staff Legal Bulletin No. 5 emphasizes that companies should review, on an ongoing basis, the need to disclose costs, problems and uncertainties associated with Year 2000 consequences. This disclosure may be required for either of two reasons: (1) there is a specific applicable disclosure requirement in the Commission's rules; or (2) the Commission's rules require disclosure of any additional material information necessary to make the required disclosure not misleading.
With respect to the specific disclosure requirements, the most significant one is "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("MD&A"). This item requires companies to discuss their liquidity, capital resources, results of operations, and other information necessary to an understanding of a company's financial condition, changes in condition, and results of operations. As the Commission stated in its 1989 interpretive release on MD&A, the requirements are "intentionally general, reflecting the Commission's view that a flexible approach elicits more meaningful disclosure and avoids boilerplate discussions, which a more specific approach could foster." Accordingly, the requirements do not specify issues that must be addressed, but rather demand that each company perform its own analysis of the issues that need to be discussed--and quantified to the extent practicable--in order for investors to assess the company and its prospects for the future. In particular, MD&A focuses on known trends, demands, commitments, events, or uncertainties that are likely to have a material impact on the company. MD&A disclosure is required in Securities Act prospectuses, as well as in annual and quarterly reports filed by public companies.
Historically, the MD&A requirement has proved to be a very useful approach to disclosure of a variety of business or financial issues. For example, the 1989 interpretive release directs issuers' attention to the specific areas where MD&A disclosure may be appropriate, such as environmental liabilities; participation in high-yield financings, highly leveraged transactions or non-investment grade loans and investments; the receipt by thrifts and banks of federal financial assistance in connection with federally assisted acquisitions or restructurings; and preliminary merger negotiations. Many other areas likely to be the subject of MD&A disclosure have been given particular attention from the Commission or its staff in the form of targeted reviews, formal or informal interpretive advice, or enforcement action.
The Commission believes that the Year 2000 issue, like those discussed in the interpretive release, clearly must be addressed in MD&A, to the extent it is material to a particular company. Specifically, as noted in the Staff Legal Bulletin, companies must include disclosure if either the cost of addressing the issue, or the cost of a failure to address the issue in a complete and timely manner, is likely to have a material financial impact on the company. Costs to fix Year 2000 problems may be material to a company's earnings over the next several quarters because, as the Emerging Issues Task Force decided in July 1996, they must be expensed as incurred. Costs arising from a failure to correct Year 2000 problems may not be incurred until that year, but they represent for some companies today a material uncertainty that could materially affect liquidity and operating results. The requirements of MD&A call for a discussion of both types of costs, if material.
Since the MD&A approach to dealing with a variety of issues has been very successful, the staff is using the same approach to Year 2000. Companies that fail to take this requirement seriously and do not provide adequate disclosure in their Commission filings run the risk of Commission enforcement action--and, just as with the other issues discussed, the staff will be prepared to recommend instituting such action if necessary.
The current requirements are based on materiality; as a result, many companies legitimately may have no disclosure in their filings about Year 2000 issues, because they do not believe the resolution of these issues will have a material impact on the company. The Commission has considered whether specific rules are needed to require every company to make a statement about the status of its Year 2000 compliance. At this time, the Commission does not think such rules are needed. In general, the Commission's disclosure rules are premised on the philosophy that investors are best served by being provided all material information about a company, not by receiving affirmative statements that a particular issue is not significant for the company or is not a problem. The Commission believes the Year 2000 issues should be treated in the same manner as the other significant issues noted above. However, as discussed below, the Commission has directed both the Divisions of Corporation Finance and Investment Management to institute targeted reviews of Year 2000 disclosure. If these or subsequent reviews suggest that the current requirements are inadequate for Year 2000 issues, the Commission will reconsider this approach.
The Commission also has concluded that current laws and regulations are sufficient to require investment advisers and, in turn, the investment companies they advise, to make appropriate disclosure to clients and shareholders in the event operational or financial obstacles are presented by the Year 2000 problem.
Under the Investment Company Act of 1940, investment companies may not omit material information from registration statements and other public filings. Mutual funds are required to disclose the investment adviser's experience and a brief description of the services an adviser provides. In response, funds may need to disclose the effect that the Year 2000 problem would have on the adviser's ability to provide the services described in the registration statement. Disclosure about the Year 2000 problem would be necessary if it would be materially misleading to shareholders to omit the information from public filings.
In addition, the Investment Advisers Act of 1940 makes it a fraudulent, deceptive, or manipulative practice for an investment adviser to fail to disclose all material facts with respect to the financial condition of the adviser that is reasonably likely to impair the ability of the adviser to meet contractual commitments to clients. The pivotal determination for advisers in deciding whether disclosure is necessary in this area is whether the Year 2000 problem would materially impair the adviser's ability to satisfy its obligations under advisory agreements with investment companies and other clients. If so, disclosure of the problem to the fund board would be warranted and disclosure to shareholders may be warranted.
Similarly, case law also supports the requirement to make disclosure of material facts even in the absence of specific rules targeting the type of material information in question. Therefore it is necessary, under current law, for investment advisers and investment companies alike to disclose the impact of the Year 2000 problem: (1) if there is a reasonable likelihood that the adviser will not become Year 2000 compliant in time, and (2) if there is a substantial likelihood that the Year 2000 problem would affect the adviser's ability to fulfill its contractual obligation to the investment company.
Following up on Staff Legal Bulletin No. 5, the Commission has directed the staff to take additional steps to continue focusing a high level of attention on Year 2000 disclosure. For example:
If the results of the reviews suggest that disclosure in this area is not satisfactory, the Divisions will consider whether to remedy the situation by increasing targeted reviews of filings on this issue, identifying ways to further educate the filing community about their disclosure obligations, or recommending that the Commission institute specific rulemaking in this area. The staff also will consider recommending that the Commission institute enforcement actions, if warranted. At present, however, the staff believes companies are attempting in good faith to understand and comply with the disclosure requirements.
Current laws and regulations are flexible enough to cover the reporting obligations of
public companies, funds, and investment advisers regarding any material impact of Year 2000
problems. The Commission and its staff will continue to focus attention on Year 2000
disclosure to determine if any further steps are necessary. The Commission fully appreciates
the importance of investor awareness of problems associated with the Year 2000, and will
continue its efforts to educate filers and the public to assure that all required disclosure is
complete, accurate and timely.
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