Remarks Of Richard Y. Roberts Commissioner* U.S. Securities and Exchange Commission Washington, D.C. "Current Disclosure Issues" Institute of Management Accountants Annual SEC/FASB Accounting & Reporting Conference New York, NY December 14, 1994 * The views expressed herein are those of Commissioner Roberts and do not necessarily represent those of the Commission, other Commissioners or the staff. I. Introduction I appreciate the opportunity to address this 10th Annual SEC Reporting Forum with respect to some current disclosure issues which I hope are of interest to you. It is my intention today to touch upon three areas of particular interest to public companies. First, the financial reporting issue surrounding employee stock option accounting. Second, the issues surrounding a new "safe harbor" for disclosure of so-called "soft" information. Finally, I will address the heart and soul of the Commission's disclosure rules, Item 303 of Regulation S-K, which is known as the Management's Discussion and Analysis ("MD&A") section. II. Stock Option Accounting Let me start with the most controversial topic first. As all of you are aware, the Financial Accounting Standards Board ("FASB") has been struggling since 1984 with the notion of whether, and to what extent, employee stock options should be reflected on a company's income statement. After many long years of consideration and a firestorm debate, the FASB issued an exposure draft which called for a charge to earnings for the present value of employee stock options, as of grant date. This represents a significant departure from the current accounting treatment espoused in Accounting Principles Board Opinion No. 25. Under the present treatment, only the spread between a fixed option's exercise price and the current market value of the underlying common stock on the date of grant is expensed. Thus, if an option is granted with an exercise price equal to the stock's current market price, there would be no expense. Supporters of the FASB project argue that the present treatment of option awards is inconsistent with the treatment of stock awards, which are expensed. They also argue that options are compensatory and have inherent value, as of the grant date. I believe they are correct. They further argue that investors need to know the financial impact of the company's aggregate option awards. Again, I have no disagreement with such an argument, although I should point out that there do not appear to be very many supporters of the FASB project at the moment. The major concern that I have with the current situation is the solution now offered by the FASB. They apparently seek a formula to value stock options on grant date, requiring footnote disclosure during a phase-in period, and culminating in a charge to earnings. The first, and largest problem, with this approach is determining how to value stock options. Should they be valued at grant date, vesting date, or exercise date? The later in the process, the greater the certainty of the valuation, but the less accurate the picture that something of value has been given to employees at date of grant. There has been no consensus on the timing or the formula. While the Black-Scholes and binomial pricing models are the most popular formulas for valuing exchange- traded options, they are less effective in valuing options that are not transferable. The Commission went through a similar, difficult exercise as part of its executive compensation disclosure project in 1992. In the end, we decided to provide flexibility to companies to use any model they wanted, or a table that disclosed the value of options at assumed rates of market price increase. I believe such an approach was a sound choice, and this concept has worked well as a disclosure approach. However, I am not inclined to believe that this approach would work well as a basis for a charge to earnings. A new accounting standard for employee stock options imposing a charge to earnings could potentially have a substantial adverse impact on small, fledgling companies. Therefore, any standard imposing such a charge should be very carefully drawn, or it could have a negative impact on our capital formation system to the detriment of both companies and investors. The problem is that it appears that no one can agree on a formula, and I am not sure that a good one exists for this purpose at the present. Given that most everyone can agree that there is a need for greater financial information in this area, there has been a growing call for a decoupling of the disclosure and charge initiatives. Investors appear to want more information about aggregate employee stock option expenses; therefore, it seems appropriate for the FASB to mandate enhanced footnote disclosure to the financial statements. This has been suggested by many groups of companies, practitioners, and institutional investors. There seems to be no reason to wait until the quest for the penultimate charging formula is complete. I am not even sure if the intense effort underway into seeking such a formula is worth the furor that has resulted. It seems to me that a formula derived for disclosure purposes would prove an interesting test case in measuring the utility of this information. The phrase "the enemy of the good is the perfect" appears to be especially relevant here. Footnote disclosure appears to me to be a good objective to accomplish. Why delay or ignore the good for what in all likelihood will be a futile search for a perfect solution? III. Safe Harbor for Soft Information Another debate that has been ongoing for over a decade concerns the use of so-called "soft" information. This includes less certain information known to an issuer, such as projections and other forward-looking information. Until the early 1970's, the use of soft information in a disclosure document was prohibited because it was thought that such information was inherently unreliable and therefore misleading. Over the years, there grew a greater appreciation for the use of soft information by sophisticated investors. As a result, the prohibition was lifted and disclosure of soft information was permitted, but not required generally. The view prevailed that disclosure of such information would provide investors with the ability to see a company through the eyes of management because management often made strategic decisions based on internal projections. Companies were reluctant to share their projections primarily out of fear that they would be sued by angry shareholders if the projections turned out to be too optimistic. The Commission responded with two safe harbor rules for projections, Securities Act Rule 175 and Exchange Act Rule 3b-6. These Rules provide protection from lawsuits to the extent that the projections were made in good faith and upon reasonable grounds. Unfortunately, it appears that over the years these safe harbors have not provided sufficient protection for many companies, and there remains a continued reluctance to disclose such information other than selectively. The practical effect of this evolution has been that companies continue to provide soft information to analysts and large investors who request it, but not to retail investors who must base their investment decision upon the information contained in the prospectus or in periodic reports. The Commission has been concerned about this disparity of information and is considering methods to elicit more soft information for the benefit of all investors. One obvious solution would be to provide a stronger safe harbor rule so that companies would be more comfortable with the prospect of disclosing soft information. However, it is my opinion that the Commission also should be confident that any such expanded safe harbor does not protect selective or misleading disclosure. I anticipate that these two sometimes conflicting objectives will make it difficult for the Commission to develop an appropriate stronger safe harbor. On October 13th, the Commission issued a concept release concerning this topic, and we need your thoughts on this subject. The deadline for comments is January 11th, and I do encourage the members of this audience to review the release carefully and to provide the Commission with the benefit of your suggestions. Further, the Commission expects to hold a public hearing on this project on February 13th. IV. Derivatives Disclosure My final topic is perhaps one of the greatest interest to the members of this audience. As the use of derivatives financial products has increased, the concern of U.S. and international financial regulators has increased as well. Hardly a day goes by without another development pertaining to the topic of derivatives. Earlier in the year, the news was filled with stories of companies declaring multi-million dollar charges against earnings as a result of losses incurred in various derivatives activities. In September, the impact of derivatives activities on the part of some money market mutual funds came to the fore when an institutional money market fund "broke a dollar" due to losses incurred as a result of certain aggressive derivatives activities. In October, witnesses representing a Texas college, a Maryland county, and an Indian tribe described to Congress their accounts as to how various imprudent investments in derivative financial instruments resulted in losses for their respective organizations. In these early days of November, the news is of lawsuits on the part of dissatisfied derivatives institutional investors. And thus far in December, the news has been centered around the aggressive investment philosophy and ensuing bankruptcy of Orange County which utilized derivatives extensively in designing its investment portfolio. Now, other than with respect to money market funds, I am inclined to believe that, as a general proposition, the marketplace and not the Commission should determine the success or failure of the various potential investment products available, even if those products are highly volatile. But the experiences I recited should make it clear how important accurate and adequate disclosure of a company's derivatives activities is to the marketplace. Potential investors need to know what the derivatives activities of a company are and the nature and level of risks involved in order to make an informed investment decision. The first disclosure-related regulatory development of interest that I intend to mention is the October issuance by the Financial Accounting Standards Board ("FASB") of Statement No. 119, entitled "Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments" ("Statement 119"). Statement 119 requires improved disclosures about derivative financial instruments, which would include futures, forwards, swaps, options contracts, or other financial instruments with similar characteristics. Statement 119 amends FASB Statement 105 to require the disaggregation of information about financial instruments with off- balance sheet risk of accounting loss by the class of the financial instrument, business activity, risk, or any other category consistent with the entity's management of those instruments. For derivative financial instruments not subject to FASB Statement 105 because they do not result in off-balance-sheet risk of accounting loss, Statement 119 requires disclosure about the amounts, nature, and terms of the instrument, including their credit and market risk and cash requirements. Entities also are encouraged, but not required, to disclose quantitative information about interest rate or other market risks of their derivative financial instruments as well as certain other assets and liabilities. I must admit that I was disappointed with this part of the statement, as I believe that such quantitative information should be required rather than just be voluntary. Please be aware that the Commission's staff is suggesting disclosure of such quantitative information as a part of the filing review comment process for financial institutions and other companies heavily involved in derivatives activities as end-users. Of course, Item 303 requires disclosure of known uncertainties that are reasonably likely to result in material effects on a company's liquidity or results of operations as well as on material trends in a company's capital resources. In the context of risk management products and strategies, the direction and magnitude of future price movements represent an uncertainty which management of a company should evaluate. Management should evaluate whether it is unlikely that future market price movements could occur which could have a material impact on the financial condition or results of operations of the company. I understand that there has been some improvement recently in disclosure by companies in Commission filings of their derivatives activities, and further improvement should result from the FASB's issuance of Statement 119. However, the staff of the Commission is inclined to believe that further disclosure guidance is necessary to ensure consistent and comprehensive disclosures to enable investors to better understand the business purpose and effects of a company's derivatives activities. Thus, the staff is currently considering recommending that the Commission issue an interpretive release that, among other things, would discuss the requirements of MD&A as they relate to a company's exposure to market risks and to related policies and procedures for managing those risks. In the interim, companies should take care to consider what disclosures should be made concerning their derivatives activities to comply with the MD&A requirements. I expect that this will continue to be an area where the staff of the Commission involved in reviewing filings will be focusing quite a bit of attention. V. Conclusion There are many other accounting and financial reporting initiatives ongoing at the Commission these days, but time does not permit me to mention them. I have chosen two of the more controversial subjects that have been with us for the past decade or so, and I fear may remain with us for another decade as well. Further, I felt compelled to review the MD&A disclosure requirements in light of one developing area of concern -- derivatives activities. If you are not sensitive to potential pitfalls in this area, you may be inviting unwelcome scrutiny from the Commission or from disgruntled investors. ###