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Corporate Disclosure From An Investors Perspective 2006


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Corporate Disclosure: The Investors’ Perspective.Reed R. Kathrein
San Francisco, California
2006 Speech to Executive Enterprises Institute

Published in: Education, Business
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Corporate Disclosure From An Investors Perspective 2006

  1. 1. Corporate Disclosure: The Investors’ Perspective Reed R. Kathrein San Francisco, California 2006 Speech to Executive Enterprises Institute
  2. 2. The Purpose of Corporate Communication <ul><li>To convey information to different audiences and constituencies in a manner that advances the charter, goals and purposes of the corporation. </li></ul><ul><li>Shareholders / Investors </li></ul><ul><li>Lenders </li></ul><ul><li>Customers </li></ul><ul><li>Employees </li></ul><ul><li>Communities, and </li></ul><ul><li>Government </li></ul>
  3. 3. The Purpose of Corporate Disclosure <ul><li>We all communicate. We do not all disclose. </li></ul><ul><li>The Constituents of Disclosure </li></ul><ul><ul><li>Directors </li></ul></ul><ul><ul><li>Investors </li></ul></ul><ul><ul><li>Employees </li></ul></ul>
  4. 4. The Impact of Bad Disclosure <ul><li>Securities Fraud Lawsuits and Class Actions </li></ul><ul><li>Derivative Actions </li></ul>
  5. 5. The Impact of the PSLRA <ul><li>What is needed to sue? </li></ul><ul><li>Who sues and why? </li></ul><ul><ul><li>Institutional investors </li></ul></ul><ul><ul><li>Individual investors </li></ul></ul><ul><li>Who is liable and why? </li></ul><ul><ul><li>Joint and several liability versus comparable fault </li></ul></ul><ul><li>How are damages determined? </li></ul>
  6. 6. Recent Trends In Filings <ul><li>Filings by type of lawsuit: source </li></ul>
  7. 7. Recent Trends in Filings <ul><li>The number of private securities litigation cases filed in the United States fell to the lowest level in nine years in 2005, but the value of settlements more than doubled . (Price Waterhouse Coopers, 2005 Securities Litigation Study, May, 2006) </li></ul><ul><li>The total 168 private securities cases reported in 2005 represent a 17% decline from the 203 cases filed in 2004. The 2005 figures is also slightly below the 10-year average of 188 cases per year. Id. </li></ul><ul><li>In 2005, accounting cases represented 46% of all private securities class actions filed, marking the lowest percentage since 1996. Id. </li></ul><ul><li>The electronics, high-technology and software sectors topped the list of industries being sued in private securities class actions, representing 29% of all such cases filed. Id. </li></ul>
  8. 8. Types of Cases Filed <ul><li>Accounting (Approximately 50%) </li></ul><ul><li>Underlying Accounting Principals of GAAP: </li></ul><ul><ul><li>Software revenue recognition (39% in 2005) </li></ul></ul><ul><ul><ul><li>Improper accounting of sales returns and “rights of returns”, </li></ul></ul></ul><ul><ul><li>Overstatement of Assets (27%) </li></ul></ul><ul><ul><ul><li>Failure to impair of long-lived assets in a timely and adequate manner, </li></ul></ul></ul><ul><ul><ul><li>Overstatements of receivables (A/R and Loans), </li></ul></ul></ul><ul><ul><ul><li>Overstatements of inventories, </li></ul></ul></ul><ul><ul><ul><li>overstatement of capitalized costs, </li></ul></ul></ul><ul><ul><li>Understatements of liabilities and expenses (23%), </li></ul></ul><ul><ul><ul><li>Understatements of allowances for doubtful accounts, </li></ul></ul></ul><ul><ul><ul><li>Understatement of costs of sales, </li></ul></ul></ul><ul><ul><ul><li>Understatement (and under-recognition) of expenses </li></ul></ul></ul><ul><ul><li>Internal controls were materially weak (55% in 2005) </li></ul></ul><ul><ul><li>Improper Estimates 25% </li></ul></ul><ul><ul><li>Other (28%) </li></ul></ul><ul><ul><ul><li>Improper accounting for restructuring charges and reserves </li></ul></ul></ul>
  9. 9. Types of Companies Sued (PWC 2005 Study)
  10. 10. Restatements =/= Lawsuit <ul><li>PWC’s 2004 Study found a non-existent relationship between restatements and securities fraud class actions. </li></ul><ul><li>In 2005 there were, according to Glass Lewis 1,295 restatements. </li></ul><ul><li>PWC counted only 37 accounting cases involving restated earnings. </li></ul><ul><li>Reasons: </li></ul><ul><ul><li>No stock drop </li></ul></ul><ul><ul><li>May relate to benign reason like change in accounting principles </li></ul></ul>
  11. 11. Types of Cases - Disclosure <ul><li>“ Product Efficacy” cases are often filed against pharmaceutical and healthcare companies (10% in 2005). </li></ul><ul><li>In the Food Industry, Royal Ahold settled in November 2005 for $1.1 billion for “vendor allowance” fraud involving. (5 th largest settlement). </li></ul>
  12. 12. Recent Cases
  13. 13. SEC Enforcement Activity <ul><li>SEC Financial Fraud and Reporting Violations (CFTC Report) </li></ul>
  14. 14. Criminal Prosecutions <ul><li>Prosecutions 2000 -2004 (U.S. Attorneys” Annual Statistical Report) </li></ul>
  15. 15. Criminal Prosecutions <ul><li>Between July 2002 and May 2004 prosecutors obtained 500 convictions or guilty pleas on corporate fraud charges against 900 defendants, 60 of whom were corporate presidents of CEOs. </li></ul><ul><li>CFTF Report </li></ul>
  16. 16. Criminal Trends <ul><li>“ In 1989,former junk bond king Michael Milken was indicted on RICO violations, stock manipulation and insider trading. After Milken pleaded guilty to securities , mail and tax fraud and market manipulation, he was sentenced to 10 years in prison, with anticipated actual service of 40 months. Due to cooperation and good behavior, Milken emerged from prison after serving less than 2 years, with a personal fortune in place.” </li></ul><ul><li>Trends in Corporate Fraud Enforcement: A Calm During the Storm? By Joseph Savage and Christine Sgarlata Chung, October 2005 edition of the LAW JOURNAL NEWSLETTERS - BUSINESS CRIMES BULLETIN </li></ul>
  17. 17. Criminal Trends <ul><li>“ In 2005, former WorldCom, Inc. CEO Bernard Ebbers was indicted for conspiracy, securities fraud and filing false statements with the Securities and Exchange Commission (SEC) after WorldCom announced that it had overstated earnings. After a New York jury found Ebbers guilty, Judge Barbara Jones sentenced 63-year-old- Ebbers — a first-time violator — to 25 years in prison, of which he must serve at least 21. Judge Jones commented that, while she recognized that this was “likely to be a life sentence for Mr. Ebbers,” anything else “would not reflect the seriousness of the crime.” Separately, Ebbers agreed to pay $5.5 million in cash and to hand over his home and other assets worth as much as $40 million to resolve claims filed by WorldCom shareholders — a settlement commentators estimate will chew up most of Ebbers’ estate.” </li></ul><ul><li>Trends in Corporate Fraud Enforcement: A Calm During the Storm? By Joseph Savage and Christine Sgarlata Chung, October 2005 edition of the LAW JOURNAL NEWSLETTERS - BUSINESS CRIMES BULLETIN. </li></ul>
  18. 18. Criminal Trends: Outside Directors <ul><li>“ Outside directors also remain beleaguered. Frank Walsh, a former outside director for Tyco International, pleaded guilty to securities fraud charges based on his receipt of an undisclosed $20 million payment from Tyco for helping to broker an acquisition. Walsh avoided prison by agreeing to repay the fee plus a $2.5 million fine and a lifetime bar from serving as a director or officer. The private actions against former outside directors of Enron and WorldCom — and the millions directors paid to settle those claims — also reflect current enforcement trends .” </li></ul><ul><li>Trends in Corporate Fraud Enforcement: A Calm During the Storm? By Joseph Savage and Christine Sgarlata Chung, October 2005 edition of the LAW JOURNAL NEWSLETTERS - BUSINESS CRIMES BULLETIN. </li></ul>
  19. 19. Trends in Outside Directors Paying <ul><li>A group of former Enron Corp. directors has agreed to a $168 million settlement of their portion of a class-action securities lawsuit. Insurance will pick up most of the cost, but under the terms of the deal, the former Enron directors will personally pay $13 million. </li></ul><ul><li>The announcement of the deal, made by the University of California, lead plaintiff in the Enron class-action case, came on the same day that the lead plaintiff in the WorldCom class-action suit formally announced a $54 million settlement covering 10 former WorldCom directors. WorldCom directors will pay $18 million from their own pockets. </li></ul><ul><li>The twin settlements highlight a new phase in the backlash against corporate wrongdoing in which board members are being pushed to bear much higher personal costs for failures in supervision. Liability for official actions is generally covered by insurance: It was nearly unheard of for directors to pay personally, particularly in the amounts announced this week. </li></ul><ul><li>Source: Former Directors Agree To Settle Class Actions Enron, WorldCom Officials to Pay Out of Pocket , by Ben White, Washington Post Staff Writer Saturday, January 8, 2005 </li></ul>
  20. 20. Settlement Trends <ul><li>Since enactment of the PSLRA total settlements have amounted to more than $37 billion. (Price Waterhouse Coopers, 2005 Securities Litigation Study, May, 2006) </li></ul><ul><li>More than 155 cases settled for more than $20 million. </li></ul><ul><li>More than 65 settled for more than $50 million. </li></ul><ul><li>More than 40 settled for more than $100 million. </li></ul><ul><li>The average value of settlements rose 156% to $71.1 million in 2005, up from $27.8 million in 2004—excluding settlements related to Enron Corp. and WorldCom Inc. The average settlement value of accounting cases in 2005 was $94 million, excluding the cases of Enron and WorldCom, 178% higher than the $33.8 million average value in 2004. Fifty-five percent of all accounting cases filed asserted that companies' internal controls were materially weak and contributed to financial fraud, the study found. </li></ul><ul><li>In 2005, 29 cases settled for over $20 million and 20 of those cases settled for over $60 million, 11 of which were huge settlements of over $100 million, according to PricewaterhouseCoopers. </li></ul>
  21. 21. What Needs to Be Disclosed? <ul><li>Often referred to as the &quot;truth in securities&quot; law, the Securities Act of 1933 has two basic objectives: </li></ul><ul><ul><li>require that investors receive financial and other significant information concerning securities being offered for public sale; and </li></ul></ul><ul><ul><li>prohibit deceit, misrepresentations, and other fraud in the sale of securities. </li></ul></ul><ul><li>SECTION 11. LIABILITY. CIVIL LIABILITIES ON ACCOUNT OF FALSE REGISTRATION STATEMENT </li></ul><ul><ul><li>“ (a) In case any part of the registration statement… contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading , any person acquiring such security (unless it is proved that at the time of such acquisition he knew of such untruth or omission) may… sue:” </li></ul></ul><ul><li>SECTION 12 LIABILITY. CIVIL LIABILITIES ARISING IN CONNECTION WITH PROSPECTUSES AND COMMUNICATIONS </li></ul><ul><ul><li>“ (a) In General. Any person who:(1) Offers or sells a security in violation of Section 5, or(2) Offers or sells a security (whether or not exempted by the provisions of Section 3, other than paragraph (2) of subsection (a) thereof), by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission, shall be liable, subject to subsection (b), to the person purchasing such security from him, who may sue ...” </li></ul></ul>
  22. 22. What Needs To Be Disclosed? <ul><li>Securities Exchange Act of 1934 created the Securities and Exchange Commission. The Act empowers the SEC with broad authority over all aspects of the securities industry. </li></ul><ul><ul><li>The Act identifies and prohibits certain types of conduct in the markets and provides the Commission with disciplinary powers over regulated entities and persons associated with them. </li></ul></ul><ul><ul><li>The Act also empowers the SEC to require periodic reporting of information by companies with publicly traded securities. </li></ul></ul><ul><ul><li>SECTION 10 LIABILITY. REGULATION OF THE USE OF MANIPULATIVEAND DECEPTIVE DEVICES. SEC. 10. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange: (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. </li></ul></ul><ul><ul><li>Rule 10b-5 -- Employment of Manipulative and Deceptive Devices It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, </li></ul></ul><ul><ul><ul><li>(a) To employ any device, scheme, or artifice to defraud, </li></ul></ul></ul><ul><ul><ul><li>(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or </li></ul></ul></ul><ul><ul><ul><li>(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, </li></ul></ul></ul><ul><ul><li>in connection with the purchase or sale of any security. </li></ul></ul>
  23. 23. Materiality <ul><li>Quantitative Approach Rejected </li></ul><ul><li>NO “Rules of Thumb” </li></ul><ul><li>[M]agnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment. </li></ul><ul><li>FASB Concepts Statement No. 2, 125. </li></ul>
  24. 24. Materiality <ul><li>Evaluation of materiality requires a registrant and its auditor to consider all the relevant circumstances, and the staff believes that there are numerous circumstances in which misstatements below 5% could well be material…. </li></ul><ul><li>SEC Accounting Staff Bulletin 99 </li></ul>
  25. 25. Materiality <ul><li>SEC Staff Accounting Bulletin 99: </li></ul><ul><li>A matter is &quot;material&quot; if there is a substantial likelihood that a reasonable person would consider it important. </li></ul>
  26. 26. Materiality <ul><li>Statement of Financial Accounting Concepts No. 2, the FASB </li></ul><ul><li>The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item. </li></ul>
  27. 27. Materiality <ul><li>TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). </li></ul><ul><li>A fact is material if there is – a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the &quot;total mix&quot; of information made available. </li></ul>
  28. 28. Materiality <ul><li>Among the considerations identified in SEC Bulletin 99 that may well render material a quantitatively small misstatement of a financial statement item are – </li></ul><ul><li>whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate </li></ul><ul><li>whether the misstatement masks a change in earnings or other trends </li></ul><ul><li>whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise </li></ul><ul><li>whether the misstatement changes a loss into income or vice versa </li></ul><ul><li>whether the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability </li></ul><ul><li>whether the misstatement affects the registrant's compliance with regulatory requirements </li></ul><ul><li>whether the misstatement affects the registrant's compliance with loan covenants or other contractual requirements </li></ul><ul><li>whether the misstatement has the effect of increasing management's compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation </li></ul><ul><li>whether the misstatement involves concealment of an unlawful transaction. </li></ul>
  29. 29. Materiality <ul><li>Other Factors: </li></ul><ul><li>The demonstrated volatility of the price of a registrant's securities in response to certain types of disclosures may provide guidance as to whether investors regard quantitatively small misstatements as material. </li></ul><ul><li>When, however, management or the independent auditor expects (based, for example, on a pattern of market performance) that a known misstatement may result in a significant positive or negative market reaction, that expected reaction should be taken into account when considering whether a misstatement is material. </li></ul><ul><li>If management does not expect a significant market reaction, a misstatement still may be material. </li></ul>
  30. 30. Materiality <ul><li>Little Adjustments </li></ul><ul><li>Small intentional misstatements in financial statements, for example those pursuant to actions to &quot;manage&quot; earnings, may be material. </li></ul><ul><li>While the intent of management does not render a misstatement material, it may provide significant evidence of materiality. </li></ul><ul><li>Investors generally would regard as significant a management practice to over- or under-state earnings up to an amount just short of a percentage threshold in order to &quot;manage&quot; earnings. </li></ul><ul><li>Investors presumably also would regard as significant an accounting practice that, in essence, rendered all earnings figures subject to a management-directed margin of misstatement. </li></ul><ul><li>Doe not include insignificant errors and omissions that may occur in systems and recurring processes in the normal course of business. </li></ul>
  31. 31. Motives and Opportunities <ul><li>Making Earnings Estimates </li></ul><ul><li>Insider Trading </li></ul><ul><li>Stock Options </li></ul><ul><li>Compensation </li></ul><ul><li>Mergers </li></ul><ul><li>Raising Cash </li></ul><ul><li>Product Sales </li></ul>
  32. 32. Bending The Rules <ul><li>Accounting Gimmickry </li></ul><ul><ul><li>Inflating Earnings and Revenue </li></ul></ul><ul><ul><li>Recognizing Revenues </li></ul></ul><ul><ul><li>Managing Revenues </li></ul></ul><ul><ul><li>Margins </li></ul></ul><ul><li>Side Letters </li></ul><ul><li>Channel Stuffing </li></ul><ul><li>New Products </li></ul>
  33. 33. Do’s and Don’ts <ul><li>Do Be Candid -- Tell The Truth </li></ul><ul><li>Do Correct and Update </li></ul><ul><li>Do Tell Everyone </li></ul>
  34. 34. Dos and Don’ts <ul><li>Don’t Ignore Problems </li></ul><ul><li>Don’t Use Boilerplate </li></ul><ul><li>Don’t Talk the Street Down </li></ul><ul><li>Don’t Say No Comment </li></ul>
  35. 35. Technical (Legalistic) versus Honest Disclosure <ul><li>Safe Harbor for Forward Looking Statements </li></ul><ul><li>Protects statements “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward looking statement” </li></ul><ul><li>Avoid: </li></ul><ul><ul><li>legalistic or overly complex presentations that make the substance of the disclosure difficult to understand; </li></ul></ul><ul><ul><li>vague &quot;boilerplate&quot; explanations that are imprecise and readily subject to different interpretations; </li></ul></ul><ul><ul><li>complex information copied directly from legal documents without any clear and concise explanation of the provision(s); and </li></ul></ul><ul><ul><li>repetitive disclosure that does not enhance the quality of the information. “ </li></ul></ul>
  36. 36. Technical (Legalistic) versus Honest Disclosure <ul><li>Sarbanes-Oxley Compliance </li></ul><ul><li>Certifications may be a basis for liability </li></ul>
  37. 37. Real Life Situations <ul><li>Merger Negotiations </li></ul><ul><li>Missing Street Estimates and Other Surprises </li></ul><ul><li>Product Problems </li></ul><ul><li>Regulatory Approvals </li></ul>
  38. 38. Moral and Ethical Approaches <ul><li>Simply complying with the law or following widespread business practices is not enough. </li></ul><ul><li>Reputation is everything. Once destroyed, it takes a long time to rebuild. </li></ul><ul><li>You build reputation by fidelity to higher principals.... principals or core values of the community.... values such as respect for others and the pursuit of excellence.... or fairness and honesty... or courage. </li></ul>
  39. 39. Moral Principals <ul><li>The Golden Rule....Do unto others... </li></ul><ul><li>Rule of inner guide.....Would you be embarrassed if when you woke up in the morning you saw it published on the front page of the Wall Street Journal, the New York Times or your Local News? </li></ul>
  40. 40. Ethical Guidelines <ul><li>Well-Established Norms </li></ul><ul><ul><li>Respect Others </li></ul></ul><ul><ul><li>Tell the Truth </li></ul></ul><ul><ul><li>Be Fair </li></ul></ul><ul><ul><li>Keep Your Promises </li></ul></ul><ul><ul><li>Do Your Share </li></ul></ul>