Remarks Of Richard Y. Roberts Commissioner* U.S. Securities and Exchange Commission Washington, D.C. "SEC Corporate Disclosure Issues Regarding Derivatives" The New York Society of Security Analysts Conference on Current Issues in the Derivatives Markets New York, New York May 17, 1995 ____________________ */ 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 Derivatives have been responsible for major losses in the 1990's, and some have jumped to the conclusion that these are dangerous instruments that should be either avoided, regulated further or perhaps banned altogether. While I believe more care can be taken by both those who sell and those who purchase derivative products, I believe that these products can serve a useful function in the marketplace. When used properly, derivatives can enable corporations, financial institutions, and institutional investors to manage more effectively the risks of their business exposures or financial assets. Potentially, derivatives can be utilized to lower the funding costs of corporations and local governments. OTC derivative products, which can be customized to match particular portfolios or investment strategies, may enable businesses to control ancillary risks in their commercial and investment transactions. Indeed, when properly used, such products can enhance an institution's ability to undertake a variety of investments, expand credit availability, and help absorb or dampen market shocks. II. RECENT DEVELOPMENTS As we all know, during last year, a number of public companies sustained multi million dollar losses as a result of investments in derivatives. Unfortunately, corporations were not the only end users of derivatives to suffer losses. Mutual funds, pension funds, colleges, municipalities, and even an Indian tribe have been burned by similar investments. Not only was the magnitude of many of these losses staggering, but the consequences were often tragic. For too long derivatives have been viewed as simply another type of investment. The reality, which only became apparent as interest rates declined, is that derivative products can be very complex, are sometimes misunderstood by even the most sophisticated, and can be extremely volatile. Derivatives are somewhat distinctive for both the magnitude and the swiftness with which losses can be incurred. III. DISCLOSURE NOT REGULATION Problems notwithstanding, I do not propose that the SEC prohibit or limit derivatives activities, at least with respect to public companies. I understand that certain states may be of a different view so far as some local government funds are concerned, but in the past I have found that most state regulatory or statutory investment restrictions become antiquated very quickly and are easily susceptible to circumvention. While there may be reason to question whether the directors, officers and senior management of corporate end-users of OTC derivative products fully understand the risks inherent in these instruments, these products can have enormous benefit, if used judiciously. Thus, as a general proposition, I am inclined to believe that the marketplace, and not the Commission, should determine the extent to which public companies avail themselves of derivatives. Of course, one exception to this proposition would be with respect to money market mutual funds where some restrictions on derivatives activities are probably necessary, and I suppose that, to some extent, all mutual funds should be treated a little differently than publicly held companies so far as the disclosure requirements pertaining to derivatives activities are concerned. For the marketplace to function efficiently, however, there must be full, fair and timely disclosure by companies of the extent and character of their derivatives activities. Given proper disclosure, investors can decide whether they want to assume the nature, level and extent of risk that management has assumed and can communicate their acceptance or rejection of such policies to management. The Commission should try to ensure that investors are not unwittingly exposed to such risks. While much of the Commission attention regarding derivatives has focused on dealers subject to the Commission's financial responsibility and oversight rules and on mutual funds subject to the Commission's disclosure and substantive regulation, let me assure you that the Commission has also devoted extensive resources to corporate end-users. After some background, it may be helpful to talk about what the Commission has been up to in this area. IV. DISCLOSURE GENERALLY Under current SEC rules, a registrant's disclosure obligations with respect to derivatives activities are largely dictated by two sets of rules. First, financial statements are governed by Regulation S-X and generally accepted accounting principles ("GAAP"). Second, narrative disclosures contained in periodic reports and registration statements are governed by Regulation S-K. Of course, a major component of the latter disclosure is the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") disclosure requirements contained in Item 303 of Regulation S-K. V. FASB STATEMENT 119 One development in this area last year was the issuance by the FASB of Statement 119. I know that another speaker has previously discussed FASB Statement No. 119, entitled "Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments" ("Statement 119"), but I do wish to add my perspective on this document. First, I applaud the FASB's efforts in issuing Statement 119. Statement 119 is only one part of a long term project undertaken by the FASB to address accounting issues raised by the use of varied financial instruments. I believe that Statement 119 will improve substantially the quality of derivatives disclosure by companies. However, one shortcoming of Statement 119 is that it does not apply to commodity contracts or structured notes. Another problem, in my view, with Statement 119 is that it encourages, but does not require, end-users to disclose quantitative information about their derivatives positions. I believe that disclosure of such quantitative information should be required. I also should point out here that the FASB intends to issue guidelines regarding hedge accounting at some future date and that the FASB apparently has reached some tentative decisions as to how this project should proceed. Recent reports suggest that such guidelines will not be finalized for some time, which is an unfortunate development. However, I recognize that many issues with respect to hedge accounting are very complex, time-consuming to deal with, and not susceptible to quick, easy answers. VI. THE COMMISSION'S DISCLOSURE REVIEW PROJECT At the Commission, the Division of Corporation Finance undertook in 1994 an intensive review of registrant disclosure in periodic reports of derivatives activities. That review is continuing. The initial review focused on approximately 500 registrants that have significant derivatives activities. Apparently, the staff selected a broad cross section of registrants from all industry groups. The staff conducted full reviews of annual and quarterly reports filed by these registrants. The purpose of the project was for a team to systematically review disclosure of derivatives activities to determine the adequacy of current disclosure and the necessity for formal action to improve disclosure. While the staff has initiated a second stage of the project for 1994 annual reports for a smaller group of registrants, some preliminary observations about the initial review can be made. First, I think it fair to say that the staff was disappointed at the extent and quality of the disclosure in general. They were particularly disappointed with the failure of many issuers to update their disclosure in quarterly reports, especially with regard to their MD&A disclosure. Many registrants apparently failed to disclose material changes in their policies and situations with respect to their derivatives activities. I understand that the staff was also stunned by the vast differences in the quality of disclosure among the registrants. Moreover, the disclosure regarding risk management practices was often too general and vague to be useful to investors, or to analysts like yourselves who are seeking to assess the risks that management had assumed. Further, many registrants failed to disclose their policies regarding whether they generally maintain positions for the duration of the derivative instruments and failed to disclose changes in their policies. Let me make some generalizations about what I understand to be some of the more significant comments provided by the staff to registrants regarding their disclosure. First, the staff has requested that registrants disclose the amount of revenues that they received from derivatives trading, and that they separately identify and quantify the amount of revenues derived from foreign exchange, interest, equity, and each other major type of derivative product. Second, the staff has requested that registrants, in their periodic reports, describe their significant end-user derivatives activities. The staff has sought disclosure of each specific risk being managed and the type of instrument and strategy used to manage that risk. For example, a registrant may use foreign currency swaps to manage exchange rate risk in designated foreign currency denominated transactions. The staff has sought quantified information related to the on balance sheet position (if any) being managed and the related derivatives positions. Third, the staff has requested registrants to summarize, in their reports, the open derivatives positions at period end. Such summaries should include, for each major category of derivative instrument, the notional amount, carrying value, fair value, and gross unrealized gains and gross unrealized losses for each category. For interest rate swaps, the staff requested that the summary include categories for year of maturity, major swap terms and average interest rates for each of the receive fixed/pay variable and the pay fixed/receive variable categories, and other information to enable investors to understand the interest rate exposure of the instruments. For futures, forwards, and options, including puts and calls, the staff asked registrants to distinguish between contracts written and contracts purchased, and to aggregate instruments with similar risk characteristics such as interest rate, foreign exchange, commodity and equity price risk. For complex instruments which contain several risks, disclosure of each instrument and its terms and attributes has been requested. Fourth, the staff has asked that registrants disclose quantified information concerning terminations of derivatives positions accounted for as hedges. Such information included the amounts of gross realized gains and gross realized losses from terminations prior to maturity, and the amounts of any such gains and losses where income statement recognition was being deferred. For such deferred gains and losses, the staff has requested disclosure of the fiscal year in which recognition in income was expected. Fifth, and finally, the staff has sought disclosure of methods and quantified parameters that management used to monitor and control risk management strategies, including any stress testing and sensitivity analysis. VII. FUTURE COMMISSION ACTION While registrants have improved their disclosure of derivatives activities and additional improvement should result from compliance with FASB's Statement 119, I believe that the Commission is of the view that further action is necessary. It is apparent that there exists a need to increase the extent and depth of disclosure to provide investors with a better understanding of the type, extent, purposes and potential effects of registrant derivatives activities. As a result, for some time now, the Commission has been considering proposed rules to enhance disclosure on derivatives and risk management activities and to ensure consistent disclosure. I am not exactly certain when Commission action on this initiative will occur, but I speculate that it would be some time this summer. I anticipate that any such proposal by the Commission would include a form of quantified data on derivatives activities which hopefully would provide investors with more precise information. As many of you know, in the mutual fund area, last March, the Commission issued a concept release requesting comment on methods to improve risk disclosure for investment companies. With this release, the Commission is attempting to improve the lengthy and highly technical description of permissible policies and investments that are often included in mutual fund prospectuses. In our release, the Commission describes and is seeking comment on several quantitative measures of risk and risk adjusted performance. It is hoped that such quantitative measures will enable investors to compare the potential returns of a fund against the risks of a fund and will enable investors to compare funds on the basis of risk. This is asking a great deal, and I would be very surprised if there exists any such one size fits all measure that would accomplish these objectives. Challenges notwithstanding, the Commission may consider a similar approach with respect to corporate disclosure. However, I suspect that flexibility will be provided to registrants on the formula that can be utilized to measure risk. Certainly, I have already indicated my support for requiring end-users to disclose quantitative/numerical information about their derivatives contracts or positions. In addition to quantitative disclosure, I suspect that, among other things, the Commission may consider requiring disclosure regarding commodity contracts and structured notes in the footnotes to the financial statements. I would also suspect that the Commission may consider amendments to Regulation S-K to require disclosure concerning management's policies and procedures to monitor, control and modify its market price risk and credit risk. Until the Commission takes formal action, companies should take care to consider what disclosures should be made concerning their derivatives activities to comply with the existing MD&A disclosure requirements. In particular, companies should be careful to keep in mind 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. At a minimum, I expect that corporate derivatives activities will continue to be an area where the staff of the Commission involved in reviewing filings will be focusing quite a bit of attention. VIII. INTERNAL CONTROLS No discussion of corporate derivatives activities and the Commission would be complete without mentioning in a little more detail the subject of internal controls. I suspect that there has already been some discussion on this topic by the prior speakers. All publicly held companies substantially involved in derivatives activities would be well advised to scrutinize carefully their internal control practices. Of course, the GAO has recommended that the Commission mandate that all registrants establish independent audit committees and disclose auditors' reports on internal controls. While I have not closed my mind completely on the subject, I have yet to be convinced of the merits of either of these two recommendations. Although I am uninterested in dictating a specific system of internal controls to which public companies engaged in derivatives transactions must adhere, it does strike me that the segregation of functions to reduce the likelihood of a particular individual or department from being in a position to make errors and to intentionally or inadvertently conceal such errors is an essential control procedure to have in place. In fact, it is my understanding that the absence of the appropriate segregation of duties is considered to be a violation of generally accepted auditing standards. However, it has been brought to my attention that some companies continue to be rather lax in this area. I am certain that there probably exists a wide variety of control devices which could be utilized in any one business environment, but I do recommend the selection and implementation of particular control procedures that are prudent under the circumstances presented. IX. CONCLUSION The Commission is currently involved in several initiatives relating to derivatives, and these initiatives go beyond the corporate disclosure issues that I have discussed today. If a public company is not already sensitive to potential pitfalls in the derivatives area, as well as to the need to describe those potential pitfalls in disclosure documents, it may be inviting unwelcome scrutiny from the Commission or from disgruntled investors and analysts. Registrants substantially involved in derivatives activities should strive for more detailed, current and consistent disclosure that will not only inform but give confidence to investors regarding the risks that the registrants are assuming through investments in derivative products. ENDNOTES -[1]- Standards already resulting from that project include: (1) Statement of Financial Accounting Standards ("SFAS") No. 105, Disclosure of Information about Financial Instruments with Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk (March 1990); (2) SFAS No. 107, Disclosures about Fair Value of Financial Instruments (December 1991); (3) SFAS No. 110, Reporting by Defined Benefit Pension Plans of Investment Contracts (August 1992); (4) SFAS No 114, Accounting by Creditors for Impairment of a Loan (May 1993); and (5) SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (May 1993). -[2]- Release Nos. 33-7153 and 34-35546. Comments are due on or before July 7, 1995. -[3]- SEE Statement on Auditing Standards 55; Consideration of the Internal Control Structure in a Financial Statement Audit, Auditing Standards Board (April 1988); Auditing Standards Section 325.21.