-------------------- BEGINNING OF PAGE #1 ------------------- REMARKS OF COMMISSIONER STEVEN M.H. WALLMAN Before the American Society of Corporate Secretaries 49th National Conference The Greenbrier White Sulphur Springs July 1, 1995 The views expressed herein are those of Commissioner Wallman and do not necessarily represent those of the Commission, other Commissioners or the staff. Introduction I am pleased to be at The Greenbrier speaking before this respected organization as it approaches its 50th anniversary, the American Society of Corporate Secretaries. Today, I would like to speak about a number of topics -- seven in fact -- that might be of interest to your members: (1) Recent rulemaking initiatives in the corporate finance area, (2) Section 16 Rules, (3) shareholder proposals and Rule 14a-8, (4) the FASB stock option project, (5) lost securityholders, (6) the SEC's Advisory Committee on the Capital Formation and Regulatory Processes, and (7) litigation reform and the safe harbor. I hope to engage in a dialogue with you after I give my remarks. Of course, the views I will express are my own and do not necessarily represent those of the Commission, other Commissioners or the staff. I. Recent Corporation Finance Releases First, I would like briefly to describe the Division of Corporation Finance's initiatives that were approved by the Commission last Tuesday. Some of the issues and proposals now out for comment are quite significant. The common goal underpinning these releases is furthering investor interests. In some releases, the means proposed to accomplish that goal will be viewed by some as controversial. That is why the public comment process is of great importance. The releases generally fall into two categories: (1) corporate disclosure, and (2) corporate capital-raising. The corporate disclosure releases include the abbreviated financial statements release and the executive pay streamlining release. Through these releases, the Commission is considering how best to ensure that shareholders receive information they need to make informed voting and investment decisions; ensure that the information shareholders do receive is useful, useable, and sufficiently focused so that it is read and understood by shareholders; and reduce the costs of presenting this information in order to save expenses for the companies and their shareholders. After all, it is the shareholders -- those whom the Commission is charged with protecting -- who ultimately pay for all these expenses. The corporate capital-raising releases include a proposal on "testing the waters," a proposal that would reduce the Rule 144 holding periods, another that would streamline acquisition financial statement disclosure, one that would expand the Securities Act Section 3(b) exemption to facilitate exempt California offerings, and another that would raise the Section 12(g) asset threshold. Generally, in all these releases, the Commission is exploring mechanisms to reduce unnecessary regulatory impediments to primary and secondary market transactions covered by the Securities Act of 1933, or reducing the burdens imposed on issuers or others that engage in certain activities. The overriding concern is to protect investor -------------------- BEGINNING OF PAGE #2 ------------------- interests by decreasing unnecessary transaction costs, which ultimately are borne by shareholders. A. Proposals to Streamline Delivered Information Two releases -- the abbreviated financial statement proposal and the executive compensation disclosure proposal -- seek comment on new approaches to streamlining the amount of disclosure delivered to investors, while retaining the full set of required disclosures in documents filed with the Commission. I want to underscore that ALL the information that is currently presented to shareholders would still be required to be filed with the Commission and would be required to be provided to any shareholder who wants it, free of charge, immediately, just for the asking. Through the comment process, we may find that shareholders prefer to sift through all company information they can receive. Given, however, the consistent complaints about the volume and complexity of currently mandated disclosures, the enormous array of required information, and the fact that it is shareholders who indirectly pay the printing and mailing costs for all this information, I suspect that the comments will be mostly favorable. In any event, if the rule is ultimately adopted, I suspect a number of companies will still prefer from a shareholder relations standpoint to print and mail all the material they do now. 1. Abbreviated Financial Statements The primary issue with respect to the abbreviated financial statements proposal relates to investors' need for DELIVERY of a full and complete set of the financial statements in the annual report to shareholders. I again stress that there would be NO DIMINUTION IN THE TYPE OR AMOUNT OF FINANCIAL DATA publicly available and on file with the Commission. The FULL set of audited financials will continue to be filed annually either as part of the company's Form 10-K (or 10-KSB or 20-F) or, if the glossy annual report is delivered before the 10-K, as part of the copy of the glossy submitted to the Commission. Companies using abbreviated financial statements must tell their shareholders that a complete set is readily available upon request at no charge to the requesting shareholder. One proposal would allow abbreviated financial statements to be used with disclosure documents other than the annual report, such as 1933 Act prospectuses. The Commission already has permitted companies eligible to register securities on Form S-3 (or F-3) to forego delivery to investors of company information, including that contained in financial statements, where the non- delivered information is on file with the SEC. I have reservations about other approaches to streamlining the annual report that are outlined, but not proposed, in the release. In particular, I do not favor at this time allowing companies the flexibility to eliminate the annual report altogether -- although I believe we properly ask the question. Nor am I yet certain of the utility of the summary annual report concept, given its history. The Commission now stands at a technological crossroads. As noted in the release, the Commission plans to expand upon the analysis in the Brown & Wood letter in a forthcoming proposal that would address on a broad scale the issue of electronic delivery of prospectuses. The Division of Corporation Finance is now preparing a draft release on this issue that I look forward to reviewing in August or September. I promise you that the -------------------- BEGINNING OF PAGE #3 ------------------- Commission will undertake to ensure that the benefits of new technologies will be available to investors. Right now, public access to Commission filings now can be obtained at relatively low cost through a wide variety of private vendors, on the Internet, and on the Commission's EDGAR system. Someday, paper delivery may even become the shareholder communications vehicle of last resort, as opposed to first resort. Consequently, in my view, these releases really represent transition rules until the day when shareholders can get the entire store of information easily and electronically. At that point, it becomes irrelevant whether information is included in a printed and mailed document or only in a filed document because it will be the latter that actually is obtained by the investor. A brief sidebar -- I am concerned that Commission filings may no longer be accessible through the Internet in the intermediate term if funding is lost for the current program with Internet Multicasting Service. That would be a terrible result. We should work toward developing a mechanism whereby the Commission can ensure that widespread public access to Commission filings on the Internet always continues to be available. 2. Streamlined Executive Compensation Disclosure and Tabularized Director Compensation Disclosure The same principle giving rise to the proposal for delivery of abbreviated financial statements animates the proposal to streamline executive and director compensation disclosure -- simplifying and rendering more comprehensible to shareholders the executive and director pay data now presented primarily in proxy and information statements. The 1992 revisions to compensation disclosure represented a much-needed change. The success of this tabularized approach prompted the Commission to propose consolidation of the current narrative description of director pay into a single, easy-to-understand table. Shareholders should benefit from a distilled set of tables setting forth, clearly and concisely, the type and amount of compensation paid not only to senior managers, but also to directors, who fix their own compensation. In the release, we asked for comment on whether companies should have the choice of moving the Performance Graph to the glossy annual report. It seems that shareholders would benefit from including the 5-year return data in the glossy, where it would be presented in the context of other financial and performance information. B. Facilitation of Capital Formation: The 1933 Act Releases Each of the capital formation releases is directed toward reducing issuer costs without affecting investor protection. These releases were intended both to help companies reduce capital-raising costs consistent with the goal of investor protection. 1. Streamlining Acquisition Disclosure Critics of our registration system have suggested that some U.S. companies may be forced to issue securities offshore, rather than here in registered transactions, because of the current registration disclosure requirements relating to significant acquisitions. The proposed acquisition disclosure rules would reduce the need for reliance on Regulation S, which clarifies the extraterritorial application of the Securities Act's registration -------------------- BEGINNING OF PAGE #4 ------------------- requirements, by eliminating certain impediments to registered offerings of securities under the Securities Act. Currently, domestic companies subject to the reporting requirements of the Exchange Act are required to report significant acquisitions on Form 8-K within 15 days after consummation of the transaction; a grace period of up to 60 days from the filing due date is given for filing the required audited financial statements. On the other hand, a company that registers its securities under the Securities Act must provide information in the registration statement about significant acquisitions, including audited financial statements, from such time as the acquisition is probable. One, two, or three years of audited financial statements may be required, depending on the relative significance of the acquired business. If the registrant is unable to obtain such financial statements from the potential acquiree for inclusion in the registration statement, the issuer would have to resort to alternative financings. Thus, reporting companies, including those with shelf registrations of securities, may be compelled to forgo public offerings and to undertake private or offshore offerings. The rules would generally allow companies to provide information about significant acquisitions in Securities Act registration statements on the same time schedule as for Exchange Act reporting. The amendments would also permit certain private placements under Regulation D to go forward under the same conditions as a registered offering. Finally, in response to concerns expressed to the staff that investors need information about private or offshore equity placements, the proposal also includes rule revisions that would require registrants to file quarterly reports on recent sales of equity securities that have not been registered under the Securities Act. Although I believe the Commission clearly must proceed to remove this and other undue regulatory burdens on capital formation, there remains a clear need for broader structural reforms. I will get to this in a minute when I discuss our Advisory Committee. 2. Rule 144 Holding Period and Equity Swaps Another capital formation proposal is to reduce the Rule 144 holding period. I am pleased to see this idea -- which was raised by several members of the Commission's Advisory Committee -- carried forward. It is also important, as a matter of policy to develop a more global, unified regulatory perspective on how derivatives should be treated, rather than addressing them in a piecemeal fashion. We have been striving to understand the basic economics of trading programs in the Rule 144, Regulation S, Section 16 (including equity swaps and other derivatives, as well as cash- only and volitional stock appreciation rights) and corporate financial reporting (MD&A) contexts, before imposing additional regulations in one regulatory context that might have unanticipated consequences in another. I am concerned that a number of the approaches we have taken have been inconsistent, or at least lacking in consistent principle. This release begins to ask some of the questions and notes some of the issues that will be part of the broader dialogue. Additionally, the release also reminds officers, directors and their companies of insiders' Section 16(a) obligations to report equity swap transactions. 3. Regulation S -------------------- BEGINNING OF PAGE #5 ------------------- The Regulation S interpretive and concept release is necessary to explain some of the strong concerns the Commission has with regard to the activities of some issuers using the Regulation S procedures. Not only have some companies stepped over the line in terms of engaging in a scheme to evade the registration requirements of the Securities Act, but they have done so with the assistance of counsel and other professionals. The release will, hopefully, pull some of these parties back from the brink and remind them of their obligations to comply with the law. It also, very helpfully, sets out in concept release format the questions needed for the Commission to understand better the economics underlying the motivation for these transnational offerings. 4. Test the Waters The "Test the Waters" proposal should provide small, emerging growth companies wider latitude to assess possible investor interest in their securities before incurring the substantial costs of going public. AT THE SAME TIME, THE COMMISSION WILL AND MUST ENSURE THAT INVESTOR PROTECTION IS MAINTAINED. Absent such protection, the risks of investment actually ESCALATE along then with the required return, ultimately harming companies by inflating their capital formation costs. The proposal offers one way that may be viewed as striking an effective balance. On this matter, I will be very interested in what commenters observe. I specifically urge commenters to respond to the questions regarding Regulation D's "general solicitation" bar. Some relief in this area may be helpful to small companies whose "testing the waters" efforts lead it to conclude that an IPO is not yet appropriate, but who would then wish to raise capital under Regulation D. The questions posed in the release also note the language of the 1933 Act as a possible constraint to a fully effective and useful rule. I believe that it may be worthwhile for the Commission to seek statutory authority if necessary to provide the Commission with more flexibility to strike the desired balance in this area. II. Section 16(b) Rules As you may know, revisions to Rule 16b-3 proposed last year are still pending. Congress appears to have a good deal of interest in streamlining or eliminating regulation by statute, rather than permitting the agencies to undertake this task. One of the proposed "deregulatory" changes that has been suggested to legislators by some is the repeal of Section 16(b). I personally believe that would be a tremendous mistake. Reform in the Section 16(b) area is needed, but the problem has been misdiagnosed. In my view, it is not the statute but the Commission's Section 16(b) exemptive rules -- most prominently, Rule 16b-3 -- that impose unnecessary regulatory burdens without appreciable countervailing investor benefits. Despite (or perhaps because of) the in terrorem effect of strict liability, Section 16(b) creates one of the few really effective private rights of action. The only other enforcement mechanism in this area is Rule 10b-5, which has far more difficult elements of proof. If Section 16(b) were rescinded, I believe insider abuses would increase with no effective shareholder remedy. I do not believe that most companies, on reflection, necessarily would favor the elimination of Section 16(b). Hopefully you who are corporate counsel would agree that, along -------------------- BEGINNING OF PAGE #6 ------------------- with the Section 16(a) reporting provisions, Section 16(b) helps company counsel monitor and guard against insider trading. In my estimation, the problems attendant to the complexity and costliness of the 16(b) exemptive rules -- particularly Rule 16b-3 -- could be alleviated by replacing current Rule 16b-3 with a new rule exempting all transactions in the company's stock or stock-based derivatives (e.g., options and SARs), between the company and its insiders, from Section 16(b) while still requiring reports and disclosure under Section 16(a). This exemption would prevent matching, for short-swing profit purposes, of company grants and awards of stock or stock derivatives to insiders and insiders' purchase of stock or derivatives from the company or the sale of stock or derivatives to the company by insiders. The rationale for such an exemption is simple and obvious: These transactions are economically just a form of compensation determined by and paid for by the company. The short-swing prohibition against matchable insider-MARKET transactions -- where there are real opportunities for abuse, and where more importantly it is an investor in the company's stock who is hurt -- should be retained. In summary, I am convinced that we seriously undermine one of the key tenets supporting our domestic market integrity if we facilitate short-swing, insider-market transactions. Repealing, or failing strongly to oppose the repeal, of Section 16(b) would do that. Simplifying the exemption for INSIDER-COMPANY transactions, while maintaining the current prohibition against short-swing, INSIDER-MARKET transactions is far preferable and would likely, in my opinion, address most all of the concerns of the corporate community in this area. With respect to Section 16(a), I believe the insider reporting scheme is a good one, benefitting companies, their shareholders and the markets by ensuring the transparency of insider transactions in their companies' securities. In this and most other areas, I tend to favor the elevation of economic substance over form -- I have no difficulty exempting from the reporting requirements those non-volitional transactions, regardless of whether they are equity or equity-based securities payable in cash -- (such as cash only SAR transactions which I believe are economically equivalent to stock settled SARs) -- that are not susceptible to insider abuse or speculation. Consistent with this theme, however, I do NOT favor exempting volitional, cash-only equity-based instruments that provide the same opportunities for speculative abuse as do transactions in the underlying equity, if the underlying equity is not also exempted. For this reason, I support eliminating such instruments as cash-only, volitional SARs from the current exemption from the Section 16(a) rules' definition of derivatives. In my view, these instruments are no different from volitional SARs payable in stock, or in stock or cash, and therefore should be treated identically for disclosure purposes. Any relief in this area, as I discussed, should come in the 16b- 3 context rather than in the area of disclosure. III. Shareholder Proposals I have been asked to discuss the latest developments on the shareholder proposal rule, Rule 14a-8, which will not take too long as not much of note is going on at the SEC. We have reached the end of the traditional proxy season. The Division of Corporation Finance resumed issuing no- action letters permitting exclusion of proposals on "ordinary business" (paragraph (c)(7)) grounds, now that the Cracker Barrel litigation has finally been resolved in the SEC's favor. The Division is again applying a bright-line test for exclusion of -------------------- BEGINNING OF PAGE #7 ------------------- social policy issues affecting employees (e.g., affirmative action, gender or race-based discrimination, MacBride Principles). Despite the apparent lull, serious flaws in the Rule 14a-8 process remain and likely will come to the fore again when the 1996 proposal season begins this fall. It is becoming increasingly difficult for the Division to draw lines between proper and improper subject matters, particularly with respect to matters relating to "ordinary" or "significant" levels of a corporation's business ((c)(7) and (c)(5), respectively). It is also difficult for the staff to have to look behind the plain language of an otherwise acceptable proposal; for example, relating to confidential voting or CEO pay, to decide whether someone has submitted the proposal to redress a personal grievance or to obtain a personal benefit not shared by the entire shareholder body (paragraph (c)(4)). I personally believe the bright-line Cracker Barrel test reflects the futility of efforts by a federal agency not equipped to serve as a trier of fact or arbiter of social or business policy to make the judgments it is required to make under Rule 14a-8. Earlier this year, in a meeting with the Commission, your organization suggested what I thought was an interesting approach to reforming the system and, as added to by others, would look something like this: * Rescinding paragraphs (c)(5) and (c)(7). * Retaining other exclusions. * Limiting the number of proposals carried at company cost to three, with the proposals, selected by lot by a company's independent auditors or other independent third parties. * Raising the eligibility thresholds (currently $1000 for 1 year) to a higher level (e.g., to $12,500 for 2 years or $2,500 for 5 years). Aggregation would be permitted if each small shareholder has held his or her shares the requisite number of years. * Raising the resubmission thresholds from 3%, 5%, and 10% to 5%, 20%, and 35%, or some other variation. * Providing an exception to the numerical cap of three for those proponents that hold individually or as group at least 5% of the outstanding voting stock. Proponents of reform appear unable to agree on any one proposal, however, and that is unfortunate. The current system allows for an unlimited number of proposals, but the proposals can only be on a very limited range of subjects. At one time, the consensus was headed toward permitting a far greater range of subjects, but placing a limit on the number of proposals. This seemed sensible given the fact that only a few dozen companies ever had more than a few proposals anyway. Had these efforts stayed on course, proponents could have achieved a substantial broadening of their rights to enter into a meaningful dialogue with corporate management and other shareholders through the proposal process, and for the first time would have had the ability to discuss matters that directly relate to the business and performance of the company -- matters that shareholders should after all care the most about. Companies would have benefitted from the certainty of the process and streamlining of the procedures. The current stalemate really is a shame, not so much for those shareholder proponents who today are able to procure the inclusion of governance-related proposals in company proxy statements, but for those activists of tomorrow who will want to discuss the actual business and performance of the companies in which they invest. For that reason, I am still hopeful that -------------------- BEGINNING OF PAGE #8 ------------------- those proponents who have declined to join the efforts to reach a consensus on Rule 14a-8 reform will reconsider their position and decide that expanding substantially their shareholder rights to engage in a wide-ranging and important dialogue on matters of importance to their company's business -- by rescinding the (c)(5) and (c)(7) exclusions -- outweighs the perceived advantage of having the right to make an unlimited number of proposals on relatively narrow issues. I also sincerely hope that the business community will continue to try to participate in reaching a consensus because of the benefits they will receive from ease of administration, certainty, and lower costs. The Commission continues to need your input on these matters. IV. Lost Securityholders Now I would like to discuss the issue of lost securityholders and get your expert views on how we might better address this problem. This is a relatively new issue for me, but others (including former U.S. Congressman Bob Shamanski) have been concerned about this area for years. Each year, issuers and transfer agents lose contact with thousands of investors for a variety of reasons, including the death of securityholders, incomplete or inaccurate addresses given to transfer agents, or changes in securityholder addresses without notification to the issuer or transfer agent. As a result, a significant amount of dividends and interest payments intended for investors remain unpaid. The magnitude of the problem is difficult to quantify with precision, although some have estimated that the value of lost securityholder accounts may aggregate in the billions of dollars -- some have said as much as ten billion dollars. A material portion of these undeliverable funds escheat to the states each year -- although only the amount of the distribution in the account escheats to the states, not the income earned on the distribution. A. Current Practices of Transfer Agents and Issuers in Locating Lost Securityholders The common procedure for locating lost securityholders is similar to that set forth in SEC Rule 14a-3, which governs the obligations of issuers to mail annual reports or proxy materials to securityholders. Generally, firms will conduct two successive mailings to the last known address of the securityholder. If both mailings are returned as undeliverable, the transfer agent or issuer will hold any further distributions. I understand that a significant number of transfer agents and issuers may take additional steps to PREVENT AGAINST losing securityholders and FIND those that are lost. For instance, some firms have established toll-free numbers for handling routine changes in addresses, others use commercial credit bureau data bases. While I prefer that the private sector move forward on this issue with bold initiatives, some argue that the Commission should take a more active role. Currently, the Commission has issued rules requiring transfer agents to keep accurate securityholder files and to safeguard all funds and securities in their custody. These rules may not be adequate to address the problem of lost securityholders. This issue is beginning to receive more attention at the Commission. Of course, I am cognizant that enhanced efforts to find lost shareholders does not come without a cost. The Commission's goal in this area should be to determine the most efficient and cost -------------------- BEGINNING OF PAGE #9 ------------------- effective way to encourage efforts to find lost securityholders. Any approach taken should recognize and take advantage of cost- effective technological advances. The Commission could require "reasonable" searches for lost securityholders. This approach has the advantage of allowing transfer agents and issuers flexibility to determine appropriate approaches, but, on the other hand, the standard may be too vague and lead to inconsistent results. We could specify explicit procedures for searches. The danger in this approach is that any procedures adopted would rapidly become obsolete in relation to technological changes. The Commission could create more explicit legal rights for lost securityholders. I am hesitant to support proposals that would create new rights of action for lost securityholders, particularly given our current debate over securities litigation reform. We could require that issuers use commercial finding services. I understand, however, that some firms charge 30-50% of the value of the lost account to locate lost securityholders. I cannot help but think there are less expensive ways to locate lost securityholders. One idea merits serious consideration: The Commission could develop a national shareholder database. This would entail consideration of a number of issues: Should we further develop existing databases (e.g., social security or IRS databases) or develop a new database? Who would operate the system, a private entity or the Commission? How should we verify that information is up-to-date? How do we protect the system against fraud? How much should we spend on the system? Would costs assessed on small transfer agents or issuers have a disparate impact? A national shareholder database would provide the benefit that important data would be available to all -- shareholders, issuers, transfer agents, financial fiduciaries -- in one centralized area. Although many states offer similar data bases at present, they are disaggregated and do not facilitate nationwide searches. Perhaps the simplest is to see if we can obtain the information currently prepared and eventually filed with the states to be filed with the Commission and then made publicly available as a centralized facility. This low cost mechanism may actually work the best. B. Compensation Issue The issue of who is entitled to the income earned on a lost securityholder account is one that will have to be addressed. I am aware of the suggestion that, because the income earned on the accounts of lost securityholders does not escheat to the states, there may be less than full incentive for issuers to locate lost securityholders. I think that it is clearly in the interests of issuers and transfer agents to remain in contact with their shareholders, thus I do not subscribe to that suggestion. Some industry representatives believe that compensation to the securityholder is not justified where the inability to make the payment is due to the negligence of the securityholder. This argument is based, in part, on the notion that inattentive securityholders should not be protected by a compensation rule. It seems to me that as a general principle, income attributable to lost securityholder accounts should go to the securityholder provided that, at least in the case where the issuer was not at fault, reasonable expenses of the transfer agent or issuer in locating or holding the account funds are reimbursed. As I mentioned, this is a new area for me and I would appreciate your thoughts. -------------------- BEGINNING OF PAGE #10 ------------------- V. Status of the FASB Stock Option Project In June 1993, FASB issued an exposure draft on accounting for stock-based compensation to employees. The proposed standard would have superseded APB Opinion No. 25 which required expense recognition for performance-based plans only and would require recognition of the fair value of all stock-based compensation on the income statement as an expense. Recognition would have been required regardless of whether the stock plan was a fixed or performance based plan. As you know, the reaction to the exposure draft was astounding. More than 1,700 comment letters were received, six days of public hearings were held, a field test of proposed standard was conducted, and numerous letters were sent to Congress and the Commission. In June 1994, the FASB again deliberated upon the issue and determined late last year to work toward improving disclosures about stock-based compensation instead of requiring income statement recognition of an expense. The new approach would encourage, rather than require, companies to recognize the fair value of all stock-based compensation as an expense on the date of grant. Companies still would be permitted to continue accounting for stock options under APB Opinion No. 25, but would be required to disclose in a footnote proforma net income and earnings per share as if compensation awards were recognized at their estimated fair values. The FASB has decided to issue a final standard later this year that will apply to financial statements for fiscal years beginning December 15, 1995. I understand the arguments made both for and against a charge to income for stock option compensation. It is wrong to conclude that there can be only one correct answer. We need to remember that the purpose of financial statements is to provide useful information to users of those statements. Given the highly charged context of the stock option debate, the FASB approach of requiring disclosure -- as opposed to requiring recognition -- of the fair value of fixed stock options is an acceptable solution to satisfy that purpose. FASB's solution recognizes the arguments of those who believe stock options are compensation and that their value should be shown instead of ignored. At the same time, it also takes into account the views of those who believe that no single number is sufficiently accurate to be included in the income statement and the views of those who believe that equity grants are sufficiently different from cash payments or the creation of a liability and should be reflected differently in the financial statements. On a different note, many have expressed concern over what they perceive to be a "politicization" of FASB's deliberations. Regardless of your view, we should all agree that politicizing the FASB process does not serve the interests of developing sound accounting standards. I believe FASB's fundamental independence, integrity, and wisdom are essential to its ability to develop high-quality accounting standards. I also prefer to have the private sector set accounting standards subject to Commission oversight, rather than having that responsibility revert to the Commission. Unless this process remains apolitical, however, that may become difficult. VI. Advisory Committee on Capital Formation and Regulatory Processes Now, I would like to address another subject, one that I hope will result in fundamental changes to the capital formation process -- namely, the work of the Advisory Committee on Capital -------------------- BEGINNING OF PAGE #11 ------------------- Formation and Regulatory Processes. As I mentioned, regulators need to take a hard look at rules that might adversely affect the capital formation process. In this regard, I want to make you aware of the Commission's Advisory Committee on Capital Formation and Regulatory Processes, which was established earlier this year by the Commission at my urging. I am the Chairman of the Committee. The Committee's current objective is to assist the Commission in evaluating the efficiency and effectiveness of the regulatory process related to public offerings, secondary market trading and corporate reporting. One issue we have been exploring is the potentially revolutionary idea of a company registration model for corporate offerings. Underlying this paradigm shift from securities transaction registration to company registration is that many of the costs, uncertainties, and complexities of a registered offering would be reduced to the extent that issuers were permitted to raise capital publicly without having to register each offering. Perhaps more importantly, however, we must also recognize the huge shift that has occurred in our markets. A few generations ago, the dollar value of securities transactions that involved company's issuing equity, relative to the trading of that equity was approximately one to five. Today, it is close to one to twenty-five or more. An extraordinary focus sixty years ago on twenty percent of the transactions made sense. To continue to give short-shrift today to over ninety-five percent of the transactions makes no sense. We need to reform our efforts to ensure that we raise the standards on which almost all of today's transactions occur. Company registration will give us the opportunity to do that. The result will be a win for investors -- not only in lower capital costs for the companies they invest in, but more integrity and transparency for the transactions they engage in every day. It will also be a win for issuers due to faster, more certain, less costly, and less complicated capital raising. If we can get there, we will shift from capital being raised in accordance with regulatory constraints to capital being raised in accordance with market needs, and with enhanced investor protection. That really should be extraordinary. At the conclusion of my remarks, I would like to hear your views as to how company registration might facilitate capital raising. I am sure many of you would be relieved if you no longer had to wrestle with such issues as gun-jumping, integration, resales of restricted securities, and other issues that create traps for even the best-counseled issuers. VII. Litigation Reform and the Safe Harbor Finally, I would like to conclude with a few observations about litigation reform and the safe harbor. As you know, securities litigation reform has for some time been one of the more hotly debated issues on Capitol Hill. Clearly there is some dysfunction in the present system. Currently, corporations and their shareholders pay other shareholders and their lawyers very large amounts, both in terms of defense costs and settlement fees, while those responsible for perpetrating serious frauds -- sometimes, yes, even corporate executives -- frequently emerge unscathed unless the Commission itself sues them. The costs of these suits are considerable. One study indicates that the average shareholder suit costs $700,000 in -------------------- BEGINNING OF PAGE #12 ------------------- legal fees and consumes 1,055 hours of management's time.-[1]- As for the settlements, according to one estimate, between 1988 and 1993, 343 publicly traded companies paid a total of $2.5 billion in settlements alone.-[2]- The American Electronics Association estimates that 93 percent of private class action securities fraud suits settle out of court at an average settlement of $8.6 million.-[3]- With respect to litigation reform, difficult policy issues confront both Congress and the Commission. How do we preserve meritorious private claims while discouraging or foreclosing frivolous private claims? What is a meritorious claim? To what extent can issuers be protected against liability for false or misleading forward-looking statements without impairing the integrity and liquidity of our capital markets? Would stronger Commission enforcement, at least in the area of forward-looking disclosures, serve as a more effective deterrent against fraud than private litigation? Any resolution of these issues must recognize the interests of small, unsophisticated shareholders who may not have the means of assessing the reliability of soft information. Larger, sophisticated institutions and analysts may have the savvy to discount or dismiss inherently non-credible projections -- but smaller investors often do not. Moreover, given our securities laws and the manner in which they are designed, and given the Commission's resources and enforcement focus, private litigation to enforce the securities laws has traditionally been viewed as a necessary adjunct to public enforcement. The private securities class action bar clearly has helped ensure the integrity of corporate disclosures and the protection of investor interests, thereby advancing the aims that Congress envisioned in the Securities Act and the Exchange Act. That notwithstanding, it is important that we remember that the securities laws are designed to further the interests of investors -- not issuers, and not plaintiffs per se. Obviously, issuers would prefer never to be sued, while plaintiffs would prefer always to win any suit they bring. Neither result is in the interest of investors. Consequently, in furthering investor interests, Congress through the years has sought to engage in appropriate balancing. The basic principles, I believe, are as follows. Clearly, all misstatements and omissions made to the public should be discouraged. It does not matter whether the misstatement was made intentionally, recklessly, negligently, or even innocently for that matter. Any misstatement reduces the integrity of the information in the market, thereby increasing investors' risk. This increased risk causes investors to demand --------- FOOTNOTES --------- -[1]- Shareholder Suits Common, Costly in Venture Backed Firms, Boston Globe, January 16, 1994, at A4., cited in CONGRESSIONAL RESEARCH SERVICE, SECURITIES LITIGATION REFORM: HAVE FRIVOLOUS SHAREHOLDER SUITS EXPLODED? (May 16, 1995). -[2]- Paul Sweeny, Full Siege Ahead, ACROSS THE BOARD at 31 (Nov./Dec. 1994), cited in SECURITIES LITIGATION REFORM, supra note 1. -[3]- AEA News Release: Litigation Strangling Silicon Valley, BUSINESS WIRE (March 22, 1995), cited in SECURITIES LITIGATION REFORM, supra note 1. -------------------- BEGINNING OF PAGE #13 ------------------- higher returns, which raises a firm's cost of capital. The result is that investors and issuers are both hurt.-[4]- Nevertheless, Congress has acknowledged that exacting too a high a price for a misstatement or omission results in an inappropriate balance that also hurts investors. Information with a forward-looking component, although highly valuable to investors is, by definition, information that carries with it a level of uncertainty. Forward-looking information in particular always involves a risk that it may become inaccurate and -- depending on what law we create -- may subject an issuer to liability. If too high a liability cost is placed on the disclosure of inaccurate information, the information required to be provided by an issuer will be subject to so many caveats that it loses much of its benefit as disclosure. There will also be less information voluntarily provided to the market. The lack of full and candid information ultimately can be as harmful to the markets and investors as misleading information. Consequently, in attempting to fashion a safe harbor from liability for forward-looking information that furthers investor interests by assuring meaningful disclosure of forward-looking information to the markets, it may be necessary to fashion rules that protect some disclosures that we might not otherwise have chosen to protect in an ideal world. But no safe harbor will be perfect; and it is simply too easy to continue to insist on a safe harbor that cannot possibly let any improper disclosure through without liability. The result of such a lack of balance hurts investors, not helps them. Any safe harbor that is crafted needs to be consistent. It should turn on the type of information provided, not on its position in an issuer's filing, such as whether it is in the financial statements or the MD&A or whether it is in a Securities Act or an Exchange Act filing. Specifically, if one were to craft a safe harbor, most likely the information you would most like to protect is information that is written, contained in public filings, unambiguous in its meaning, placed in context, independently reviewed, and calculated or generated in accordance with well understood principles and procedures. One might recognize this as the financial statements. The safe harbor might then be extended to other information that is in writing and filed. Finally, one might extend the safe harbor to information that is oral, ambiguous, not necessarily in context, not filed, not independently reviewed, and not produced in accordance with any generally recognized principles or procedures. All the proposals to date, however, provide for the opposite -- they protect the last category of information, but not the first. Why? Because the arguments in favor of a safe harbor started with the proposition that forward-looking information was not being provided to the market voluntarily. The unstated assumption was that this information was not being provided because of the liability associated with making statements that contain inherent uncertainties. But the logic of that unstated assumption -- that the liability associated with information that contains inherent uncertainties may be too high, a proposition by the way on which many still have substantial doubts -- never made it past the articulated complaint about information not being provided voluntarily. And so the focus is on providing relief for the information that may be the most suspect, and not for the --------- FOOTNOTES --------- -[4]- An additional adverse consequence of a higher cost of capital is a reduction in the competitiveness of the U.S. securities markets in relation to overseas markets. -------------------- BEGINNING OF PAGE #14 ------------------- information that is least suspect. Perhaps as more thought over the years is given to whatever safe harbor emerges, there will be a better discussion of what should be included in it. Any safe harbor that is crafted also needs to be clear and provide certainty. If the safe harbor is ambiguous, it means plaintiffs will undergo delays and extensive costs only to discover that their suit cannot be brought, while issuers and their shareholders will bear expensive defense costs merely to prove that they were in fact within the safe harbor. Additionally, and perhaps more importantly, a poorly-crafted safe harbor will not serve its purpose of furthering investor interests by reasonably protecting forward-looking information when it is provided or by promoting and enhancing the dissemination of that information. In that instance, no safe harbor is likely better than an ineffective one. At least then one would know the rules, without falling into traps. There is a flaw, however, in our current system of securities litigation that makes ANY analysis of the appropriate balance more difficult. The problem is that in the normal fraud on the market suit, INNOCENT investors are hurt whenever a claim is filed against the issuer, EVEN IF the claim is a meritorious one. For example, when there is a misstatement that positively affects the market, those shareholders of the company that bought before the misstatement and sold before any corrective disclosure, benefit. Quite simply, these shareholders bought low and sold high, and made a profit they would not have made if the disclosures had been correct. The investors who are hurt are those shareholders who bought from these other shareholders -- in other words, the shareholders that are hurt are those who bought high and now either hold or sold low-priced stock. In these cases, the issuer -- and all the CURRENT shareholders of the issuer -- did not benefit at all. But the lawsuit, of course, is not and cannot be against the benefitting shareholders. Instead it is against the ISSUER and, by extension, all its CURRENT shareholders. The result then is a wealth transfer from one group of innocent shareholders -- the current shareholders (which includes for certain some of the members of the plaintiff class) -- to the defrauded investors. Despite their innocence, the current shareholders pay for the damages award (directly if the issuer is not insured, and indirectly through insurance premiums if it is). This example highlights the dysfunctional economics of the present system -- we have wealth transfers from one group of innocent shareholders -- the current shareholders -- to another -- the defrauded shareholders. The group of shareholders who actually BENEFITTED from the fraud because they bought low and sold prior to the share price correction will not have to pay at all. Although this doesn't make much sense, we have been stymied to date in finding a better alternative. Who else can defrauded shareholders sue? We have no good mechanism to reach the people who actually benefitted from the misleading statement -- namely, the shareholders who bought low and sold high. The corporate spokespersons and officers don't have enough money to pay the damages. So we are left with the innocent shareholders of the company paying. In essence, we have a very crude form of insurance as the foundational idea for our system, with extraordinarily high transaction costs. Ultimately, is this really the best way to serve investor interests? My guess is no one would have intentionally designed such a system except for one problem -- as mentioned, what's the alternative? As a society, are we willing to allow investors who have lost their life's savings to have no recompense? I doubt it; although we should recognize that is the law now when an -------------------- BEGINNING OF PAGE #15 ------------------- investor loses everything due to a company's negligent statements. What this means is that we should neither give up on efforts to reform the system, but neither should we reform it in such a way that we create a new unfairness for those investors least able to protect themselves. We have to think a lot harder, and try to be a lot more creative, in finding a solution that effectively balances all the competing concerns. For too long, the debate has been whether there is a problem. The debate must now switch to how to make the system better. If we had started that discussion a few years ago, we would be much farther along in furthering investor interests today. In a very real way, I believe this search and examination for better solutions is only just beginning, not ending, with the current Congressional action. Overall, Congress and the Commission must continue to recognize these competing considerations and do their best to further the interests of investors long-term -- not make determinations that further either plaintiffs or issuers in the short term. There may be differences as to the preferred route to further investor interests, but there should be no misunderstanding that it is investor interests, not plaintiff interests or issuer interests that should control. There seems to be a continuing tendency in this context to confuse plaintiff or issuer interests with investor interests. That is a mistake in our basic understanding. Finally, if there is to be a safe harbor from private litigation, then Congress must also ensure that there is effective public enforcement. In that regard it becomes increasingly important to provide the Commission with authority to seek disgorgement where the safe harbor might otherwise apply, provided the disgorgement would not hurt innocent shareholders. In addition, the Commission should clearly have authority to pursue aiding and abetting claims whenever a person engages in action that would constitute a violation of the securities laws if done directly. I realize that I have commented on a number of subjects in a short period of time and I thank you for your attention. I would be happy to take questions on any of these matters as well as any other issues of concern to you.