Man Without Qualities

Sunday, July 07, 2002

The SEC Tries To Stem The Shock?

Times have changed
And we've often rewound the clock
Since the Puritans got a shock
When they landed on Plymouth Rock
If today, any shock they should try to stem,
'Stead of landing on Plymouth Rock
Plymouth Rock would land on them!

Cole Porter, Anything Goes

The SEC is now requiring the Chief Executive Officer and Chief Financial Office of large public companies to personally certify the company's securities filings under oath penalty of perjury!

This is important stuff. The talking heads told us that. Even the author of the book Irrational Exuberance, Yale economics professor Robert Shiller, was on television telling us this was a "drastic but necessary measure" to restore investor confidence - and he was framed by a nice blue background bearing the tasteful and repeated word "Yale" on it, just to make the point. Professor Shiller is an accomplished economist, but one might wonder why he was pressed into this service, since his biography does not include credentials in the area of securities regulations - a highly technical and legalistic area peopled by its own specialists. But, curiously, although those specialists might have been out there somewhere, the Man Without Qualities did not see them, or even read their quotes in the reports concerning the new rule. Could that be because the new SEC rule actually means very little - except if the rule DOES have significant consequences, those consequences are likely to be mostly perverse?

The new rule says that when a large public company makes its 10-K (annual report), 10-Q (quarterly report) and 8-K (special event report) filings (called "covered reports" in the new rule) under the Exchange Act or 1934, its CFO and CEO must file a statement under oath which, among other things, says:

To the best of my knowledge, based upon a review of the covered reports ... , and, except as corrected or supplemented in a subsequent covered report, no covered report contained an untrue statement of a material fact ... ; and no covered report omitted to state a material fact necessary to make the statements in the covered report, in light of the circumstances under which they were made, not misleading as of the end of the period covered by such report (or in the case of a report on Form 8-K or definitive proxy materials, as of the date on which it was filed).

The Wall Street Journal says that some nameless lawyers the Journal interviewed said "that a criminal case based on lying in a sworn statement is generally much easier to prove than a complex accounting fraud."

It seems like only yesterday that the media were full of reports - prompted by President Clinton's own perjury in the Lewinski matter - that perjury is incredibly hard to prove, and that criminal charges in civil cases were almost never brought - and, in the eyes of some, were downright "unusual and flimsy." In those days, many Democrats and academics even said that "civil perjury" perhaps warranted the essentially symbolic disbarment of Mr. Clinton (who was not a practicing lawyer) - but certainly did not warrant impeachment. So maybe the actual penalty for breach of this rule will be equivalent to disbarring a non-practicing lawyer. Considering that the amounts involved in recent scandals have been in the BILLIONS of dollars, one might be forgiven thinking that a bad CEO or CFO might consider that an additional risk worth taking.

Further, the new rule only requires that the officer's statement be "to the best of my knowledge." The Journal reports that "exactly how the phrase 'to the best of my knowledge' will be interpreted remains unclear," which is more than a little strange because in common language as well as in the drafting of financial documents and regulations the phrase "to the best of my knowledge" has a clear, established meaning - and that meaning is NOT the same as "to the best of my knowledge after a reasonable investigation." If the drafters of this rule had intended to require a reasonable investigation, they could have said so - and they didn't. For example, the form created by the SEC that must be filed by holders of more than 5% of a company's stock (Schedule 13D) places just before its signature line the sentence: "After reasonable inquiry and to the best of my knowledge and belief, I certify that the information set forth in this statement is true, complete and correct." The new rule does not do that. What the SEC did include is a statement that the statement is "based upon a review of the covered reports" - which just reinforces the fact that it need not be based on any additional due diligence investigation.

But the Journal's unnamed lawyers say that "the SEC will expect signers of the sworn statements... to conduct due diligence on the accuracy of their companies' results." It certainly makes sense that the SEC would have this expectation, but the new rule clearly does not require the signing officer to conduct a due diligence investigation. Most of the time - but by no means always - a sensible officer will conduct such an investigation, but the authorities will not be able to charge the officer for breaking this rule if the officer in fact does not conduct such an investigation.

Which brings up the muli-faceted perversity of this rule. The current hysteria over wrongdoing and alleged wrongdoing of company executives appears to have obscured the sound purpose of the securities laws: to deliver accurate and complete information to the investing public. The purpose of the securities laws is not to put bad executives in jail. The threat of such criminal sanctions is only appropriate if the net effect of such sanctions is likely to increase the delivery of accurate and complete information to the investing public. But the net effect of this new rule will likely be to reduce the amount of accurate and complete information to the investing public.

Suppose the new rule has a substantial effect, despite my reservations on that point above. As noted, the rule does not require due diligence. So it may well create a strong incentive for signing executives to have "clean hearts and empty heads." If this rule incentivises senior officers to be ignorant, it probably will reduce the reliability of company information.

Moreover, if a signing officer had previously certified reports that included false or misleading information, then disclosure of that information in subsequent reports will create the risk of criminal prosecution of the certifying officer. As the Journal's nameless lawyers put it: "After the sworn statements are submitted, subsequent revisions of financial reports could potentially expose executives to criminal charges." Very true. The possibility that an executive could be so criminally charged could be a very good reason for such an executive not to order an investigation and, if errors are discovered, it could be a good reason not to disclose it to the public, say in a corrected or supplemented in a subsequent covered report.

But the new rule says that the executive is responsible for material misstatements "except as corrected or supplemented in a subsequent covered report?" Does the executive actually have an enhanced incentive to investigate so that he can correct past errors? Well, if that's what the rule means, then it really is meaningless, because under that construction of the rule the company can file a corrected report at any time - which will mean the executives would then be off the hook. The new rule's drafting is surely a dog's breakfast - and the exception for misstatements "corrected or supplemented in a subsequent covered report" may completely gut it. But if the rule is to have any substantial effect, there has to be a threat of liability to the executive for past misstatements - and that has to create an incentive not to investigate and/or disclose.

Additionally, if a certifying officer does not know the covered reports are wrong, then the signing officer will have to weigh the costs and benefits to that officer of doing an investigation. For example, the new CEO of WorldCom is reported to have innocently sent an internal auditor to do a routine check of the companies capital accounts, which turned up that disaster. If the WorldCom CEO had certified to even one prior set of financials, would he have been as likely to innocently send in his auditor? This question just doesn't have an easy answer - but it is certainly possible that the answer is "he would not have been as likely to send in that auditor."

But suppose, despite the rule's apparently clear language to the contrary, a due diligence investigation is held to be required of the signing executive by the rule. What would that mean? Whatever else it means, it certainly means that if something goes wrong some outside government agent - SEC representative, prosecutor, judge or jury - will be second-guessing what kind of due diligence investigation was or could have been conducted. So the executives will have a big incentive to create a really nice and expensive paper trail to document that a very elaborate due diligence investigation was conducted, which turned up nothing.

Does any sensible person think that a company committing actual fraud in its SEC filings would not also be able to create such a paper trail?

Looks like we may find out.

At least the Commission did not attempt to put into effect the seriously counterproductive suggestion of Treasury Secretary Paul O'Neill (endorsed by Burton G. Malkiel of Princeton) that CEOs should personally vouch for the veracity and fairness of their company's financial statements and be held personally criminally liable simply because the firm's statements later prove to be misleading.

And certainly the SEC under Mr. Pitt has been vastly more effective and constructive than it was under his predecessor, the largely comatose Arthur Levitt, and Mr. Pitt has been vastly more constructive in his approach than the erratic and dangerous Tom Daschle. Senator Daschle "faulted Chairman Harvey Pitt for having 'too cozy a relationship' with those his agency regulates, including meeting with accountants he used to represent "on many occasions before issuing regulation." Senator Daschle is deliberately ignoring that almost all of the emerging accounting irregulariities arose or began in earnest under Mr. Levitt's reign during the Clinton administrations. Senator Daschle is a hugely destructive force in the Senate and the nation - and this malfeasance is only the most recent example.

But it would be better if the SEC and the Congress as a whole could bring themselves to deam a better dream.

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