Financial Reporting - Securities Regulation

Financial Reporting

1. In General

   1. Rules Governing Disclosures by Issuers

      1. Required Reports Filed with the SEC

         • The core reports required by § 13 are

           • Annual 10-K (periodic)

           • Quarterly 10-Q (periodic)

           • 8-K (occasional)

             • Required to be filed where triggered by significant events:

               • Change of control;

               • Changing auditors;

               • Financial statements misleading;

               • Director's resignation;

               • Amendments or waivers to the issuer's code of ethics;

               • The company entering into or terminating a material agreement outside the ordinary course of business;

               • Acquisition/disposition of material assets;

               • The creation of, or default upon, a material financial obligation;

               • Credit rating changes;

               • Asset impairment that lead to material deduction to the financial statements;

               • Bankruptcy/receivership;

               • After announcing financial information for a completed fiscal year.

             • In most cases, filing must occur within four business days after significant event.

         • § 13's reporting obligations are triggered if:

           • (1) § 12(a) - listing on a national exchange

             • This section makes it unlawful for any broker, dealer, or exchange member to effect transactions on a national securities exchange in securities (other than exempt securities) that are not registered.

               • § 12(b) provides a mechanism by which issuers can register their securities with the exchanges (and indirectly with the SEC).

               • The registration form (Form 12) is in essence a portrait of the management and financial condition of the issuer, today part of the integrated disclosure system.

           • (2) § 12(g) - over the counter stocks over a certain limit

             • Issuers must register a class of equity securities with the SEC if, on the last day of their fiscal year, that class is held of record by 2,000 or more persons and (by virtue of Rule 12g-1, which has periodically revised the statutory standard) the issuer has more than $10 million in assets.

               • BUT a company is a reporting company if it has 500 or more record holders who are not accredited investors.

               • Shares held by persons who acquired them pursuant to an employee compensation plan, e.g. Rule 701, are not deemed holders of record.

             • Rule 12g5-1(b)(3) states that if an issuer knows or has reason to know that a manner of holding securities of record has been used primarily to circumvent the registration requirements, the beneficial owners of such securities shall be deemed to be record owners.

             • The registration obligation terminates, subject to SEC review for accuracy, 90 days after the issuer files a certification that the number of shareholders of record of such class is fewer than 300 persons or that there are fewer than 500 record holders of its stock and its total assets have not exceeded $10 million on the last day of each of the three most recent fiscal years. § 12(g)(4) and Rule 12g-4

           • (3) § 15(d) - filing a registration statement under the '33 Act

             • § 15(d) requires an issuer that files a registration statement under the '33 Act in connection with a public distribution to file periodic reports thereafter under the scheme set forth in § 13 of the '34 Act.

             • This reporting duty ceases if at the beginning of any fiscal year other than the one in which the registration statement became effective, the securities of each class to which the registration statement related came to be held of record by fewer than 300 persons.

         • § 13 also requires filings by investors who acquire more than 5% or more of a company

         • § 16

           • Individuals who are statutory insiders when there is a change in their ownership (Form 4)

             • This facilitates:

               • § 16(b) - Insider Trading (Short Swing Trading)

                 • Enforceable by derivative suit

         • The line items for 10-K and 10-Qs are set out in Regulation S-K

         • The financial information is set out in Regulation S-X

      2. The core of periodic reports are the financial statements

         • Periodic Reports

           • 10-K: Must include audited financial statements

           • 10-Q: Includes unaudited financial statements

         • These reports are used by investors, managers, rating agencies, creditors, suppliers, competitors, and government.

         • Both the 10-K and the 10-Q require the Management Discussion & Analysis

           • MD & A

             • Discussion and analysis of the financial conditions and results of operations

               • Comparing company history with this quarter/year and say why

               • What is the financial condition? (e.g., we are short on working capital and here is why)

         • Financial Statements

           • Generally Accepted Accounting Principles (GAAP)

             • Principles come from everywhere but mostly FASB

             • There is a lot of room for judgment & estimates in financial statements

           • Accounting Industry is regulated by PCAOB

             • Regulated Public Accounting Profession

               • Inspects Accounting Firms

               • Promulgates Rules

   2. Under the '34 Act, the SEC has the power to approve rules adopted by exchanges and the SEC has the power to prescribe that exchanges adopt certain rule

   3. Consequences of Registration:

      1. File § 13 reports

      2. Subject to proxy regulations

         • If not going to solicit proxies, still have to distribute information statement

      3. Potential liability under § 18 for misstatements in '34 filings (BUT High Burden)

         • Congress explicitly provided a private right of action in § 18 for persons harmed as a result of misleading filings required by the Exchange Act.

         • § 18 imposes liability upon any person who makes or causes to be made a false or misleading statement in a required filing under the Act and permits recovery of damages by any person "who in reliance upon such statement, shall have purchased or sold a security at a price which was affected by such statement" unless "the person sued shall prove that he acted in good faith and had no knowledge that such statement was false or misleading."

         • ELEMENTS

           • (1) Read and relied on false statement

           • (2) Decline in price caused by the false statement

           • (3) Good Faith Defense?

           • BUT the elements are exceedingly hard to meet:

             • (1) There is the double reliance requirement: The plaintiff must actually have relied on the particular misstatement (i.e., must establish (apparently) that he read the document), See Heit v. Weitzen, AND the misstatement must have affected the market price of the security.

             • (2) There is the good faith defense.

             • ALSO there are procedural rules - for example, allowing the court to require plaintiff to post bond and to impose costs (including attorneys' fees) against an unsuccessful plaintiff.

         • Nonetheless, courts have been willing to permit evasion of § 18's double reliance requirement by allowing suits under Rule 10b-5 for false rulings.

         • Courts have tended not to imply an action for injured investors directly under § 13(a), so as to allow them to avoid altogether the restrictions of either Rule 10b-5 or § 18.

   4. Foreign Issuers

      1. Foreign issuers are treated a little bit differently.

      2. They file Form 20-F Annually

      3. They don't always have to file quarterly reports.

      4. They don't have to use GAAP

         • They can use whatever accounting standards are applicable in home country.

2. Internal Controls

   1. In General

      1. § 13(b)(2) of the Exchange Act (added by the Foreign Corrupt Practices Act) requires registered or reporting companies to:

         • (1) make and keep books and records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the issuer; and

         • (2) have in place a system of internal accounting controls sufficient to provide reasonable assurances that

           • (a) transactions are executed only in accordance with management's authorization,

           • (b) transactions are recorded so as to permit proper accounting and maintain accountability for assets,

           • (c) access to assets is only in accordance with management's authorization, and

           • (d) recorded accountability for assets is compared with existing assets at reasonable intervals, and corrective action taken if appropriate.

         • The phrases reasonable detail and reasonable assurances mean "such levels of detail and degree of assurances as would satisfy prudent officials in the conduct of their own affairs." § 13(b)(7)

      2. The SEC can bring an action seeking an injunction to enforce the internal controls provisions of the '34 Act. See SEC v. World-Wide Coin Investments Ltd. (pg. 559)

      3. The degree of error in not relevant to an issuer's responsibility for any inaccuracies. SEC v. World-Wide Coin Investments Ltd. (pg. 560)

      4. The motivation of those who erred is irrelevant; there is not requirement of scienter. SEC v. World-Wide Coin Investments Ltd. (pg. 560)

      5. The requirement that issuers maintain a system of internal controls is not limited to material transactions or to those above a specific dollar amount. SEC v. World-Wide Coin Investments Ltd. (pg. 560)

      6. With respect to reasonableness, management must consider the following factors in establishing and maintaining an internal accounting control system:

         • (1) The size of the business,

         • (2) Diversity of operations,

         • (3) Degree of centralization of financial and operating management,

         • (4) Amount of contact by top management with day-to-day operations, and

         • (5) Numerous other circumstances. SEC v. World-Wide Coin Investments Ltd. (pg. 559)

SEC v. World-Wide Coin Investments Ltd. (pg. 561)

• "[A]n issuer would probably not be successful in arguing a cost-benefit defense in circumstances where the management, despite warnings by its auditors or significant weaknesses of its accounting control system, had decided, after a cost-benefit analysis, not to strengthen them, and then the internal accounting controls proved to be so inadequate that the company was virtually destroyed. SEC v. World-Wide Coin Investments Ltd. (pg. 561)

• "[T]he internal accounting controls...