Business Law Today: The SEC talks about Y2K

ABA Section of Business Law
Business Law Today
November/December 1998

The SEC talks about Y2K

Agency issues a release to guide reporting obligations

By JAMES R. DOTY

Doty is a senior partner at Baker & Botts, L.L.P., in Washington. From 1990 through 1992, he was general counsel of the SEC. Gregory J. Golden of Baker & Botts contributed to the preparation of this article for publication.

Year 2000 seems to be on everyone's mind these days. Everyone includes the SEC. What do they expect companies to disclose about their readiness for the millennium?

In a public meeting held on July 29, the Securities and Exchange Commission ordered publication of its Interpretive Release on Y2K issues, providing guidance for public companies, investment advisers, investment companies and municipal securities issuers regarding disclosure obligations.

If you need the specifics, it's the Statement of the Commission Regarding Disclosure of Year 2000 Issues and Consequences of Public Companies, Investment Advisers, Investment Companies, and Municipal Securities Issuers, Securities Act Release No. 33-7558, Exchange Act Release 34-40277, Investment Advisers Act Release No. 1738, Investment Company Act Release No. 23366, International Series Release No. 1149, 63 Fed. Reg. 41,394 (1998).

The release represents the culmination of a year-long process in which the commission and its staff wrestled with issues of disclosure policy, first in issuing and revising Staff Legal Bulletin No. 5 (Fed. Sec. L. Rep. (CCH) ¶ 60,005, at 50,115, referred to as "SLB 5") and later in an internal task force survey on compliance with the informal guidance of SLB 5. As the published survey indicated, SLB 5 had not in the agency's view produced significantly enhanced disclosure of Y2K issues by public companies.

SLB 5 was, of course, issued against a backdrop of public statements by the chairman, commissioners and members of the senior staff, both before committees of Congress and in the press. Notwithstanding the circumstances of its issuance, it was noted that SLB 5 represented only the views of the staff and did not constitute a rule, regulation or rule interpretation of the commission. The new release expressly supersedes the staff guidance contained in SLB 5, and carries the force of a commission vote on specific interpretations of disclosure policies.

The most salient feature of the release is that it couples a detailed expression of disclosure policy with a clear affirmation of the application of statutory safe harbors, provided in the Private Securities Litigation Reform Act of 1995, for the forward-looking statements elicited by the disclosures. Indeed, the disclosures focus not on known, historical facts — amounts expended and liabilities incurred — but on the preparation for Year 2000, recognized to be a company-specific, continuing process, for which the results are inherently conjectural.

The release states, for example, that disclosure of Year 2000 issues should include such "soft" information as:

the company's state of readiness;
the costs to address the company's Year 2000 issues;
the risks of the company's Y2K issues; and
the company's contingency plans.

As such, the release and the approach to disclosure policy are remarkable when construed in the context of SEC administrative practice: The commission's interpretations of its rules do not normally comment on the relationship or applicability of the statutory safe harbor to the disclosure obligations of its rules. For this reason, there is a risk that registrants and their counsel may overlook the "olive branch" and get hung up on the brambles of the release.

It would be a mistake, however, for companies, their counselors or the courts to be unmindful of the close connection between the disclosure policy announced in the release and the unusual step of confirming the safe-harbor's application. Nor should there be any doubt that the commission has authority to amplify its disclosure policy through the medium of an interpretive release — a medium that is justified here by both the imminence of the Year 2000, and by the legal and factual predicate laid by SLB 5 and the task force survey.

As the discussion at the SEC's July 29 meeting emphasized, in following the route of the interpretive release rather than that of rule making, the commission and its staff were responding to externally valid concerns of timing: specifically, the necessity of alerting public companies and their lawyers to the need for prompt action to enhance disclosure. Chairman Levitt's opening statement to the July 29 meeting addressed this choice of the administrative vehicle: I know some have suggested that the SEC promulgate a formal rule on Year 2000 disclosure rather than an interpretation of existing standards. And if I could freeze the hands of time, I might agree. But the essence of timeliness demands practicality. Responsive government tries to manage problems more and react less. And we can't afford to waste one more minute and debate the best vehicle to issue guidance while our markets and investors are left exposed.

Reflecting these time constraints, the release became effective on the date of its publication in the Federal Register, Aug. 5, 1998. The disclosure obligations and other provisions of the release therefore apply to information to be included in the first periodic reports filed by public companies after this date. For companies with fiscal years ending on June 30 or July 31, the commission expects them to follow the release when filing their annual reports. For the larger universe of companies with fiscal quarters ending after Aug. 5, 1998, the release's guidance is required to be followed in the next quarterly report. The commission encourages companies with fiscal quarters ending on June 30 or July 31 to consider the release's guidance in their next-filed quarterly reports.

The release focuses on the requirement of public companies to address known material events, trends, commitments or uncertainties in the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of their disclosure documents. Specifically, the release addresses the two critical issues of whether a company is required to provide Y2K disclosure, and the type of disclosure that is required. Under the release, a company must provide such disclosure if:

its assessment of its Year 2000 issues is not complete; or
management determines that the consequences of its Y2K issues would have a material effect on the company's business, results of operations or financial condition, without taking into account the company's efforts to avoid these consequences.

Under the second test, a company, in all but the narrowest of circumstances, must assume that it will not be Year 2000 compliant and weigh the likely results of this unpreparedness. The SEC expects "that for the vast majority of companies, Year 2000 issues are likely to be material, and therefore disclosure would be required."

If disclosure is required under that test, the SEC believes that full and fair disclosure includes:

the company's state of readiness;
the costs of addressing the company's Year 2000 issues;
the risks of the company's Y2K issues; and
the company's contingency plans.

Each company is also directed to consider whether its own Y2K circumstances require MD&A disclosure of additional information. Most important, in the SEC's view, a company's assessment will not be complete unless the company has considered third-party relationships (including vendor, supplier and customer relationships), and has taken reasonable steps to verify the Y2K readiness of any third party that could cause a material impact on the company.

There are important judgments of materiality to be made by a company that has completed, or is nearing completion of, its Year 2000 assessment. In making a determination of whether the company has a disclosure obligation under the second, materiality, prong of the release, companies must evaluate their issues on a "gross" basis. That is, "in the absence of clear evidence of readiness" the company must assume it will not be Year 2000 compliant and must weigh, or evaluate, the consequences of its unpreparedness. This includes assuming that third parties will not be ready either, unless these third parties have delivered written assurances to the company that they expect to be compliant in time.

The SEC's Division of Corporation Finance has been at pains to emphasize, in public statements made since its revision of SLB 5, that it views this disclosure obligation as requiring management to assess the magnitude of the consequences of Year 2000 issues if the company is not prepared, regardless of the amount of money spent or planned to be spent on remediation efforts — a position carried into the release:

The [materiality] test is driven by measuring the consequences if the company is not prepared, rather than the amount of money the company spent, or plans to spend, to address this issue.

Most recently, Brian Lane, director of the Division of Corporate Finance, has observed that the focus of the assessment is not on the amount of money at risk in the assessment and remediation process, but the consequence of not being ready, that drives the materiality determination.

The intended practical effect of this disclosure obligation is to prod issuers to make inquiry of third parties and to initiate the assessment and remediation process on a timeline that will permit them to respond to similar inquiries from their counter-parties and third-party customers or clients. In this respect, the commission's disclosure policy reflects mounting congressional pressures, to which was added on July 14 a presidential speech delivered at the National Academy of Sciences in which the views of the White House task force appeared: "Far too many businesses, especially small- and medium-sized firms, will not be ready [for the Year 2000] unless they begin to act."

The regulatory expectation that businesses be prepared to disclose "worst-case" scenarios of failure of compliance may indeed have some collateral effect in moving management to "get cracking" on plans for readiness.

There is nothing new about the use of disclosure policy in a manner that may also have an indirect effect of inducing desirable corporate conduct — the proxy rules abound with examples. Among these are required disclosures concerning non-arm's length transactions, executive compensation and certain types of litigation. Additionally, the MD&A disclosure requirements have often been the vehicle by which issuers have been directed to make specific disclosures in such areas as environmental liabilities, participation in high-yield financings, portfolio exposure from highly leveraged transactions and low-investment grade loans, federal financial assistance to banks and thrifts in federally assisted acquisitions or restructurings, and the timelines of disclosure of preliminary merger negotiations.

What distinguishes the Y2K release is that:

it follows an extended period of mounting congressional interest in what the commission was going to do about the readiness of companies; and
significant staff resources, such as the task force survey, had been invested in reviewing the responses to SLB 5. Indeed, the "gross" estimate of materiality — or "worst case" standard — was put forward in SLB 5 and, as the staff points out, has its antecedents in the environmental remediation disclosures of MD&A. In short, the "gross" estimates approach is not new, and its application here is no surprise.

But there is one surprising aspect of the commission's Year 2000 initiative.

In an unusual step, the commission expanded in the release on its previous statements regarding the application to Y2K disclosure of the statutory safe harbors for forward-looking information, provided by the Private Securities Litigation Reform Act of 1995. The release states: We recognize that companies face difficult disclosure challenges due to the forward-looking nature of Year 2000 issues. In drafting disclosure documents, companies necessarily have to address uncertainties and describe future events relating to their Year 2000 issues. To help companies in this task, we provide the following interpretive guidance regarding the application of the two statutory safe harbors for forward-looking information provided by the Private Securities Litigation Reform Act of 1995.

The statutory safe harbors apply to forward-looking statements provided by eligible companies. Almost all of the required MD&A disclosures concerning Year 2000 problems contain forward-looking statements.

Examples of the pervasive, forward-looking nature of the contemplated disclosures include:

projections of capital expenditures or items such as estimated costs of remediation and testing;
estimated future costs because of business disruption;
assumptions regarding such estimated costs developed in connection with plans for future operations; and
the contingency plans assessing various scenarios.

Most important, a company's statement of its own readiness, based on third-party representations, is recognized as forward-looking, and would "fall within the statutory safe harbors." By the same token, a company's reasonable reliance on the third-party statements would be assumptions underlying that forward-looking statement and would also be entitled to safe-harbor protection.

The release adds three significant reminders regarding safe harbors:

material forward-looking statements must be accompanied by "meaningful cautionary statements," which cannot be boilerplate;
the safe harbors do not apply if the statement was knowingly false when made; and
the safe harbors apply only to private actions (not SEC enforcement proceedings) in federal court.

These qualifications are by no means as significant as the SEC interpretive statements to which they are added, for several reasons. First, the commission's view of meaningful cautionary statements as compared to "boilerplate" is illustrated by two helpful, formatted examples made public at the July 29 hearing. The SEC's sample boilerplate disclosure can be viewed at the agency's Web site: http://www.sec.gov. Second, the release is sufficiently detailed to suggest the appropriate scope and nature of meaningful cautionary disclosure. That is, registrants and their advisers who consult the specific disclosure guidance of the release are unlikely to be at a loss for the means of substantive, good faith compliance with this statutory precondition. Finally, the overriding limitations on safe harbors — that they do not protect knowing false statements, do not preclude commission enforcement, and do not apply to state court actions — are not expanded on by any interpretive advice, and thus are only citations to known elements of safe harbors.

The release recognizes that existing accounting and auditing standards provide guidance concerning the accounting and disclosure issues arising from the Year 2000 problem. Although the focus of the release is MD&A disclosure, it does recognize that these disclosures may implicate existing financial reporting standards. The release includes a rehearsal of citations to the accounting and auditing literature, in the same vein in which SLB 5 cited the other federal securities rules and regulations that might require disclosure related to companies' Y2K issues.

Significant here is the fact that these are matters that might be implicated depending on considerations of materiality and a registrant's own particular financial reporting situation. As such, the SEC neither purports to amend nor expand on any prior SEC interpretation of these accounting and auditing rules and other federal securities rules and regulations. Rather, the commission appears to be engaged in the categorizing of additional sources of guidance available to companies in order to call the companies' attention to their possible relevance.

In one area, the release may intensify the pressures on the auditor-client relationship, by highlighting the potential for "going concern" qualification of reports, if the auditor identifies "conditions and events that in the aggregate indicate there could be substantial doubt" about the company's response to Year 2000 issues; and for resignation of independent auditors in the wake of disagreements on accounting or reportable events that relate to Year 2000 issues, with consequences of a required filing under Item 4 of Form 8-K.

That is because the commission states that it would expect justification of any decision by a company or its auditors not to comply with the American Institute of Certified Public Accountants (AICPA) guidelines, published as The Year 2000 Issue — Current Accounting and Auditing Guidelines, in planning and carrying out the audit. Thus, any attempt by companies to restrict the scope of the audit in order to preclude procedures considered appropriate in light of Y2K issues, would appear to constitute the basis of a reportable disagreement with auditors, in the SEC's view, unless the company and its auditors were prepared to justify the departure from the AICPA guidelines.

As such, this is a prospective announcement by the commission of the predicate of its enforcement intentions, where companies disregard the advice of their auditors or the auditors merely accede to client wishes in abandoning the AICPA guidelines.

In recognition of the "key role" that investment advisers and investment companies play in the financial markets, the commission in the release reiterates its position that these entities should be prepared to make a full and accurate disclosure of their Year 2000 issues without regard to the materiality of such concerns. In addition, the release notes several existing bases that may give rise to a disclosure obligation by advisers or funds regarding Y2K issues.

First, and most significantly, the release highlights the commission's June 30, 1998 release, Investment Adviser Year 2000 Reports, Investment Advisers Act Release No. 1728, 63 Fed. Reg. 36,632 (1998) (released June 30, 1998). That earlier release proposed new Rule 204-5 under the Investment Advisers Act of 1940 (the Advisers Act), that would require nearly all registered advisers to file public reports with the commission regarding their Y2K readiness. Rule 204-5 was adopted as a final rule on Oct. 8, 1998 and will take effect on Nov. 13, 1998. Investment Adviser Year 2000 Reports, Investment Advisers Act Release No. 1769 (to be codified at 17 C.F.R. pts. 275 & 279) (Oct. 8, 1998).

Second, the release reminds advisers and funds that if Year 2000 issues are material to their operating results or financial condition, such issues must be disclosed in accordance with existing provisions of the Advisers Act or Investment Company Act of 1940. In particular, the release notes that the anti-fraud provisions of the Advisers Act generally impose an affirmative duty, consistent with the adviser's fiduciary obligation, to disclose to clients material facts concerning their advisory relationships.

The release warns that if the failure to address Y2K issues could materially affect the advisory _services provided to a client, an adviser who is unable, or is uncertain of its ability, to meet Year 2000 challenges would be obligated to disclose this information in a timely manner to its clients. Similarly, under the Investment Company Act, funds must discuss in their registration statements and public filings all Y2K issues that present material risks to investors.

Third, the release notes that specific items of the registration forms for funds may require disclosure of Year 2000 issues and their effect on a fund. For example, Y2K complications may impede the ability of a fund's adviser to provide certain services, affect the fund's pricing, purchasing and redemption procedures, or affect the fund's investment objectives and policies, all of which must be described in the fund's registration statement. Accordingly, the release suggests that in evaluating their Year 2000 disclosure, funds consider the very detailed guidance provided to public companies with respect to the preparation of their MD&A.

Unlike most investment advisers, individual funds are free to assess the materiality of their Year 2000 issues and then determine their disclosure obligation. Nevertheless, in the release the commission strongly encourages funds to include Y2K disclosure in periodic reports to shareholders or in special reports to shareholders regarding Year 2000 matters, "particularly where the fund has concluded that the materiality of the problem does not trigger a disclosure obligation in a registration statement."

Another notable feature of the release is the inclusion of a section addressing the disclosure obligations of municipal securities issuers. While the commission concedes that its regulatory authority over municipal issuers is not as broad as its authority over advisers and funds, it goes to substantial lengths to emphasize that municipal issuers remain subject to the anti-fraud provisions of the federal securities laws.

The release urges municipal issuers to avoid running afoul of the anti-fraud provisions by disclosing to investors any Year 2000 problems that could undermine the issuer's operations, creditworthiness or ability to pay debt service on outstanding municipal securities. The release reminds municipal issuers that while they are exempt from the reporting provisions of the federal securities laws, they are not exempt from the anti-fraud provisions. Accordingly, the SEC strongly encourages municipal issuers to consider whether their disclosure documents should contain a discussion of Y2K issues in order to avoid false or misleading statements.

Here again, the commission's confirmation of its disclosure policy is accompanied by detailed guidance regarding the type of disclosure the commission expects. While recognizing that the variety of municipal issuers and municipal securities requires an individual assessment of Year 2000 issues, the SEC suggests three general categories of these issues with respect to municipal issuers — "internal" issues, "external" issues and "mechanical" issues. Internal issues may arise from an issuer's own operations and materially affect its credit worthiness and ability to make timely payment of its obligations. External issues may arise from third parties that provide payments that support the issuer's debt service. Finally, mechanical issues may arise if Year 2000 complications disrupt the actual process used by a municipal issuer to send payments to its bondholders. All or some of these categories of Year 2000 issues are seen as having the potential to disrupt a municipal issuer's operations and therefore may be material to investors, thus giving rise to a disclosure obligation under the anti-fraud provisions of federal securities law.

That the underlying philosophy of the release is intertwined with concerns over the issue of public confidence in the securities market is evident from Chairman Levitt's July 29, 1998 letter to executives at more than 9,000 public companies. The letter, which has been posted on the SEC's Web site, directs the executives' attention to the release. Citing the "unprecedented growth of our capital markets during the past decade . . . largely due to the confidence investors have in public companies like yours," the chairman expressed the view that it would be the lack of information on Year 2000 readiness that in his view "could seriously undermine the confidence investors place in your company" and, by extrapolation, the markets.

The release follows on amended Rule 17a-5, requiring certain brokers and dealers to complete reports on Year 2000 readiness, and a "dry-run" on Wall Street, all reflecting the view that if the information flows, investor confidence will follow. Consistent with this philosophy, the commission is less worried that the information is negative, than that it be out there. While that may not square with the philosophy of the executive suite, there is nothing surprising about the commission's position on the salutary indirect effect of disclosure on both management conduct and investor confidence.

Viewed as a recognized issue of investor confidence, it is highly likely that the commission has authority to interpret its disclosure requirements in this fashion. Its interpretation would most likely be accorded deference by the federal courts should that authority be put to the test. Where, as in the present case, the commission has gone to great lengths to fully explain a consistent interpretation of an existing rule, courts can be expected to give such an interpretation "substantial deference." See, for example, Thomas Jefferson Univ. v. Shalala, 512 U.S. 504, 512 (1994); Chevron, U.S.A. Inc. v. Natural Resources Defense Council, 467 U.S. 837, 842-45 (1984).

Furthermore, federal courts have tended to defer to the commission's interpretation of its rules regarding disclosure policy, as opposed to the commission's remedial enforcement efforts. Compare New York City Employees Retirement Sys. v. SEC, 45 F.2d 7 (2d Cir. 1995) (finding that the commission's new interpretation of Rule 14a-8 did not constitute an impermissible legislative rule), with Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (dismissing proceeding against accountants where commission failed to adequately explain its interpretation of a disciplinary rule).

Only in cases where the commission has failed to state reasons supporting its interpretation have courts refused to give such interpretations substantial deference. See, for example, SEC v. Medical Comm. for Human Rights, 404 U.S. 403 (1972). The factual and legal basis for the commission's Year 2000 disclosure policy is extensively and consistently set forth in two staff reports to Congress, the testimony of the commissioners and senior staff before the subcommittee, SLB 5, the task force survey and related rule making concerning broker-dealers and transfer agents. Reports To Be Made by Certain Brokers and Dealers, Exchange Act Release No. 34-40162, 63 Fed. Reg. 37,668 (1998) (to be codified at 17 C.F.R. pt. 240) (July 2, 1998); Year 2000 Readiness Reports To Be Made by Certain Transfer Agents, Exchange Act Release No. 34-40163, 63 Fed. Reg. 37,688, 42,229 (1998) (to be codified at 17 C.F.R. pt. 240) (July 2, 1998). Accordingly, it is highly unlikely that a reviewing court would find the release to be unsupported.

Nor would it appear to be in the best interests of public companies, their lawyers and independent accountants to suggest otherwise. The commission has articulated a structured view of what constitutes adequate disclosure of Year 2000 readiness, and has clothed that with its own interpretation of the meaning and application of the statutory safe harbors. To suggest that the release lacks authority, as some have done, leaves companies and their advisers at maximum risk for the failure to accurately predict Year 2000 consequences.

Unlike the savings and loan collapse, the event of Year 2000 and the general causes of disruption are predictable. The uncertainties relate generally to the magnitude of the disruption and the steps and time required to avoid or minimize the disruption. The press carries almost weekly accounts of a cottage industry gearing up to sue on the consequences of Y2K disruption. Similarly, speaking to lawyers at the recent annual meeting in Toronto, the director of the Division of Corporation Finance predicted an increase in auditor resignation over disagreements with clients, rooted in Year 2000 readiness and disclosure. Indeed, a series of letters from the AICPA to Chairman Levitt, leading up to the promulgation of the release, indicate that the accounting profession has been urging business to do more — and to do it faster — to get ready for Y2K.

Against this backdrop, the question may well be asked, what did the lawyers do to implement the disclosure policy represented by the release? Rightly or wrongly, the accounting profession has perceived reluctance by corporate counsel to advise their clients to take on the difficult task of presenting in their filings the company's Year 2000 readiness through the eyes of management, with candid estimates of materiality, remediation cost, risks of noncompliance and contingency plans. These are the areas that the SEC expects to see addressed, particularly in light of their having given express confirmation of the application of the protections of the statutory safe-harbor provisions.