Stock Buyouts and Corporate Cashouts

Washington D.C.

Thank you so much, Neera, for that very kind introduction. I’ve long admired all that you and everyone here at the Center for American Progress do to promote a progressive economic agenda. And I share your commitment to making sure our markets are safe and efficient—and fair for all Americans. So it’s a real honor to be with you here today.[1]

I also want to thank my friend Andy Green, who in addition to being Managing Director of Economic Policy here at CAP, has been a critical source of wisdom for me since my swearing in at the Commission back in January.

Before I begin, let me start with the standard disclaimer that the views I’m about to express are my own and do not reflect the views of the Commission, my fellow Commissioners, or the SEC’s Staff. And let me add my own standard caveat, which is that I fully expect someday to convince my colleagues that I am, as usual, completely correct in everything I say and do.

Today, I’d like to share a few thoughts about corporate stock buybacks—and some research produced by my staff that raises significant new questions about this activity. As Neera mentioned, I’m a recovering researcher. Before I was appointed to the SEC, I was a law professor who spent most of my time thinking about how to give corporate managers incentives to create sustainable long-term value. I’d often ask my students: are we making sure that executive pay gives managers reason to invest in the long-term development of their workforce and their communities? Or are we paying executives to pursue short-term stock-price spikes rather than long-term growth?

Little did I know that, so soon into my tenure, I’d have a sobering case study to put these questions to the test. That’s because the Trump tax bill, promising to bring overseas corporate cash home, became law last December.

Now, we all know what happened the last time a Republican-controlled government pushed through a corporate tax holiday in 2004. As that bill’s sponsors hoped, American companies repatriated billions of dollars of overseas cash.[2] But corporations didn’t invest most of that money in innovation. They didn’t invest it in retraining their workforce or raising wages. Instead, executives largely used the influx of fresh funds for massive stock buybacks.[3]

So when I first took this job, I worried that 14 years later history would repeat itself, and the tax bill would cause managers to focus on financial engineering rather than long-term value creation. Sure enough, in the first quarter of 2018 alone American corporations bought back a record $178 billion in stock.[4] On too many occasions, companies doing buybacks have failed to make the long-term investments in innovation or their workforce that our economy so badly needs.[5] And, because we at the SEC have not reviewed our rules governing stock buybacks in over a decade, I worry whether these rules can protect investors, workers, and communities from the torrent of corporate trading dominating today’s markets.[6]

Even more disturbing, there is clear evidence that a substantial number of corporate executives today use buybacks as a chance to cash out the shares of the company they received as executive pay.[7] We give stock to corporate managers to convince them to create the kind of long-term value that benefits American companies and the workers and communities they serve. Instead, what we are seeing is that executives are using buybacks as a chance to cash out their compensation at investor expense.

Executives often claim that a buyback is the right long-term strategy for the company, and they’re not always wrong. But if that’s the case, they should want to hold the stock over the long run, not cash it out once a buyback is announced. If corporate managers believe that buybacks are best for the company, its workers, and its community, they should put their money where their mouth is. That’s why I’m here today to call on my colleagues at the Commission to update our rules to limit executives from using stock buybacks to cash out from America’s companies.

And I am also calling for an open comment period to reexamine our rules in this area to make sure they protect employees, investors, and communities given today’s unprecedented volume of buybacks.

Stock Buybacks and Executive Pay

Basic corporate-finance theory tells us that, when a company announces a stock buyback, it is announcing to the world that it thinks the stock is cheap.[8] That announcement, and the firm’s open-market purchasing activity, often causes the company’s stock price to jump, so the SEC has adopted special rules to govern buybacks.

Those rules, first adopted in 1982, provide companies with a safe harbor[9] from securities-fraud liability if the pricing and timing of buyback-related repurchases meet certain conditions.[10] After experience proved that buybacks could be used to take advantage of less-informed investors,[11] the SEC updated its rules in 2003, though researchers noted that several gaps remained.[12]

In the meantime, the use of stock-based pay at American public companies has exploded.[13] Although these pay programs present many challenges, the one that I’ve spent much of my career thinking about is how to make sure that corporate management has skin in the game—that is, how to keep top executives from cashing out stock they receive as compensation.[14]

You see, the theory behind paying executives in stock is to give them incentives to create long-term, sustainable value.[15] Because executives who receive shares rather than cash demand higher levels of pay, the use of stock-based compensation has led to eye-opening pay packages for top executives. In the trade, investors—and the economy as a whole—tie executives’ fortunes to the growth of the company.

But that only works when executives are required to hold the stock over the long term. Researchers have long worried that executives, who always prefer cash to stock, will try to sell rather than hold their shares, eliminating the incentives they were meant to produce.[16] So it’s no surprise that, in the years leading up to the financial crisis, top executives at Bear Stearns and Lehman Brothers personally cashed out $2.4 billion in stock before the firms collapsed.[17] And it’s no wonder that sophisticated investors have for decades strictly limited executives’ freedom to cash out their shares.[18]

In the wake of the financial crisis, Congress realized the importance of keeping executives’ skin in the game, so the Dodd-Frank Act included several provisions designed to give investors more information about whether and how managers cash out.[19] Unfortunately, as you all know too well, those rules have still not yet been completed, keeping investors in the dark about executives’ incentives.

Nearly eight years since that landmark legislation, it is completely unacceptable that the SEC has still not promulgated these and other rules required by law. But it’s not just that the regulations haven’t been finalized. It’s that the problem itself keeps getting worse. You see, the Trump tax bill has unleashed an unprecedented wave of buybacks, and I worry that lax SEC rules and corporate oversight are giving executives yet another chance to cash out at investor expense.

How Executives Use Buybacks to Cash out

That’s why, when I was sworn in a few weeks after the Trump tax bill took effect, I asked my staff to take a look at how buybacks affect how much skin executives keep in the game. I was worried that lax corporate practices and SEC rules might lead to buybacks that give executives yet another chance to cash out at investor expense.

So we dove into the data, studying 385 buybacks over the last fifteen months.[20] We matched those buybacks by hand to information on executive stock sales available in SEC filings.[21] First, we found that a buyback announcement leads to a big jump in stock price: in the 30 days after the announcements we studied, firms enjoy abnormal returns of more than 2.5%.[22] That’s unsurprising: when a public company in the United States announces that it thinks the stock is cheap, investors bid up its price.

What did surprise us, however, was how commonplace it is for executives to use buybacks as a chance to cash out. In half of the buybacks we studied, at least one executive sold shares in the month following the buyback announcement. In fact, twice as many companies have insiders selling in the eight days after a buyback announcement as sell on an ordinary day.[23] So right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell.[24]

And, in the process, executives take a lot of cash off the table. On average, in the days before a buyback announcement, executives trade in relatively small amounts—less than $100,000 worth. But during the eight days following a buyback announcement, executives on average sell more than $500,000 worth of stock each day—a fivefold increase. Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement:

Transaction volume of insiders’ shares sold before and after a buyback announcement

Now, let’s be clear: this trading is not necessarily illegal. But it is troubling, because it is yet another piece of evidence that executives are spending more time on short-term stock trading than long-term value creation. It’s one thing for a corporate board and top executives to decide that a buyback is the right thing to do with the company’s capital. It’s another for them to use that decision as an opportunity to pocket some cash at the expense of the shareholders they have a duty to protect, the workers they employ, or the communities they serve.

More importantly, policymakers, advocates, investors and corporate boards have spent decades, and billions of dollars of shareholder money, trying to tie executive pay to long-term corporate performance. But the evidence shows that buybacks give executives an opportunity to take significant cash off the table, breaking the pay-performance link. SEC rules do nothing to discourage executives from using buybacks in this way. It’s time for that to change.

The Path Forward

There are two steps we can and should take right away to address the practice of executives using buybacks as a chance to sell their shares. First, as I mentioned earlier, the SEC last revised its rules governing buybacks in 2003. Those rules give companies a so-called “safe harbor” from liability when pursuing buybacks. But there are no limits on boards and executives using the buyback—and the safe harbor—as an opportunity to cash out.

I cannot see why a safe harbor to the securities laws should subsidize this behavior. Instead, SEC rules should encourage executives to keep their skin in the game for the long term. That’s why our rules should be updated, at a minimum, to deny the safe harbor to companies that choose to allow executives to cash out during a buyback.[25]

And that’s why today I’m also calling for an open comment period to reexamine our rules in this area to make sure they protect American companies, employees, and investors given today’s unprecedented volume of buybacks.[26]

Second, corporate boards and their counsel should pay closer attention to the implications of a buyback for the link between pay and performance. In particular, the company’s compensation committee should be required to carefully review the degree to which the buyback will be used as a chance for executives to turn long-term performance incentives into cash. If executives will use the buyback to cash out, the committee should be required to approve that decision and disclose to investors the reasons why it is in the company’s long-term interests. It is hard to see why a company’s buyback announcement shouldn’t be accompanied by this kind of disclosure.[27]

Executives who can’t sell their holdings in the short term—but instead have to create real value over time—have far fewer incentives to manage to quarterly earnings and pursue the kind of short-term thinking that dominates our economy today. The esteemed experts on our next panel will, I’m sure, offer broader policy proposals that can help us address those problems. But at the SEC, it’s time for our rules to require corporate managers who say they want to manage for the long term to put their money where their mouth is. At the very least, our rules should stop giving executives incentives to use buybacks to cash out.

*          *          *          *

The increasingly rapid cycling of capital at American public companies has had real costs for American workers and families. We need our corporations to create the kind of long-term, sustainable value that leads to the stable jobs American families count on to build their futures. Corporate boards and executives should be working on those investments, not cashing in on short-term financial engineering.

Each day when I arrive at work, I’m reminded that the SEC’s mission is to protect investors, ensure a level playing field in our financial markets, and encourage capital formation. Updating our rules to reflect the effects of buybacks on executives’ incentives to create long-term value would serve all three of those goals.

Investors deserve to know when corporate insiders who are claiming to be creating value with a buyback are, in fact, cashing in.[28] A level playing field requires that shareholders selling into a buyback know what managers are doing with their own money. And investors who feel assured that buybacks won’t be used as a chance for insiders to cash in will be more willing to fund the kinds of long-term investments our economy needs.

All of you here at CAP have provided essential leadership in developing policies that produce growth for all Americans—and favor long-term value creation over financial engineering. That’s why I’m so proud to be here today. I’m very much looking forward to your questions. And I so look forward to working with you to ensure that the SEC’s policies create the kinds of markets that American families need—and deserve.

 


[1] Commissioner, United States Securities and Exchange Commission. I am, as always, grateful to my SEC colleagues Bobby Bishop, Caroline Crenshaw, Marc Francis, Satyam Khanna, Prashant Yerramalli, and Jon Zytnick for their invaluable counsel. Professor Jesse Fried of the Harvard Law School also provided insights that significantly deepened my thinking about these matters. The views expressed here are solely my own, and do not necessarily reflect those of the Staff or my colleagues on the Commission, though I hope someday they will.

[2] See American Jobs Creation Act, Pub. L. No. 108-357, 118 Stat. 1418-1660 (2004).

[3] Although the degree to which corporations used the proceeds of the 2004 holiday for buybacks is debatable, whether they did so—even though the statute prohibited such uses—is not. Compare Dhammika Dharmapala, C. Fritz Foley, and Kristin J. Forbes, Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act, 66 J. Fin. 753 (2011) with Thomas J. Brennan, Where the Money Really Went: A New Understanding of the AJCA Tax Holiday (Northwestern Law and Economics Working Paper) (2014). What’s worse, “the temporary holiday conditioned firms to anticipate future holidays and to change their behavior by placing more earnings overseas than ever before.” Thomas J. Brennan, What Happens After a Holiday? Long-Term Effects of the Repatriation Provisions of the AJCA, 5 Nw. J. L. & Soc. Pol’y 1 (2010).

[4] Talib Visram, Tax Cut Fuels Record $200 Billion Stock Buyback Bonanza, CNN.com (June 5, 2018); see also William Lazonick, Stock Buybacks: From Retain-and-Reinvest to Downsize-and-Distribute, Brookings Initiative on 21st Century Capitalism (April 2015), at 2 (“Over the decade 2004-2013, 454 companies in the S&P 500 Index in March 2014 that were publicly listed over the ten years did $3.4 trillion in stock buybacks, representing 51 percent of net income.”).

[5] Savvy market observers also worry that the magnitude of this year’s buyback spree reflects a troubling trend in corporate investment. See, e.g., Matt Egan, Goldman Sachs Warns Against Falling in Love with Stock Buybacks, CNNMoney.com (April 26, 2018) (noting a recent equity research report describing the perhaps-unsurprising result that, since the 2016 presidential election, “Goldman Sachs’s collection of stocks that are focused on capital spending and research and development soared 42% . . . besting the S&P 500’s 24% gain”).

[6] For an exceptionally clear demonstration as to how buybacks can harm investors while benefiting insiders, see Jesse M. Fried, Insider Trading Via the Corporation, 162 U. Pa. L. Rev. 801, 805 (2014) (referring to stock buybacks as “indirect insider trading” and noting that such “trading likely imposes considerable costs on public investors in two ways. First, just like ‘ordinary’ direct insider trading, indirect insider trading secretly redistributes value from public investors to insiders. . . . Second, the use of the corporation as a vehicle for insider trading can lead insiders to waste economic resources.”).

[7] In these remarks, I focus on executives’ use of buybacks to cash out shares granted as part of compensation packages otherwise designed to link executive pay with long-term performance. There are, of course, circumstances where managers who founded the firm or are otherwise large shareholders seek liquidity for those holdings using buybacks. Those cases, too, should be addressed if the SEC chooses to reevaluate its rules in this area. But here I focus on cases where executives use buybacks to cash out shares granted as stock-based pay.

[8] See, e.g., George Constantinides & Bruce Grundy, Optimal Investment with Stock Repurchase and Financing as Signals, 2 Rev. Fin. Stud. 445 (1989) (providing a theoretical model on the role of repurchases when a firm is undervalued).

[9] Among other reasons, a safe harbor is necessary because firms often pursue buybacks under informational circumstances that might lead to securities-law liability in other contexts. See Fried, supra note 5, at 813-814 (“The SEC takes the position that Rule 10b-5 . . . applies to a firm buying its own shares.”).

[10]  Securities and Exchange Commission, Final Rule: Purchases of Certain Equity Securities by the Issuer and Others, Release Nos. 33-8335, 34-48766, 17 C.F.R. Pt. 228 et seq.

[11] For example, because these rules permitted firms to announce a buyback—generating a stock-price spike—and then choose not to buy back any stock at all without disclosing that fact to investors, commentators and the SEC worried that managers opportunistically used buyback announcements to manipulate share prices. See, e.g., Jesse Fried, Informed Trading and False Signaling with Open Market Repurchases, 93 Cal. L. Rev. 1323, 1336-40 (2005); see also Final Rule, supra note 8 (“Studies have . . . shown that some issuers publicly announce repurchase programs, but do not purchase any shares or purchase only a small portion of the publicly disclosed amount.”).

[12] See Final Rule, supra note 8. Among other things, commentators have pointed out that the SEC’s still-lax disclosure rules regarding buybacks give corporate insiders “a strong incentive to exploit [those] rules in order to engage in indirect insider trading: having the firm buy and sell its own shares at favorable prices to increase the value of the insiders’ equity.” Fried, supra note 8, at 804. Indeed, there is important evidence that the limited tightening of disclosure rules in this area have had some benefits in addressing opportunistic buyback activity. See Michael Simkovic, The Effect of Mandatory Disclosure on Open-Market Stock Repurchases, 6 Berkeley Bus. L. J. 98 (2009). That evidence makes the case for revisiting these rules now all the more compelling. Indeed, the Commission issued a proposal to update these rules in 2010, see Proposed Rule, Purchases of Certain Equity Securities by the Issuer and Others, Release No. 34-61414 (2010), but to date has taken no action on the proposal.

[13]  See, e.g., Kevin J. Murphy, Executive Compensation: Where We Are and How We Got There, in George Constantinides, Milton Harris, and Rene Stulz, Eds., Handbook on Economics and Finance 211 (2013).

[14]  See, e.g., Robert J. Jackson, Jr., Stock Unloading and Banker Incentives, 112 Colum. L. Rev. 951 (2012); Robert J. Jackson, Jr. & Colleen Honigsberg, The Hidden Nature of Executive Retirement Pay, 100 Va. L. Rev. 479 (2014); Robert J. Jackson, Jr. & Jonathon Zytnick, The Effects of a Tax Notch on CEO Golden Parachute Contracts and Option Exercises (working paper 2018).

[15] See, e.g., Kevin Murphy, Executive Compensation, in Orley C. Ashenfelter & David Card, Eds., 3B Handbook of Labor Economics 2485 (1999).

[16] See Lucian A. Bebchuk, Jesse Fried, and David Walker, Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. Chi. L. Rev. 751 (2002); see also Lucian A. Bebchuk & Jesse Fried, Paying for Long-Term Performance, 158 U. Pa. L. Rev. 1915, 1921 (2010) (describing concerns related to “ensuring that, whatever equity incentives are used [in executive pay, executives’] payoffs are primarily based on long-term stock values rather than on short-term gains that may be reversed.”).

[17] Lucian A. Bebchuk, Alma Cohen, and Holger Spamann, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, 27 Yale. J. Reg. 257 (2012).

[18] Robert J. Jackson, Jr., Private Equity and Executive Compensation, 60 U.C.L.A. L. Rev. 638, 640 (2013) (“[T]he pay-performance link is much weaker in public companies than in companies owned by private equity investors. Borrowing from their private equity counterparts, public company boards seeking to strengthen the link between pay and performance should restrict CEOs’ freedom to unload.”).

[19] See, e.g., Dodd-Frank Wall Street Reform and Consumer Protection Act §§ 953(a), 954, 955, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (requiring the SEC to adopt rules requiring disclosure of the pay-performance link, public companies’ policies related to the clawback of erroneously awarded compensation, and policies related to insider hedging of public companies’ stocks, none of which has been finalized).

[20] We drew information on buybacks from the Securities Data Company (SDC) database, using transactions identified by SDC as buybacks with announcements in the year 2017 and the first three months of 2018. For consistency in treatment across the sample, we identify an initial sample of 708 repurchases and retain only the first repurchase announcement by each company—and only those repurchases not followed by a subsequent repurchase announcement within 60 days. We merged those data with information from the Center for Research on Securities Prices (CRSP) database, leaving a sample of 385 public company buybacks.

[21] We used data from Form 4 filed pursuant to Section 16. See Securities and Exchange Commission, Ownership Reports and Trading By Officers, Directors and Principal Securities Holders, 56 Fed. Reg. 7,242 (Feb. 21, 1991); see also Securities and Exchange Commission, Mandated Electronic Filing and Web Site Posting for Forms 3, 4 and 5, 68 Fed. Reg. 25,788 (May 13, 2003).

[22] That finding is consistent with the longstanding finance literature on the effects of these announcements on stock prices. See, e.g., David Ikenberry, Josef Lakonishok, and Theo Vermalen, Market Underreaction to Open Market Share Repurchases, 39 J. Fin. Econ. 181 (1995); Jesse M. Fried, Insider Signaling and Insider Trading with Repurchase Tender Offers, 67 U. Chi. L. Rev. 421 (2000).

[23] On an average day, between 3 and 4 percent of corporate insiders trade in the company’s stock, but we found that, during the eight days following a buyback announcement, more than 8 percent do. We direct the interested reader to the data appendix to this speech, where you can learn more about our methodology and analysis.

[24] Investors receive a mixed signal from a buyback announcement that is accompanied by insider selling. Indeed, as we explain in our data appendix, we observe statistically significantly lower returns during the ten- and thirty-day window following buyback announcements with executive selling than we do in buybacks where executives hold their shares for the long term.

[25]  The precise way in which the safe-harbor could be restructured to disfavor the use of buybacks for insider sales is beyond the scope of my remarks—and, in all events, well within the expertise of our exceptional Staff. Suffice it to say that, if the Commission were so inclined, our Staff would have little difficulty making sure that our rules are not used in a way that encourages corporate executives to use buybacks to sell their shares.

[26] We should also use this opportunity to review other problems with Rule 10b-18 and related rules—including the fact that they require only quarterly disclosure of the amount of shares a company has actually repurchased, leaving investors largely in the dark about corporate trading in their own shares. For an exceptionally thoughtful proposal in this respect, see Fried, supra note 5.

[27] Except, of course, the fact that our rules let them. See Final Rule, supra note 8; but see Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437, 444 & n.15 (Del. 1971) (“Inequitable action does not become permissible simply because it is legally possible.”).

[28] It’s true, of course, that investors eventually receive disclosure of executives’ selling on Form 4, which is how we were able to conduct this study. But those disclosures come after the executive has already sold—too late for shareholders to price the executive’s decision into their own determination whether to sell their shares. See Fried, supra note 5.

https://www.sec.gov/news/speech/speech-jackson-061118

Stock Buybacks and Corporate Cashouts

Washington D.C.

Thank you so much, Neera, for that very kind introduction. I’ve long admired all that you and everyone here at the Center for American Progress do to promote a progressive economic agenda. And I share your commitment to making sure our markets are safe and efficient—and fair for all Americans. So it’s a real honor to be with you here today.[1]

I also want to thank my friend Andy Green, who in addition to being Managing Director of Economic Policy here at CAP, has been a critical source of wisdom for me since my swearing in at the Commission back in January.

Before I begin, let me start with the standard disclaimer that the views I’m about to express are my own and do not reflect the views of the Commission, my fellow Commissioners, or the SEC’s Staff. And let me add my own standard caveat, which is that I fully expect someday to convince my colleagues that I am, as usual, completely correct in everything I say and do.

Today, I’d like to share a few thoughts about corporate stock buybacks—and some research produced by my staff that raises significant new questions about this activity. As Neera mentioned, I’m a recovering researcher. Before I was appointed to the SEC, I was a law professor who spent most of my time thinking about how to give corporate managers incentives to create sustainable long-term value. I’d often ask my students: are we making sure that executive pay gives managers reason to invest in the long-term development of their workforce and their communities? Or are we paying executives to pursue short-term stock-price spikes rather than long-term growth?

Little did I know that, so soon into my tenure, I’d have a sobering case study to put these questions to the test. That’s because the Trump tax bill, promising to bring overseas corporate cash home, became law last December.

Now, we all know what happened the last time a Republican-controlled government pushed through a corporate tax holiday in 2004. As that bill’s sponsors hoped, American companies repatriated billions of dollars of overseas cash.[2] But corporations didn’t invest most of that money in innovation. They didn’t invest it in retraining their workforce or raising wages. Instead, executives largely used the influx of fresh funds for massive stock buybacks.[3]

So when I first took this job, I worried that 14 years later history would repeat itself, and the tax bill would cause managers to focus on financial engineering rather than long-term value creation. Sure enough, in the first quarter of 2018 alone American corporations bought back a record $178 billion in stock.[4] On too many occasions, companies doing buybacks have failed to make the long-term investments in innovation or their workforce that our economy so badly needs.[5] And, because we at the SEC have not reviewed our rules governing stock buybacks in over a decade, I worry whether these rules can protect investors, workers, and communities from the torrent of corporate trading dominating today’s markets.[6]

Even more disturbing, there is clear evidence that a substantial number of corporate executives today use buybacks as a chance to cash out the shares of the company they received as executive pay.[7] We give stock to corporate managers to convince them to create the kind of long-term value that benefits American companies and the workers and communities they serve. Instead, what we are seeing is that executives are using buybacks as a chance to cash out their compensation at investor expense.

Executives often claim that a buyback is the right long-term strategy for the company, and they’re not always wrong. But if that’s the case, they should want to hold the stock over the long run, not cash it out once a buyback is announced. If corporate managers believe that buybacks are best for the company, its workers, and its community, they should put their money where their mouth is. That’s why I’m here today to call on my colleagues at the Commission to update our rules to limit executives from using stock buybacks to cash out from America’s companies.

And I am also calling for an open comment period to reexamine our rules in this area to make sure they protect employees, investors, and communities given today’s unprecedented volume of buybacks.

Stock Buybacks and Executive Pay

Basic corporate-finance theory tells us that, when a company announces a stock buyback, it is announcing to the world that it thinks the stock is cheap.[8] That announcement, and the firm’s open-market purchasing activity, often causes the company’s stock price to jump, so the SEC has adopted special rules to govern buybacks.

Those rules, first adopted in 1982, provide companies with a safe harbor[9] from securities-fraud liability if the pricing and timing of buyback-related repurchases meet certain conditions.[10] After experience proved that buybacks could be used to take advantage of less-informed investors,[11] the SEC updated its rules in 2003, though researchers noted that several gaps remained.[12]

In the meantime, the use of stock-based pay at American public companies has exploded.[13] Although these pay programs present many challenges, the one that I’ve spent much of my career thinking about is how to make sure that corporate management has skin in the game—that is, how to keep top executives from cashing out stock they receive as compensation.[14]

You see, the theory behind paying executives in stock is to give them incentives to create long-term, sustainable value.[15] Because executives who receive shares rather than cash demand higher levels of pay, the use of stock-based compensation has led to eye-opening pay packages for top executives. In the trade, investors—and the economy as a whole—tie executives’ fortunes to the growth of the company.

But that only works when executives are required to hold the stock over the long term. Researchers have long worried that executives, who always prefer cash to stock, will try to sell rather than hold their shares, eliminating the incentives they were meant to produce.[16] So it’s no surprise that, in the years leading up to the financial crisis, top executives at Bear Stearns and Lehman Brothers personally cashed out $2.4 billion in stock before the firms collapsed.[17] And it’s no wonder that sophisticated investors have for decades strictly limited executives’ freedom to cash out their shares.[18]

In the wake of the financial crisis, Congress realized the importance of keeping executives’ skin in the game, so the Dodd-Frank Act included several provisions designed to give investors more information about whether and how managers cash out.[19] Unfortunately, as you all know too well, those rules have still not yet been completed, keeping investors in the dark about executives’ incentives.

Nearly eight years since that landmark legislation, it is completely unacceptable that the SEC has still not promulgated these and other rules required by law. But it’s not just that the regulations haven’t been finalized. It’s that the problem itself keeps getting worse. You see, the Trump tax bill has unleashed an unprecedented wave of buybacks, and I worry that lax SEC rules and corporate oversight are giving executives yet another chance to cash out at investor expense.

How Executives Use Buybacks to Cash out

That’s why, when I was sworn in a few weeks after the Trump tax bill took effect, I asked my staff to take a look at how buybacks affect how much skin executives keep in the game. I was worried that lax corporate practices and SEC rules might lead to buybacks that give executives yet another chance to cash out at investor expense.

So we dove into the data, studying 385 buybacks over the last fifteen months.[20] We matched those buybacks by hand to information on executive stock sales available in SEC filings.[21] First, we found that a buyback announcement leads to a big jump in stock price: in the 30 days after the announcements we studied, firms enjoy abnormal returns of more than 2.5%.[22] That’s unsurprising: when a public company in the United States announces that it thinks the stock is cheap, investors bid up its price.

What did surprise us, however, was how commonplace it is for executives to use buybacks as a chance to cash out. In half of the buybacks we studied, at least one executive sold shares in the month following the buyback announcement. In fact, twice as many companies have insiders selling in the eight days after a buyback announcement as sell on an ordinary day.[23] So right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell.[24]

And, in the process, executives take a lot of cash off the table. On average, in the days before a buyback announcement, executives trade in relatively small amounts—less than $100,000 worth. But during the eight days following a buyback announcement, executives on average sell more than $500,000 worth of stock each day—a fivefold increase. Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement:

Transaction volume of insiders’ shares sold before and after a buyback announcement

Now, let’s be clear: this trading is not necessarily illegal. But it is troubling, because it is yet another piece of evidence that executives are spending more time on short-term stock trading than long-term value creation. It’s one thing for a corporate board and top executives to decide that a buyback is the right thing to do with the company’s capital. It’s another for them to use that decision as an opportunity to pocket some cash at the expense of the shareholders they have a duty to protect, the workers they employ, or the communities they serve.

More importantly, policymakers, advocates, investors and corporate boards have spent decades, and billions of dollars of shareholder money, trying to tie executive pay to long-term corporate performance. But the evidence shows that buybacks give executives an opportunity to take significant cash off the table, breaking the pay-performance link. SEC rules do nothing to discourage executives from using buybacks in this way. It’s time for that to change.

The Path Forward

There are two steps we can and should take right away to address the practice of executives using buybacks as a chance to sell their shares. First, as I mentioned earlier, the SEC last revised its rules governing buybacks in 2003. Those rules give companies a so-called “safe harbor” from liability when pursuing buybacks. But there are no limits on boards and executives using the buyback—and the safe harbor—as an opportunity to cash out.

I cannot see why a safe harbor to the securities laws should subsidize this behavior. Instead, SEC rules should encourage executives to keep their skin in the game for the long term. That’s why our rules should be updated, at a minimum, to deny the safe harbor to companies that choose to allow executives to cash out during a buyback.[25]

And that’s why today I’m also calling for an open comment period to reexamine our rules in this area to make sure they protect American companies, employees, and investors given today’s unprecedented volume of buybacks.[26]

Second, corporate boards and their counsel should pay closer attention to the implications of a buyback for the link between pay and performance. In particular, the company’s compensation committee should be required to carefully review the degree to which the buyback will be used as a chance for executives to turn long-term performance incentives into cash. If executives will use the buyback to cash out, the committee should be required to approve that decision and disclose to investors the reasons why it is in the company’s long-term interests. It is hard to see why a company’s buyback announcement shouldn’t be accompanied by this kind of disclosure.[27]

Executives who can’t sell their holdings in the short term—but instead have to create real value over time—have far fewer incentives to manage to quarterly earnings and pursue the kind of short-term thinking that dominates our economy today. The esteemed experts on our next panel will, I’m sure, offer broader policy proposals that can help us address those problems. But at the SEC, it’s time for our rules to require corporate managers who say they want to manage for the long term to put their money where their mouth is. At the very least, our rules should stop giving executives incentives to use buybacks to cash out.

*          *          *          *

The increasingly rapid cycling of capital at American public companies has had real costs for American workers and families. We need our corporations to create the kind of long-term, sustainable value that leads to the stable jobs American families count on to build their futures. Corporate boards and executives should be working on those investments, not cashing in on short-term financial engineering.

Each day when I arrive at work, I’m reminded that the SEC’s mission is to protect investors, ensure a level playing field in our financial markets, and encourage capital formation. Updating our rules to reflect the effects of buybacks on executives’ incentives to create long-term value would serve all three of those goals.

Investors deserve to know when corporate insiders who are claiming to be creating value with a buyback are, in fact, cashing in.[28] A level playing field requires that shareholders selling into a buyback know what managers are doing with their own money. And investors who feel assured that buybacks won’t be used as a chance for insiders to cash in will be more willing to fund the kinds of long-term investments our economy needs.

All of you here at CAP have provided essential leadership in developing policies that produce growth for all Americans—and favor long-term value creation over financial engineering. That’s why I’m so proud to be here today. I’m very much looking forward to your questions. And I so look forward to working with you to ensure that the SEC’s policies create the kinds of markets that American families need—and deserve.

 


[1] Commissioner, United States Securities and Exchange Commission. I am, as always, grateful to my SEC colleagues Bobby Bishop, Caroline Crenshaw, Marc Francis, Satyam Khanna, Prashant Yerramalli, and Jon Zytnick for their invaluable counsel. Professor Jesse Fried of the Harvard Law School also provided insights that significantly deepened my thinking about these matters. The views expressed here are solely my own, and do not necessarily reflect those of the Staff or my colleagues on the Commission, though I hope someday they will.

[2] See American Jobs Creation Act, Pub. L. No. 108-357, 118 Stat. 1418-1660 (2004).

[3] Although the degree to which corporations used the proceeds of the 2004 holiday for buybacks is debatable, whether they did so—even though the statute prohibited such uses—is not. Compare Dhammika Dharmapala, C. Fritz Foley, and Kristin J. Forbes, Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act, 66 J. Fin. 753 (2011) with Thomas J. Brennan, Where the Money Really Went: A New Understanding of the AJCA Tax Holiday (Northwestern Law and Economics Working Paper) (2014). What’s worse, “the temporary holiday conditioned firms to anticipate future holidays and to change their behavior by placing more earnings overseas than ever before.” Thomas J. Brennan, What Happens After a Holiday? Long-Term Effects of the Repatriation Provisions of the AJCA, 5 Nw. J. L. & Soc. Pol’y 1 (2010).

[4] Talib Visram, Tax Cut Fuels Record $200 Billion Stock Buyback Bonanza, CNN.com (June 5, 2018); see also William Lazonick, Stock Buybacks: From Retain-and-Reinvest to Downsize-and-Distribute, Brookings Initiative on 21st Century Capitalism (April 2015), at 2 (“Over the decade 2004-2013, 454 companies in the S&P 500 Index in March 2014 that were publicly listed over the ten years did $3.4 trillion in stock buybacks, representing 51 percent of net income.”).

[5] Savvy market observers also worry that the magnitude of this year’s buyback spree reflects a troubling trend in corporate investment. See, e.g., Matt Egan, Goldman Sachs Warns Against Falling in Love with Stock Buybacks, CNNMoney.com (April 26, 2018) (noting a recent equity research report describing the perhaps-unsurprising result that, since the 2016 presidential election, “Goldman Sachs’s collection of stocks that are focused on capital spending and research and development soared 42% . . . besting the S&P 500’s 24% gain”).

[6] For an exceptionally clear demonstration as to how buybacks can harm investors while benefiting insiders, see Jesse M. Fried, Insider Trading Via the Corporation, 162 U. Pa. L. Rev. 801, 805 (2014) (referring to stock buybacks as “indirect insider trading” and noting that such “trading likely imposes considerable costs on public investors in two ways. First, just like ‘ordinary’ direct insider trading, indirect insider trading secretly redistributes value from public investors to insiders. . . . Second, the use of the corporation as a vehicle for insider trading can lead insiders to waste economic resources.”).

[7] In these remarks, I focus on executives’ use of buybacks to cash out shares granted as part of compensation packages otherwise designed to link executive pay with long-term performance. There are, of course, circumstances where managers who founded the firm or are otherwise large shareholders seek liquidity for those holdings using buybacks. Those cases, too, should be addressed if the SEC chooses to reevaluate its rules in this area. But here I focus on cases where executives use buybacks to cash out shares granted as stock-based pay.

[8] See, e.g., George Constantinides & Bruce Grundy, Optimal Investment with Stock Repurchase and Financing as Signals, 2 Rev. Fin. Stud. 445 (1989) (providing a theoretical model on the role of repurchases when a firm is undervalued).

[9] Among other reasons, a safe harbor is necessary because firms often pursue buybacks under informational circumstances that might lead to securities-law liability in other contexts. See Fried, supra note 5, at 813-814 (“The SEC takes the position that Rule 10b-5 . . . applies to a firm buying its own shares.”).

[10]  Securities and Exchange Commission, Final Rule: Purchases of Certain Equity Securities by the Issuer and Others, Release Nos. 33-8335, 34-48766, 17 C.F.R. Pt. 228 et seq.

[11] For example, because these rules permitted firms to announce a buyback—generating a stock-price spike—and then choose not to buy back any stock at all without disclosing that fact to investors, commentators and the SEC worried that managers opportunistically used buyback announcements to manipulate share prices. See, e.g., Jesse Fried, Informed Trading and False Signaling with Open Market Repurchases, 93 Cal. L. Rev. 1323, 1336-40 (2005); see also Final Rule, supra note 8 (“Studies have . . . shown that some issuers publicly announce repurchase programs, but do not purchase any shares or purchase only a small portion of the publicly disclosed amount.”).

[12] See Final Rule, supra note 8. Among other things, commentators have pointed out that the SEC’s still-lax disclosure rules regarding buybacks give corporate insiders “a strong incentive to exploit [those] rules in order to engage in indirect insider trading: having the firm buy and sell its own shares at favorable prices to increase the value of the insiders’ equity.” Fried, supra note 8, at 804. Indeed, there is important evidence that the limited tightening of disclosure rules in this area have had some benefits in addressing opportunistic buyback activity. See Michael Simkovic, The Effect of Mandatory Disclosure on Open-Market Stock Repurchases, 6 Berkeley Bus. L. J. 98 (2009). That evidence makes the case for revisiting these rules now all the more compelling. Indeed, the Commission issued a proposal to update these rules in 2010, see Proposed Rule, Purchases of Certain Equity Securities by the Issuer and Others, Release No. 34-61414 (2010), but to date has taken no action on the proposal.

[13]  See, e.g., Kevin J. Murphy, Executive Compensation: Where We Are and How We Got There, in George Constantinides, Milton Harris, and Rene Stulz, Eds., Handbook on Economics and Finance 211 (2013).

[14]  See, e.g., Robert J. Jackson, Jr., Stock Unloading and Banker Incentives, 112 Colum. L. Rev. 951 (2012); Robert J. Jackson, Jr. & Colleen Honigsberg, The Hidden Nature of Executive Retirement Pay, 100 Va. L. Rev. 479 (2014); Robert J. Jackson, Jr. & Jonathon Zytnick, The Effects of a Tax Notch on CEO Golden Parachute Contracts and Option Exercises (working paper 2018).

[15] See, e.g., Kevin Murphy, Executive Compensation, in Orley C. Ashenfelter & David Card, Eds., 3B Handbook of Labor Economics 2485 (1999).

[16] See Lucian A. Bebchuk, Jesse Fried, and David Walker, Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. Chi. L. Rev. 751 (2002); see also Lucian A. Bebchuk & Jesse Fried, Paying for Long-Term Performance, 158 U. Pa. L. Rev. 1915, 1921 (2010) (describing concerns related to “ensuring that, whatever equity incentives are used [in executive pay, executives’] payoffs are primarily based on long-term stock values rather than on short-term gains that may be reversed.”).

[17] Lucian A. Bebchuk, Alma Cohen, and Holger Spamann, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, 27 Yale. J. Reg. 257 (2012).

[18] Robert J. Jackson, Jr., Private Equity and Executive Compensation, 60 U.C.L.A. L. Rev. 638, 640 (2013) (“[T]he pay-performance link is much weaker in public companies than in companies owned by private equity investors. Borrowing from their private equity counterparts, public company boards seeking to strengthen the link between pay and performance should restrict CEOs’ freedom to unload.”).

[19] See, e.g., Dodd-Frank Wall Street Reform and Consumer Protection Act §§ 953(a), 954, 955, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (requiring the SEC to adopt rules requiring disclosure of the pay-performance link, public companies’ policies related to the clawback of erroneously awarded compensation, and policies related to insider hedging of public companies’ stocks, none of which has been finalized).

[20] We drew information on buybacks from the Securities Data Company (SDC) database, using transactions identified by SDC as buybacks with announcements in the year 2017 and the first three months of 2018. For consistency in treatment across the sample, we identify an initial sample of 708 repurchases and retain only the first repurchase announcement by each company—and only those repurchases not followed by a subsequent repurchase announcement within 60 days. We merged those data with information from the Center for Research on Securities Prices (CRSP) database, leaving a sample of 385 public company buybacks.

[21] We used data from Form 4 filed pursuant to Section 16. See Securities and Exchange Commission, Ownership Reports and Trading By Officers, Directors and Principal Securities Holders, 56 Fed. Reg. 7,242 (Feb. 21, 1991); see also Securities and Exchange Commission, Mandated Electronic Filing and Web Site Posting for Forms 3, 4 and 5, 68 Fed. Reg. 25,788 (May 13, 2003).

[22] That finding is consistent with the longstanding finance literature on the effects of these announcements on stock prices. See, e.g., David Ikenberry, Josef Lakonishok, and Theo Vermalen, Market Underreaction to Open Market Share Repurchases, 39 J. Fin. Econ. 181 (1995); Jesse M. Fried, Insider Signaling and Insider Trading with Repurchase Tender Offers, 67 U. Chi. L. Rev. 421 (2000).

[23] On an average day, between 3 and 4 percent of corporate insiders trade in the company’s stock, but we found that, during the eight days following a buyback announcement, more than 8 percent do. We direct the interested reader to the data appendix to this speech, where you can learn more about our methodology and analysis.

[24] Investors receive a mixed signal from a buyback announcement that is accompanied by insider selling. Indeed, as we explain in our data appendix, we observe statistically significantly lower returns during the ten- and thirty-day window following buyback announcements with executive selling than we do in buybacks where executives hold their shares for the long term.

[25]  The precise way in which the safe-harbor could be restructured to disfavor the use of buybacks for insider sales is beyond the scope of my remarks—and, in all events, well within the expertise of our exceptional Staff. Suffice it to say that, if the Commission were so inclined, our Staff would have little difficulty making sure that our rules are not used in a way that encourages corporate executives to use buybacks to sell their shares.

[26] We should also use this opportunity to review other problems with Rule 10b-18 and related rules—including the fact that they require only quarterly disclosure of the amount of shares a company has actually repurchased, leaving investors largely in the dark about corporate trading in their own shares. For an exceptionally thoughtful proposal in this respect, see Fried, supra note 5.

[27] Except, of course, the fact that our rules let them. See Final Rule, supra note 8; but see Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437, 444 & n.15 (Del. 1971) (“Inequitable action does not become permissible simply because it is legally possible.”).

[28] It’s true, of course, that investors eventually receive disclosure of executives’ selling on Form 4, which is how we were able to conduct this study. But those disclosures come after the executive has already sold—too late for shareholders to price the executive’s decision into their own determination whether to sell their shares. See Fried, supra note 5.

https://www.sec.gov/news/speech/speech-jackson-061118

Progress Is Being Made: Continued Focus on Addressing Implementation Matters

Remarks before the 37th Annual SEC and Financial Reporting Institute Conference
Los Angeles, CA

The Securities and Exchange Commission (“SEC” or “Commission”) disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

Introduction

Good morning and thank you for the kind introduction.

Before I begin, let me remind you that the views expressed are my own and not necessarily those of the Commission, the Commissioners, or other members of the staff.

Please let me first express a word of gratitude to the accounting group (“Accounting Group”) within the Office of the Chief Accountant (“OCA”) for all of their work including their efforts on revenue recognition,[1] leases,[2] and measurement of credit losses on financial instruments[3] (“new GAAP standards”) that we will be discussing today. I also want to specifically acknowledge Michael Berrigan, Andrew Pidgeon, Brian Staniszewski, Sheri York, and Rahim Ismail for their assistance in today’s remarks.

The focus of my remarks today will be 1) to discuss the work our group has been involved with on the financial reporting implications of the new tax law, and 2) to provide an update on the implementation of the new GAAP standards from previous comments made by our office.[4]

SEC staff guidance on reporting implications of Tax Reform and New GAAP Standards

The observations I will discuss today are derived from the experience we have had on our recently issued Staff Accounting Bulletin No. 118 (“SAB 118”)[5] and the implementation of the new GAAP standards.

Before I delve into specifics, I did want to note that during the last few months we have seen the adoption of the new revenue standard by calendar year-end public business entities. First and foremost, I want to thank those involved in the financial reporting process for all of their hard work regarding the implementation of the new revenue standard. The efforts to date have been a true collaboration between preparers, auditors, audit committees, standard setters, and regulators, and have been done both domestically and internationally. It is an encouraging sign as the effective dates for leases, and measurement of credit losses on financial instruments nears. I will speak more on revenue recognition shortly.

Let’s now specifically discuss tax reform (and specifically SAB 118) and the ongoing implementation efforts for each of the new GAAP standards.

Tax Reform

Let’s start by sharing some observations on tax reform and the related financial reporting implications. Last year, on December 22, 2017, as you know, an Act[6] was signed into law that represented the most comprehensive overhaul of the United States (“U.S.”) tax law since 1986.

Prior to the Act being signed into law, we observed that the income tax accounting guidance[7] addresses the accounting for a change in tax laws or tax rates. This guidance, however, did not appear to address certain circumstances that could arise in accounting for the income tax effects of the Act.

One of the many challenges OCA staff started to hear from various stakeholders—leading up to December 22, 2017—was on timing. Specifically, registrants indicated they could encounter situations in which the accounting for certain income tax effects of the Act would be incomplete by the time financial statements are issued for the reporting period that includes the enactment date.[8] OCA staff also became aware that registrants could approach accounting for the Act differently which in turn, could give rise to uncertainty or diversity of views in practice regarding the application of the income tax accounting guidance for purposes of reporting the effects of the Act.

So, given that background when the Act was enacted on December 22, 2017, the staff issued SAB 118 on that same day to clarify and address any uncertainty or diversity of views in practice in situations where a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Act.

I will plan to touch on SAB 118 in more detail, but I first want to thank all of the stakeholders that provided feedback to OCA and the Division of Corporation Finance during the periods leading up to December 22, 2017. Such feedback was extremely helpful as the staff considered potential paths forward to address this matter.

Now, I’d like to share a few observations regarding SAB 118.

Let me start by clarifying that SAB 118 is not providing an option to defer application of the income tax accounting guidance. While some stakeholders requested a deferral option, the staff opted to not follow that approach. Instead, we believe that the approach highlighted in SAB 118 provides investors with better and more timely information and addresses the financial reporting concerns raised by various stakeholders leading up to the enactment of the Act. The approach ensures investors receive decision useful information related to the income tax effects of the Act in a timely manner. A deferral option would not have yielded such results for investors and therefore, the staff opted not to follow such an approach.

A second observation of SAB 118 is that it categorizes the accounting for the income tax effects of the Act into one of three “buckets.”

  • Bucket 1 represents the income tax accounting effects of the Act that an entity is able to complete. Some entities, however, may not have the necessary information available, prepared, or analyzed in reasonable detail to complete the accounting for certain income tax effects of the Act. This brings us to the next bucket – Bucket 2.
  • Bucket 2 represents the specific income tax accounting effects of the Act that are not yet complete, but for which an entity can determine a reasonable estimate. The reasonable estimate should be reported as a provisional amount in the first reporting period a reasonable estimate can be determined. Additionally, there may be certain situations in which a reasonable estimate cannot be determined. This brings us to the last bucket – Bucket 3.
  • Bucket 3 represents those specific income tax effects for which a reasonable estimate cannot be determined. In such cases there should be no provisional amount included in the financial statements for those specific income tax effects for which a reasonable estimate cannot be determined.

For the specific income tax effects that fall into Bucket 2 or Bucket 3, the SAB notes that an entity should be acting in good faith to complete its accounting during the measurement period. Let me clarify a point about the measurement period and the expectation to be acting in good faith. SAB 118 states that the measurement period ends when an entity has obtained, prepared, and analyzed the information that was needed in order to complete the accounting required under ASC 740 and in no cases should the measurement period extend beyond one year from the enactment date. This should not be interpreted as a window to put pencils down until we are close to one year from the enactment date to get started on the accounting. Instead, entities should continue to keep moving in good faith to complete the accounting. The measurement period ends when an entity has completed the process described above, which for certain income tax effects of the Act could be well before the one year mark.

So to be clear, some entities depending on their facts and circumstances and for specific income tax effects may complete the accounting in the early to middle parts of the measurement period, while other entities may not be able to complete the accounting for certain income tax effects until the end of the measurement period. There are no bright lines as to when the accounting for a specific income tax item should be completed during the measurement period; when the accounting is completed will clearly vary depending on an entity’s facts and circumstances. The key is to simply be progressing in good faith when looking to the staff’s guidance in SAB 118.

The last observation I’d like to highlight regarding SAB 118 is the included disclosures. I want to emphasize that the disclosure guidance in SAB 118 should not be overlooked. Such disclosures provide important information to financial statement users about the financial reporting impact of the Act where the accounting is incomplete and are a meaningful component of SAB 118. The staff has been monitoring—and will continue to monitor—SAB 118 disclosures.

Next, I’d like to share a few observations on implementation issues.

  • First, the comprehensive overhaul to the U.S tax law may present unique application issues when applying the income tax accounting guidance to certain provisions of the Act. I want to highlight that OCA staff stands ready to continue to address application issues on an as needed basis. To date, OCA has already received consultations related to accounting considerations arising as a result of the Act.
  • Second, the Financial Accounting Standards Board (“FASB”) staff issued five Staff Q&A documents in January 2018. The FASB also issued guidance[9] in February 2018 to address a matter related to the Act.

My takeaway for practice is to ensure any application issues in applying the income tax accounting guidance related to the Act are raised, which can, for example, be through continued consultations with OCA staff.

Revenue Recognition

Next, I would like to provide an update on revenue recognition.

The implementation of the revenue recognition standard required a significant effort from many stakeholders and OCA was active in supporting the implementation efforts. You may recall OCA outlined our plans for the transition period back at the 2015 BNA Conference[10] on Revenue Recognition, and I am proud to say we continued to execute this strategy throughout the last few years.

A few examples of the significant efforts include:

  • Active monitoring of implementation groups such as the Transition Resource Group (“TRG”) for revenue and AICPA Task Forces;
  • Participating in a wide variety of meetings with preparers, industry groups, and accounting firms, to provide insights on application issues;
  • Providing the views of the staff to a significant number of registrants through the consultation process;
  • Delivering over 20 published OCA staff speeches with the goal of sharing the results of our active monitoring and consultations in order to create institutional knowledge across the profession.
  • Providing training to support the education of several accountants within the SEC.

As we progressed over these few years from broad implementation efforts to company specific finalization of accounting positions, registrants consulted with OCA on a wide variety of topics. Over this time period, consultations related to revenue recognition represented the most commonly consulted topic within OCA.

While consultations received to date have related to a number of topics, several of which have been communicated in previous speeches, the most frequently discussed issues related to the identification of performance obligations and the application of the principal versus agent guidance.

As I mentioned earlier, last year[11] we shared observations from the experiences we had with the implementation of the new revenue standard. We have heard from many constituents that these observations were useful and allowed them to focus their efforts in key areas as they worked towards a high quality implementation of the new standard.

For those companies that are still working on adoption, we encourage you to keep the momentum going. As a reminder, OCA staff continues to be available for consultation on a formal or informal basis to both domestic and foreign registrants.

Leases

The new leases standard is the next new GAAP standard from which investors will benefit from widespread adoption. For those registrants that are not early adopters, the 2019 adoption of the new leases standard is quickly approaching. The new leases standard has been a significant focus of OCA, and our focus is naturally increasing as the effective date nears.

In my view, the new leases standard will result in improved transparency and consistency in accounting for lease arrangements. Users of lessee financial statements will benefit from lessee recognition of an asset and a liability for nearly all of their leases, not just capital leases. Said differently, operating leases will no longer be “off balance sheet” in many cases. Similar to the new revenue standard, the new leases standard will also enhance the quality and transparency of information disclosed in the notes to the financial statements. The disclosures will aid in investor understanding of the amount, timing, and uncertainty of cash flows arising from leases.

Experience, such as that gained during implementation of the new revenue standard, has taught us that high quality implementation of a new accounting standard takes time, and that doing anything for the first time can be challenging.

With respect to guidance on lease implementation, I will echo what we have previously stated: for those underway, keep going, and for anyone else, get going. Implementation will require (among other steps): understanding the accounting and disclosure requirements of the new standard; identifying relevant arrangements and leases within those arrangements; determining appropriate accounting policies, including applicable transition elections; applying the new standard to arrangements within the scope of the standard; preparing transition and ongoing disclosures; and establishing adequate and appropriate processes and controls to support implementation and application of the standard, including the preparation of required disclosures.

I want to expand on an item I just mentioned: the identification of an entity’s leases. It is important for registrants to ensure their implementation plans include sufficient time to identify arrangements that include leases subject to Topic 842. I am emphasizing this point because it may require time to complete; registrants should carefully evaluate all of their arrangements and transactions to evaluate the appropriate accounting literature. A thorough and complete process to identify arrangements subject to the new standard will enable investors to fully benefit from transparency about a registrant’s leases.

In contrast to the new revenue and credit losses standards, the FASB did not establish a transition resource group (“TRG “) to support the implementation process for the new leases standard. We support that decision. In the absence of a TRG, the FASB has been active in listening and responding to stakeholder feedback, with the objective of ensuring “a smooth transition” to the new standard.[12] To date, the FASB efforts have resulted in the issuance of an Accounting Standard Update (ASU), and two proposed ASUs. The issued ASU clarifies the application of the new leases guidance to land easements and eases adoption efforts related to land easements.[13] One of the proposed ASUs would simplify transition requirements and, for lessors, provide a practical expedient for the separation of lease and non-lease components in an arrangement.[14] The other proposed ASU would clarify certain aspects of the new standard, including transition.[15] The FASB has also added a project to its agenda to address issues related to lessor accounting for certain lessor costs, such as sales taxes and property taxes and insurance.[16] I commend the timely FASB actions to balance investor benefits and stakeholder concerns related to the smooth transition to, and application of, the new standard. I believe the real-time responsiveness of the FASB is a superior approach relative to waiting to aggregate potential issues and dealing with those potential issues closer to the effective date.

Without a TRG, the onus to promote a smooth transition of course rests with several different parties. I believe that registrants, auditors, and audit committees all of course have key roles to play. Registrants and their auditors should be actively working to identify and resolve any application and transition issues related to the new standard. Registrants, with the oversight of their audit committees, should ensure any issues related to adopting and applying the new standard are identified and resolved. As I have stated in previous remarks,[17] audit committees should also understand management’s implementation plans to help achieve a high quality implementation.

Implementation of the new leases standard continues to be top of mind to OCA. We have previously spoken about the new leases standard on several occasions,[18] and, as I mentioned earlier, our focus on leases continues to naturally increase as the adoption date nears.

We are actively monitoring implementation efforts. We have been meeting with various stakeholders, including preparers, industry groups, standard setters, and accounting firms, to better understand application issues identified to date. Thus far, the application questions we have addressed have primarily related to scoping and transition issues.[19] We continue to welcome dialogue with any interested stakeholders. Consistent with our past practices, we will continue to accept reasonable judgments put forth in consultations that we handle related to the new leases standard.

Credit Losses

The FASB’s new standard on credit losses (“CECL”) is another major standard that will require careful planning, implementation, and oversight for successful adoption. The new standard will be effective beginning in 2020 for calendar year end public business entities that are SEC filers.[20] As a reminder to all entities, although much of the focus has been on banks and other financial institutions, the impact goes well beyond any particular industry group and we encourage all reporting entities to assess the scope of CECL.

OCA continues to be very active in overseeing the implementation of the CECL standard, and we have spent considerable time monitoring implementation activities to date. We continue to have dialogue with various members of the accounting profession, including representatives from financial institutions, registrants, accounting firms, other regulators, and industry groups. These stakeholder discussions have been productive.

The dialogue we are having has moved towards a focus on implementation and we have noted meaningful progress to date being made by the institutions that have engaged with us. Registrants and their auditors are actively working to identify and resolve accounting and implementation issues related to the new standard.

As questions arise, there are a number of forums for which implementation questions are being discussed. In addition to the FASB’s TRG for credit losses which will be meeting again soon,[21] the AICPA Depository Institutions Expert Panel (“DIEP”), banking regulators, and other groups are working to educate constituents on the application of the new standard. I would encourage you to familiarize yourselves with these resources as you continue your implementation activities. The implementation process operates best when all stakeholders engage in raising and resolving important issues under consideration.

We have also seen the level of consultation submissions regarding CECL pick-up this year, and have previously spoken about observations from several of the consultations.[22] While I am pleased by the increase in CECL related consultations, our doors remain open, of course, and we continue to welcome dialogue with stakeholders on both a formal and informal basis.

Reminder on Other New GAAP

While the focus of my remarks so far has been on SAB 118 and specific new GAAP standards, companies have implemented other new GAAP standards whose effective dates for calendar year companies was January 1, 2018, such as the new guidance on the statement of cash flows[23] and recognition and measurement of financial assets and liabilities[24] (to name just a couple of the several new areas of GAAP that became effective on January 1, 2018).

Companies need to also look ahead to other standards whose effective dates are coming up soon, including, for example, targeted improvements to hedging.[25] While I appreciate the focus for companies has been and will continue to be on SAB 118 and the new GAAP standards such as revenue, leases, and credit losses, companies should appropriately consider and implement the other new GAAP standards that either are or will also be effective soon. We are actively monitoring and answering questions related to the implementation of all new standards and are of course available for consultation.

Couple of General Observations

As I mentioned earlier, in addition to providing our detailed feedback on the new GAAP standards, I wanted to provide a couple of general observations on the implementation of the new GAAP standards.

Give Yourself Enough Time

Last year I noted[26] the significant amount of progress that had been made by many companies on the new standards. Again, I want to applaud and thank companies for the work they have invested in their implementation. I encourage each of you to build on the implementation of the revenue standard and keep the momentum going on leases, credit losses and other standards that have effective dates that are coming up soon. The work and progress you have made is a great example of companies who will be providing investors with enhanced financial reporting.

We have also highlighted the meaningful benefits of having adequate time to make reasonable judgments, having sufficient time to identify accounting questions, and having adequate time to implement appropriate internal controls. All of these items are critical and those who have gone through the implementation of revenue recognition will attest to the importance of giving yourself enough time in order to implement these new GAAP standards.

Reasonable Judgment

OCA staff will continue to accept reasonable judgment in the application of the new GAAP standards. Our consultations on revenue recognition are evidence of this, where as I mentioned earlier we have already answered numerous pre-filing consultation questions and have accepted reasonable judgments. This same framework applies to all of our consultations and will continue as well on leases, credit losses, and other standards. This point underscores the importance for companies to put in place a good implementation process that enables them to apply sound judgment. As noted above, we note that well reasoned judgments frequently require the important element of time in order to gather the facts, consider the accounting alternatives, and make a judgment on the conclusion.

Closing

In closing, I want to thank preparers, auditors, audit committees, and other stakeholders for all the effort to date in the implementation of the new GAAP standards. The new GAAP standards will provide investors with enhanced financial reporting and disclosure. Implementation of the new revenue standard and major progress on SAB 118 are efforts that all stakeholders should be proud of and I have no doubt the parties will continue to meet the challenge as we look ahead to the implementation of the other new GAAP standards. We in OCA will continue to do our part and will be available to help. I want to thank you again for the opportunity to be with you today.


[1] FASB Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (May 2014) which is codified in Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers.

[2] FASB ASU No. 2016-02, Leases (Feb. 2016) which is codified in ASC Topic 842, Leases.

[3] FASB ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (June 2016) which is codified in ASC Topic 326, Financial Instruments – Credit Losses

[4] See, e.g., Sagar Teotia, Deputy Chief Accountant, Office of the Chief Accountant, U.S. Securities and Exchange Commission, Addressing Implementation Matters to Improve Financial Reporting (Sept. 21, 2017), available at https://www.sec.gov/news/speech/speech-teotia-2017-09-21.

[5] Included in the Codification of Staff Accounting Bulletins Topic 5.EE, Income Tax Accounting Implications of the Tax Cuts and Jobs Act.

[6] See An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018, Pub. L. No. 115-97, 131 Stat. 2054 (2017) (the “Act”).

[7] ASC 740, Income Taxes.

[8] ASC paragraph 740-10-25-47 notes that “the effect of a change in tax laws or rates shall be recognized at the date of enactment.”

[9] FASB ASU No. 2018-02, Income Statement – Reporting Comprehensive Income: Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (Feb. 2018).

[10] See Wesley R. Bricker, Deputy Chief Accountant, Office of the Chief Accountant, U.S. Securities and Exchange Commission, Remarks at the Bloomberg BNA Conference on Revenue Recognition (Sept. 17, 2015), available at https://www.sec.gov/news/speech/wesley-bricker-remarks-bloomberg-bna-conf-revenue-recognition.html.

[11] See supra note 4.

[12] See, e.g., FASB, Leases Educational Resources – Amendments to the Standard, available at: http://www.fasb.org/cs/ContentServer?d=Touch&c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FCompletedProjectPage&cid=1176170005741.

[13] FASB ASU No. 2018-01, Leases: Land Easement Practical Expedient for Transition to Topic 842 (Jan. 2018), which is codified in ASC Topic 842, Leases.

[14] FASB, Proposed ASU, Leases (Topic 842): Targeted Improvements (Jan. 5, 2018), available at: http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176169751791&acceptedDisclaimer=true.

[15] FASB, Proposed ASU, Technical Corrections and Improvements to Recently Issued Standards (Sept. 27, 2017), available at: http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176169358459&acceptedDisclaimer=true.

[16] See FASB, Tentative Board Decisions – Board Meeting (March 28, 2018), Leases—Implementation Requests, available at: http://www.fasb.org/cs/ContentServer?c=FASBContent_C&cid=1176170269741&d=&pagename=FASB%2FFASBContent_C%2FActionAlertPage.

[17] See supra note 4.

[18] See, e.g., Wesley R. Bricker, Chief Accountant, U.S. Securities and Exchange Commission, Statement in Connection with the 2017 AICPA Conference on Current SEC and PCAOB Developments (Dec. 4, 2017), available at https://www.sec.gov/news/speech/bricker-2017-12-04; Michael P. Berrigan, Professional Accounting Fellow, Office of the Chief Accountant, U.S. Securities and Exchange Commission, Remarks before the 2017 AICPA Conference on Current SEC and PCAOB Developments (Dec. 4, 2017), available at https://www.sec.gov/news/speech/berrigan-aicpa-2017-conference-sec-pcaob-developments; and Ruth Uejio, Professional Accounting Fellow, Office of the Chief Accountant, U.S. Securities and Exchange Commission, Remarks Before the 2016 AICPA National Conference on Current SEC and PCAOB Developments (Dec. 5, 2016), available at https://www.sec.gov/news/speech/uejio-2016-aicpa.html.

[19] See Michael P. Berrigan, Remarks before the 2017 AICPA Conference on Current SEC and PCAOB Developments (December 4, 2017).

[20] ASC 326-10-20 defines Securities and Exchange Commission (SEC) Filer as “an entity that is required to file or furnish its financial statements with either of the following: a) The Securities and Exchange Commission (SEC), b) With respect to an entity subject to Section 12(i) of the Securities Exchange Act of 1934, as amended, the appropriate agency under that Section.

[22] See Robert B. Sledge, Professional Accounting Fellow, Office of the Chief Accountant, U.S. Securities and Exchange Commission, Remarks before the 2017 AICPA Conference on Current SEC and PCAOB Developments (December 4, 2017), available at: https://www.sec.gov/news/speech/sledge-aicpa-2017-conference-sec-pcaob-developments

[23] FASB ASU No. 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments which is codified in ASC 230 Statement of Cash Flows (Aug. 2016).

[24] FASB ASU No. 2016-01, Financial Instruments – Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (Jan. 2016) which is codified in ASC 825-10 Financial Instruments — Overall.

[25] FASB ASU No. 2017-12, Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities which is codified in ASC Topic 815, Derivatives and Hedging (Aug. 2017).

[26] See supra note 4.

https://www.sec.gov/news/speech/teotia-progress-being-made

Address to Girls Who Invest at University of Pennsylvania

Thank you, Cindy [Esparragoza], for that kind introduction and for inviting me to speak. I am very pleased to have been invited to speak to so many bright young women interested in pursuing careers in asset management. As we’ve seen over and over, diversity is a strength. When women, minorities, and people of diverse backgrounds have a seat at the table, decision-making improves, and businesses grow. To achieve that, we need to ensure that young women are shown all of their options and can access the paths to rewarding careers.

For women, building a career in finance and investment has not been easy. As you can see from my background, my path to the Securities and Exchange Commission was not a direct one.

In many ways, my career path has been a strength. Diversifying one’s experience can broaden your perspective and help you see the big picture. But it also means that my path is not necessarily easy to replicate. To make a meaningful difference in the diversity of the investment industry, we need paths that are easier to follow. I hope that, for you and those that follow, this program can be part of that.

I want to talk this evening about two themes. One is the importance of rules in the investment markets. I want to show you how rules play an important role in creating wealth and shouldn’t be seen simply as impediments. The other theme is the role you can serve, as the next generation of advisors and investors, in helping Americans achieve their dreams. I want you to think about these two themes this evening, as you go through the program, and as you make career choices in the future. They have helped guide me in a career that has been satisfying and, I hope, has improved the lives of others. Perhaps they can do the same for you.

Before I dive in, however, let me pause to say that I am speaking today as an individual Commissioner and not on behalf of the SEC as a whole.

Starting with my first theme—why do we need rules? If you decide to build your career in asset management, you will inevitably encounter the rules that govern investment markets. I understand that your curriculum includes instruction on valuation and investment selection, and you’ll be hearing from industry leaders who have enjoyed tremendous success managing investments. Compared to that, talking about rules isn’t very exciting. At first glance, many rules sound like frustrating limitations on what we’d like to do. For example, when you were a child, didn’t you really dislike the rule that you had to go to bed by a specific time? Or the rule that you had to clean your room before going out to play with friends?

But in finance and investment, rules play an incredibly important role—they enable strangers to trust each other. Let’s say you’ve saved $10,000. You could use that $10,000 in a number of ways. You could spend it, invest it, or put it under your mattress. Putting it under your mattress is probably the safest bet, but it won’t do you much good there. Indeed, over time, you will be able to buy fewer smart phones with that same $10,000 that’s been sitting under your mattress. Investing, on the other hand, might help it grow. Investing also could help the businesses in which you invest, may help create jobs for others, and can benefit society as a whole. The problem is, when Jane Doe comes around asking you to invest in her company, how do you know whether to trust her? Maybe she isn’t very good at running a company. Maybe she’ll run off with your money.

The rules that govern investment markets are designed to address this uncertainty. They provide a framework for trust so that businesses can grow and savings aren’t either tucked under mattresses or lost to the dishonest. So, how did we end up with this framework? Where did these rules come from?

To answer that, I’m going to tell you the story of Mr. Edgar D. Brown. Mr. Brown was a local businessman in Pottsville, Pennsylvania. He had recently sold his business and was preparing for a long vacation in California when he saw an advertisement from a bank offering advice. It said, if you’re thinking of taking a lengthy trip, get in touch with us so we can “keep you closely guided” regarding your investments.[1] That seemed just right for Mr. Brown, so he answered the advertisement. Soon after, an advisor from the bank came calling.

Mr. Brown explained to the advisor that he had some money following the sale of his business and he wanted advice on how to invest. At the time, he had cash and some government bonds. The advisor looked over Mr. Brown’s portfolio and came back with some advice. The advice was, essentially, everything you own is wrong—let me sell you some bonds instead. Mr. Brown decided to put his trust in his new advisor. And the advisor began buying and selling bonds for Mr. Brown’s account. He traded a lot for Mr. Brown, including bonds from all over the world, from Germany to Greece to Peru. But the advisor didn’t think this went far enough. So, he started arranging loans secured by Mr. Browns’ investments. The advisor used the loans to more than double the amount of Mr. Brown’s investments. Double the opportunity, but also double the risk.

Unfortunately, soon after his advisor sold him the bonds, their value began dropping. Mr. Brown complained. The advisor told him, “that is your fault for insisting upon bonds…. Why don’t you let me sell you some stock?”[2] This went against Mr. Brown’s earlier inclinations, but, again, he decided to trust the expert. Stock trading ensued—a lot of it. Mr. Brown, in his words, didn’t “know whether the companies [the stocks] represented made cake, candy, or automobiles,” but he figured his advisor knew better than him.[3]

After a while, though, Mr. Brown found that he couldn’t get the numbers in his accounts to add up. He went to the bank offices to take it up with management. Management referred him back to the advisor. The advisor told him, here’s what we’ll do, we’ll sell all the stock you have now and buy stock of the bank instead.

And, for the third time, Mr. Brown found himself holding losing investments. Mr. Brown, seeing his savings dwindle, told the bank he wanted to sell its stock while the price was still high. In response, bank representatives treated him as if he were acting foolishly.[4] When Mr. Brown continued to ask to sell the bank stock, the representatives resisted. Until, that is, the day the bank’s stock collapsed. On that day, the bank bought his stock from him at $320 a share. Of course, at the time, it was quoting at $360 a share, and a day before, it had been at $450 a share. In the end, Mr. Brown, who once was a successful businessman with savings, had to return to work as an office clerk.

What went wrong here? A bunch of things. Mr. Brown wasn’t wrong to trust in an advisor. Broker-dealers and investment advisers can play an important role in helping investors understand investments and make good choices. But trust requires honesty and honest motivations. All that trading and the loans were probably “not suitable” for someone in Mr. Brown’s position. In this case, however, the bank had numerous conflicts of interest that motivated acting in its interest instead of Mr. Brown’s. For example, the bank earned fees from some of the bonds sold to Mr. Brown.[5] However, even while the advisor was selling those bonds to Mr. Brown, bank leadership thought the issuer was in bad shape.[6] The advisor and his bank were working in their own interests, and Mr. Brown was left to live with the consequences.

As you may have guessed, Mr. Brown’s story is actually an old one. In fact, these events took place in 1929, in the run-up to the Great Crash. Back then, there were no federal rules for this type of activity, and the SEC didn’t exist.[7] This left a vacuum where fraud could thrive. A Congressional report from the time found that, “in the decade after World War I, approximately fifty billion dollars of new securities were floated in the United States, and half of them were worthless.”[8] These conditions in the 1920s and 1930s made it clear that some discipline and oversight were called for. In 1933, the U.S. government adopted the Securities Act, its first rules for investment offerings. And in 1934, it created the Securities and Exchange Commission to protect and improve the markets.

As far as I know, there was no justice for Mr. Brown in 1929. To be sure, there are still plenty of dishonest people willing to cheat investors out of their savings. Unfortunately, I see such cases every week as part of my job. However, unlike in 1929, we now have rules that help to protect investors, such as those that require investment advisers to work in their clients’ best interests and reveal conflicts of interest. We also have the SEC to police the capital markets. The SEC brings hundreds of enforcement cases each year. When possible, these cases return money to harmed investors. For example, in one case, a large broker-dealer agreed to return more than $25 million to individual customers.[9] Other times, we successfully get bad actors out of the industry. For example, in one case, we charged an attorney, who was offering investors an opportunity to receive what he claimed were 100% to 300% guaranteed returns with “minimal” or “no” risk. In reality, he, along with his collaborator, were selling very risky investments.[10] They ended up spending more than $1 million of investor money on personal expenses, including a loft in downtown L.A. As a result of the SEC’s intervention, the attorney is now barred from the investment industry.[11]

Take note as you learn about evaluating investments—any time you hear someone call an investment “no risk,” walk the other way.

More importantly, the SEC has programs that seek to protect investors before they are harmed. Some of these programs are aimed at industry participants—for example, through the examination of investment advisers or periodic chief compliance officer outreach. Other programs are aimed at investors—for example, rewards for whistleblowers and investor education through websites like investor.gov, where investors can find information on avoiding fraud. The SEC has also launched the SEC Action Lookup for Individuals, or “SALI,” an online search feature that enables investors to research whether the person trying to sell them investments has a judgment or order entered against them in an enforcement action.[12] And, most recently, the SEC launched a mock initial coin offering website called HoweyCoin.com that mimics a bogus coin offering to educate investors about what to look for before they invest in a scam.[13] These efforts aim to reduce the hidden risks of investing, making investment activity safer.

Why does all this matter? First, if you decide to work in the financial industry, whether as a portfolio manager or a regulator, I ask that you remember Mr. Brown. There are real people behind the numbers, the calculations, and the financial theories. Don’t forget about them. They have real hopes, real dreams, and real needs.

Second, these are all issues that will personally impact your lives and the lives of your parents and friends. Over the last few decades, investment has become much more important to the well-being of Americans. Unfortunately, jobs that provide a pension have become far less common over the last few decades. Many employers have scaled back pensions or eliminated them entirely. Workers must now save for their own retirements, either in plans their employers provide, like 401(k)s, or in investment accounts they establish for themselves, like IRAs. In fact, we’re heading toward a world in which your investments will be your most significant source of retirement income.[14]

At the same time, for young people today to do better than their parents, they generally face more years of schooling at higher tuition costs.[15] I imagine this part of the story is deeply familiar to all of you. As a result, Americans may be saving for college bills while their children are still in elementary school. Indeed, many are now making investments through 529 plans for this purpose.[16]

Altogether, these changes mean that more Americans have become investors. For many of us, financial security depends, at least in part, on how well our investments meet our needs.[17] In some ways, this is a good development. Investing means putting money to work in today’s economy. And there are a broad range of choices, from individual stocks to mutual funds, from infrastructure projects to municipal bonds. Through investment, a broad range of Americans may now be able to share in the entrepreneurial possibilities of dynamic businesses.

However, without a framework of trust, that investment wouldn’t be possible. Instead, we would all have to make a choice between tucking our savings under the mattress or taking the risk of becoming a Mr. Brown.

So, where do you all fit into the story? At the very least, you will almost certainly be faced with choices about investing your own money or helping your parents navigate their retirement. My hope for you is that, at the end of the summer, you will decide to go a step further and pursue a career in finance and investment. Maybe that will mean becoming a portfolio manager or running a venture capital fund. For some of you, it may even mean spending part of your career working for the government, using your talents to help promote the framework of trust that makes all this investment possible.

Whichever role you choose, you will face a world that has evolved rapidly in recent years. Some of this is really exciting. For example, many new investment opportunities have opened up that allow you to invest not just for short-term profit but also for social impact. You can invest in portfolios designed around sustainability, long-term growth, or quality of corporate governance. The existence of these investment options suggests a desire on the part of a new generation of investors to interact with their investments in a different way.

Technology is also rapidly changing both what people invest in and how people find and make investments. Crowdfunding, robo-advisers, and artificial intelligence are technologies that, while having potential for both positive and negatives effects on the market, are sure to continue making an impact. For your generation, these technologies are a native form of interaction. You will be the first to try the new apps and decide whether they succeed or fail. And you will be the ones who help my generation figure out how to navigate in this new world.

Another significant change, but one I’m less excited about, is the trend toward more complex products being sold to individuals.[18] As we saw earlier, Mr. Brown ended up in plenty of trouble almost 90 years ago with plain old stocks and bonds. If he were seeking investment advice today, what would his advisor recommend? Well, chances are that it would be much more complex than the bonds sold to him in 1929. Perhaps he would be recommended a complex structured note that is linked to an index or that pays interest based on the difference between two swap rates?

My point here is not to overwhelm you with the complexity. What I want you to take from this is an appreciation of how important you can be in this business. We need people with your talents and perspectives to help sort the investments that build wealth from the investments that obscure risk. We need smart women like you, who will promote a culture in which advisors put their clients’ interests first and make level-headed assessments of risk.

Pursuing these opportunities may not be as easy as pursuing some others. You may have to step outside of your comfort zone. You may be in environments where there are not many people who look, think, speak, or act like you. But you should be strong and move forward each time and create your role. Envision where you can, and should, be, and you will benefit all of us.

Even if you choose not to become a portfolio manager or investment adviser, you are still going to be part of the next generation of entrepreneurs, executives, regulators, and investors. You will have an opportunity to shape the businesses in which Americans invest, as well as the business of investing. I hope you will use that opportunity not just to promote growth but to foster growth that sticks. Ten years ago, we unfortunately saw what happens when business becomes focused on profits at any cost.

As you think about a possible career in finance and investing, I want you to come back to the two themes I’ve discussed this evening—how can smart rules help promote healthy investment? And what is your role, as an investor, adviser or entrepreneur, in helping Americans achieve their dreams? If talented women like you focus on those questions, I am confident that we will be in good hands as your generation steps into leadership roles in the years to come.

With that, I want to open it up to your questions and thoughts. What have you learned so far that is interesting? What questions do you have for me?


[1] Stock Exch. Practices: Hearings Before a Subcomm. of the Comm. on Banking and Currency, 72d Cong. 2170, 2170 (1933) (testimony of Edgar D. Brown) (“Brown Testimony”). For additional commentary, see Ferdinand Pecora, Wall Street Under Oath (1968) (“Pecora”); Michael Perino, The Hell Hound of Wall Street 254 (2010).

[2] Brown Testimony, supra note 1.

[5] See Stock Exch. Practices: Hearings Before a Subcomm. of the Comm. on Banking and Currency, 72d Cong. 2087 (1933) (testimony of Hugh G. Baker, President of the National City Co.) (“Baker Testimony”) (noting the bank continued underwriting Peruvian bonds through 1928, when it was doing business with Mr. Brown).

[6] The bank had taken the view for several years that the country was, “flat on its back and gasping for breath.” Baker Testimony, supra note 5; see also Pecora, supra note 1.

[7] Elizabeth Keller, Introductory Comment: A Historical Introduction to the Securities Act of 1933 and the Securities Exchange Act of 1934, 49 Ohio St. L.J. 329 (1988).

[14] See Barbara A. Butrica et al., The Disappearing Defined Benefit Pension and Its Potential Impact on the Retirement Incomes of Baby Boomers, 69 Soc. Sec. Bull. 3 (2009), available at https://www.ssa.gov/policy/docs/ssb/v69n3/ssb-v69n3.pdf (noting that, from 1980 to 2008, “the proportion of wage and salary workers participating in [defined benefit] pension plans fell from 38 percent to 20 percent”); see also Diane Oakley & Kelly Kenneally, Nat’l Inst. on Ret. Sec., Retirement Security 2017: A Roadmap for Policy Makers (2017) (noting that, in 1975, 88% of private sector employees with retirement plans had pensions); John J. Topoleski, Cong. Research Serv., R43439, Worker Participation in Employer-Sponsored Pensions: A Fact Sheet, tbl.1 (2017) (27% of full-time civilian workers have access to a defined benefit plan, while 58% have access to a defined contribution plan).

[15] From 1991 to 2015, accounting for inflation, the average cost of a four-year degree increased by over 50%, from $14,107 to $25,409. Nat’l Ctr. for Educ. Statistics, Inst. of Educ. Sci., Digest of Education Statistics, tbl.330.10 (2016), available at https://nces.ed.gov/programs/digest/d15/tables/dt15_330.10.asp?referrer=report. Over that same period, however, again accounting for inflation, the average salary of an individual 25 or over with a bachelor’s degree increased his or her annual salary by only 1.72%, from $61,231 to $62,304. U.S. Census Bureau, Historical Income Tables: People (2016), tbl.P-16, available at https://www.census.gov/data/tables/time-series/demo/income-poverty/historical-income-people.html.

[16] See U.S. Securities and Exchange Commission, An Introduction to 529 Plans (2014), available at https://www.sec.gov/investor/pubs/intro529.htm (“A 529 plan is a tax-advantaged savings plan designed to encourage savings for future college costs. . . . [They] are sponsored by states, state agencies, or education institutions and are authorized by Section 529 of the Internal Revenue Code.”) As of 2016, $282.2 billion was held in 529 plans, up over tenfold from $26.8 billion in 2002. See Inv. Co. Inst., 529 Plan Data (2016).

[17] Today, more than 90 million Americans have defined contribution retirement plans, and those plans have over $6.7 trillion in assets under management. Vanguard, How America Saves 2016: Vanguard 2015 Defined Contribution Plan Data (2016), available at https://pressroom.vanguard.com/nonindexed/HAS2016_Final.pdf.

https://www.sec.gov/news/speech/speech-stein-060718

“A Framework of Trust”

Thank you, Cindy [Esparragoza], for that kind introduction and for inviting me to speak at the Girls Who Invest (GWI) Summer Intensive Program.[1] I am very pleased to have been invited to speak to so many bright young women interested in pursuing careers in asset management. As we’ve seen over and over, diversity is a strength. When women, minorities, and people of diverse backgrounds have a seat at the table, decision-making improves, and businesses grow. To achieve that, we need to ensure that young women are shown all of their options and can access the paths to rewarding careers.

For women, building a career in finance and investment has not been easy. As you can see from my background, my path to the Securities and Exchange Commission was not a direct one.

In many ways, my career path has been a strength. Diversifying one’s experience can broaden your perspective and help you see the big picture. But it also means that my path is not necessarily easy to replicate. To make a meaningful difference in the diversity of the investment industry, we need paths that are easier to follow. I hope that, for you and those that follow, this program can be part of that.

I want to talk this evening about two themes. One is the importance of rules in the investment markets. I want to show you how rules play an important role in creating wealth and shouldn’t be seen simply as impediments. The other theme is the role you can serve, as the next generation of advisors and investors, in helping Americans achieve their dreams. I want you to think about these two themes this evening, as you go through the program, and as you make career choices in the future. They have helped guide me in a career that has been satisfying and, I hope, has improved the lives of others. Perhaps they can do the same for you.

Before I dive in, however, let me pause to say that I am speaking today as an individual Commissioner and not on behalf of the SEC as a whole.

Starting with my first theme—why do we need rules? If you decide to build your career in asset management, you will inevitably encounter the rules that govern investment markets. I understand that your curriculum includes instruction on valuation and investment selection, and you’ll be hearing from industry leaders who have enjoyed tremendous success managing investments. Compared to that, talking about rules isn’t very exciting. At first glance, many rules sound like frustrating limitations on what we’d like to do. For example, when you were a child, didn’t you really dislike the rule that you had to go to bed by a specific time? Or the rule that you had to clean your room before going out to play with friends?

But in finance and investment, rules play an incredibly important role—they enable strangers to trust each other. Let’s say you’ve saved $10,000. You could use that $10,000 in a number of ways. You could spend it, invest it, or put it under your mattress. Putting it under your mattress is probably the safest bet, but it won’t do you much good there. Indeed, over time, you will be able to buy fewer smart phones with that same $10,000 that’s been sitting under your mattress. Investing, on the other hand, might help it grow. Investing also could help the businesses in which you invest, may help create jobs for others, and can benefit society as a whole. The problem is, when Jane Doe comes around asking you to invest in her company, how do you know whether to trust her? Maybe she isn’t very good at running a company. Maybe she’ll run off with your money.

The rules that govern investment markets are designed to address this uncertainty. They provide a framework for trust so that businesses can grow and savings aren’t either tucked under mattresses or lost to the dishonest. So, how did we end up with this framework? Where did these rules come from?

To answer that, I’m going to tell you the story of Mr. Edgar D. Brown. Mr. Brown was a local businessman in Pottsville, Pennsylvania. He had recently sold his business and was preparing for a long vacation in California when he saw an advertisement from a bank offering advice. It said, if you’re thinking of taking a lengthy trip, get in touch with us so we can “keep you closely guided” regarding your investments.[2] That seemed just right for Mr. Brown, so he answered the advertisement. Soon after, an advisor from the bank came calling.

Mr. Brown explained to the advisor that he had some money following the sale of his business and he wanted advice on how to invest. At the time, he had cash and some government bonds. The advisor looked over Mr. Brown’s portfolio and came back with some advice. The advice was, essentially, everything you own is wrong—let me sell you some bonds instead. Mr. Brown decided to put his trust in his new advisor. And the advisor began buying and selling bonds for Mr. Brown’s account. He traded a lot for Mr. Brown, including bonds from all over the world, from Germany to Greece to Peru. But the advisor didn’t think this went far enough. So, he started arranging loans secured by Mr. Browns’ investments. The advisor used the loans to more than double the amount of Mr. Brown’s investments. Double the opportunity, but also double the risk.

Unfortunately, soon after his advisor sold him the bonds, their value began dropping. Mr. Brown complained. The advisor told him, “that is your fault for insisting upon bonds…. Why don’t you let me sell you some stock?”[3] This went against Mr. Brown’s earlier inclinations, but, again, he decided to trust the expert. Stock trading ensued—a lot of it. Mr. Brown, in his words, didn’t “know whether the companies [the stocks] represented made cake, candy, or automobiles,” but he figured his advisor knew better than him.[4]

After a while, though, Mr. Brown found that he couldn’t get the numbers in his accounts to add up. He went to the bank offices to take it up with management. Management referred him back to the advisor. The advisor told him, here’s what we’ll do, we’ll sell all the stock you have now and buy stock of the bank instead.

And, for the third time, Mr. Brown found himself holding losing investments. Mr. Brown, seeing his savings dwindle, told the bank he wanted to sell its stock while the price was still high. In response, bank representatives treated him as if he were acting foolishly.[5] When Mr. Brown continued to ask to sell the bank stock, the representatives resisted. Until, that is, the day the bank’s stock collapsed. On that day, the bank bought his stock from him at $320 a share. Of course, at the time, it was quoting at $360 a share, and a day before, it had been at $450 a share. In the end, Mr. Brown, who once was a successful businessman with savings, had to return to work as an office clerk.

What went wrong here? A bunch of things. Mr. Brown wasn’t wrong to trust in an advisor. Broker-dealers and investment advisers can play an important role in helping investors understand investments and make good choices. But trust requires honesty and honest motivations. All that trading and the loans were probably “not suitable” for someone in Mr. Brown’s position. In this case, however, the bank had numerous conflicts of interest that motivated acting in its interest instead of Mr. Brown’s. For example, the bank earned fees from some of the bonds sold to Mr. Brown.[6] However, even while the advisor was selling those bonds to Mr. Brown, bank leadership thought the issuer was in bad shape.[7] The advisor and his bank were working in their own interests, and Mr. Brown was left to live with the consequences.

As you may have guessed, Mr. Brown’s story is actually an old one. In fact, these events took place in 1929, in the run-up to the Great Crash. Back then, there were no federal rules for this type of activity, and the SEC didn’t exist.[8] This left a vacuum where fraud could thrive. A Congressional report from the time found that, “in the decade after World War I, approximately fifty billion dollars of new securities were floated in the United States, and half of them were worthless.”[9] These conditions in the 1920s and 1930s made it clear that some discipline and oversight were called for. In 1933, the U.S. government adopted the Securities Act, its first rules for investment offerings. And in 1934, it created the Securities and Exchange Commission to protect and improve the markets.

As far as I know, there was no justice for Mr. Brown in 1929. To be sure, there are still plenty of dishonest people willing to cheat investors out of their savings. Unfortunately, I see such cases every week as part of my job. However, unlike in 1929, we now have rules that help to protect investors, such as those that require investment advisers to work in their clients’ best interests and reveal conflicts of interest. We also have the SEC to police the capital markets. The SEC brings hundreds of enforcement cases each year. When possible, these cases return money to harmed investors. For example, in one case, a large broker-dealer agreed to return more than $25 million to individual customers.[10] Other times, we successfully get bad actors out of the industry. For example, in one case, we charged an attorney, who was offering investors an opportunity to receive what he claimed were 100% to 300% guaranteed returns with “minimal” or “no” risk. In reality, he, along with his collaborator, were selling very risky investments.[11] They ended up spending more than $1 million of investor money on personal expenses, including a loft in downtown L.A. As a result of the SEC’s intervention, the attorney is now barred from the investment industry.[12]

Take note as you learn about evaluating investments—any time you hear someone call an investment “no risk,” walk the other way.

More importantly, the SEC has programs that seek to protect investors before they are harmed. Some of these programs are aimed at industry participants—for example, through the examination of investment advisers or periodic chief compliance officer outreach. Other programs are aimed at investors—for example, rewards for whistleblowers and investor education through websites like investor.gov, where investors can find information on avoiding fraud. The SEC has also launched the SEC Action Lookup for Individuals, or “SALI,” an online search feature that enables investors to research whether the person trying to sell them investments has a judgment or order entered against them in an enforcement action.[13] And, most recently, the SEC launched a mock initial coin offering website called HoweyCoin.com that mimics a bogus coin offering to educate investors about what to look for before they invest in a scam.[14] These efforts aim to reduce the hidden risks of investing, making investment activity safer.

Why does all this matter? First, if you decide to work in the financial industry, whether as a portfolio manager or a regulator, I ask that you remember Mr. Brown. There are real people behind the numbers, the calculations, and the financial theories. Don’t forget about them. They have real hopes, real dreams, and real needs.

Second, these are all issues that will personally impact your lives and the lives of your parents and friends. Over the last few decades, investment has become much more important to the well-being of Americans. Unfortunately, jobs that provide a pension have become far less common over the last few decades. Many employers have scaled back pensions or eliminated them entirely. Workers must now save for their own retirements, either in plans their employers provide, like 401(k)s, or in investment accounts they establish for themselves, like IRAs. In fact, we’re heading toward a world in which your investments will be your most significant source of retirement income.[15]

At the same time, for young people today to do better than their parents, they generally face more years of schooling at higher tuition costs.[16] I imagine this part of the story is deeply familiar to all of you. As a result, Americans may be saving for college bills while their children are still in elementary school. Indeed, many are now making investments through 529 plans for this purpose.[17]

Altogether, these changes mean that more Americans have become investors. For many of us, financial security depends, at least in part, on how well our investments meet our needs.[18] In some ways, this is a good development. Investing means putting money to work in today’s economy. And there are a broad range of choices, from individual stocks to mutual funds, from infrastructure projects to municipal bonds. Through investment, a broad range of Americans may now be able to share in the entrepreneurial possibilities of dynamic businesses.

However, without a framework of trust, that investment wouldn’t be possible. Instead, we would all have to make a choice between tucking our savings under the mattress or taking the risk of becoming a Mr. Brown.

So, where do you all fit into the story? At the very least, you will almost certainly be faced with choices about investing your own money or helping your parents navigate their retirement. My hope for you is that, at the end of the summer, you will decide to go a step further and pursue a career in finance and investment. Maybe that will mean becoming a portfolio manager or running a venture capital fund. For some of you, it may even mean spending part of your career working for the government, using your talents to help promote the framework of trust that makes all this investment possible.

Whichever role you choose, you will face a world that has evolved rapidly in recent years. Some of this is really exciting. For example, many new investment opportunities have opened up that allow you to invest not just for short-term profit but also for social impact. You can invest in portfolios designed around sustainability, long-term growth, or quality of corporate governance. The existence of these investment options suggests a desire on the part of a new generation of investors to interact with their investments in a different way.

Technology is also rapidly changing both what people invest in and how people find and make investments. Crowdfunding, robo-advisers, and artificial intelligence are technologies that, while having potential for both positive and negatives effects on the market, are sure to continue making an impact. For your generation, these technologies are a native form of interaction. You will be the first to try the new apps and decide whether they succeed or fail. And you will be the ones who help my generation figure out how to navigate in this new world.

Another significant change, but one I’m less excited about, is the trend toward more complex products being sold to individuals.[19] As we saw earlier, Mr. Brown ended up in plenty of trouble almost 90 years ago with plain old stocks and bonds. If he were seeking investment advice today, what would his advisor recommend? Well, chances are that it would be much more complex than the bonds sold to him in 1929. Perhaps he would be recommended a complex structured note that is linked to an index or that pays interest based on the difference between two swap rates?

My point here is not to overwhelm you with the complexity. What I want you to take from this is an appreciation of how important you can be in this business. We need people with your talents and perspectives to help sort the investments that build wealth from the investments that obscure risk. We need smart women like you, who will promote a culture in which advisors put their clients’ interests first and make level-headed assessments of risk.

Pursuing these opportunities may not be as easy as pursuing some others. You may have to step outside of your comfort zone. You may be in environments where there are not many people who look, think, speak, or act like you. But you should be strong and move forward each time and create your role. Envision where you can, and should, be, and you will benefit all of us.

Even if you choose not to become a portfolio manager or investment adviser, you are still going to be part of the next generation of entrepreneurs, executives, regulators, and investors. You will have an opportunity to shape the businesses in which Americans invest, as well as the business of investing. I hope you will use that opportunity not just to promote growth but to foster growth that sticks. Ten years ago, we unfortunately saw what happens when business becomes focused on profits at any cost.

As you think about a possible career in finance and investing, I want you to come back to the two themes I’ve discussed this evening—how can smart rules help promote healthy investment? And what is your role, as an investor, adviser or entrepreneur, in helping Americans achieve their dreams? If talented women like you focus on those questions, I am confident that we will be in good hands as your generation steps into leadership roles in the years to come.

With that, I want to open it up to your questions and thoughts. What have you learned so far that is interesting? What questions do you have for me?


[2] Stock Exch. Practices: Hearings Before a Subcomm. of the Comm. on Banking and Currency, 72d Cong. 2170, 2170 (1933) (testimony of Edgar D. Brown) (“Brown Testimony”). For additional commentary, see Ferdinand Pecora, Wall Street Under Oath (1968) (“Pecora”); Michael Perino, The Hell Hound of Wall Street 254 (2010).

[3] Brown Testimony, supra note 1.

[6] See Stock Exch. Practices: Hearings Before a Subcomm. of the Comm. on Banking and Currency, 72d Cong. 2087 (1933) (testimony of Hugh G. Baker, President of the National City Co.) (“Baker Testimony”) (noting the bank continued underwriting Peruvian bonds through 1928, when it was doing business with Mr. Brown).

[7] The bank had taken the view for several years that the country was, “flat on its back and gasping for breath.” Baker Testimony, supra note 5; see also Pecora, supra note 1.

[8] Elizabeth Keller, Introductory Comment: A Historical Introduction to the Securities Act of 1933 and the Securities Exchange Act of 1934, 49 Ohio St. L.J. 329 (1988).

[15] See Barbara A. Butrica et al., The Disappearing Defined Benefit Pension and Its Potential Impact on the Retirement Incomes of Baby Boomers, 69 Soc. Sec. Bull. 3 (2009), available at https://www.ssa.gov/policy/docs/ssb/v69n3/ssb-v69n3.pdf (noting that, from 1980 to 2008, “the proportion of wage and salary workers participating in [defined benefit] pension plans fell from 38 percent to 20 percent”); see also Diane Oakley & Kelly Kenneally, Nat’l Inst. on Ret. Sec., Retirement Security 2017: A Roadmap for Policy Makers (2017) (noting that, in 1975, 88% of private sector employees with retirement plans had pensions); John J. Topoleski, Cong. Research Serv., R43439, Worker Participation in Employer-Sponsored Pensions: A Fact Sheet, tbl.1 (2017) (27% of full-time civilian workers have access to a defined benefit plan, while 58% have access to a defined contribution plan).

[16] From 1991 to 2015, accounting for inflation, the average cost of a four-year degree increased by over 50%, from $14,107 to $25,409. Nat’l Ctr. for Educ. Statistics, Inst. of Educ. Sci., Digest of Education Statistics, tbl.330.10 (2016), available at https://nces.ed.gov/programs/digest/d15/tables/dt15_330.10.asp?referrer=report. Over that same period, however, again accounting for inflation, the average salary of an individual 25 or over with a bachelor’s degree increased his or her annual salary by only 1.72%, from $61,231 to $62,304. U.S. Census Bureau, Historical Income Tables: People (2016), tbl.P-16, available at https://www.census.gov/data/tables/time-series/demo/income-poverty/historical-income-people.html.

[17] See U.S. Securities and Exchange Commission, An Introduction to 529 Plans (2014), available at https://www.sec.gov/investor/pubs/intro529.htm (“A 529 plan is a tax-advantaged savings plan designed to encourage savings for future college costs. . . . [They] are sponsored by states, state agencies, or education institutions and are authorized by Section 529 of the Internal Revenue Code.”) As of 2016, $282.2 billion was held in 529 plans, up over tenfold from $26.8 billion in 2002. See Inv. Co. Inst., 529 Plan Data (2016).

[18] Today, more than 90 million Americans have defined contribution retirement plans, and those plans have over $6.7 trillion in assets under management. Vanguard, How America Saves 2016: Vanguard 2015 Defined Contribution Plan Data (2016), available at https://pressroom.vanguard.com/nonindexed/HAS2016_Final.pdf.

https://www.sec.gov/news/speech/speech-stein-060718

Remarks to the Institute of Chartered Accountants in England and Wales: “The intersection of financial reporting and innovation”

The Securities and Exchange Commission (“SEC” or “Commission”), as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission, individual Commissioners, or of the author’s colleagues upon the staff of the Commission.

Introduction

Thank you, Robert [Hodgkinson] for the kind introduction. Thank you, also, to the Institute of Chartered Accountants in England and Wales (“ICAEW”) for sponsoring this event. I am delighted to be in London and with you this afternoon.London continues to be recognized as one of the world’s leading international financial centers, along with New York and other highly globally connected cities. Whether in London or New York or my childhood town of Chambersburg, Pennsylvania, people in every walk of life are affected by financial reporting, the cornerstone on which our process of capital allocation is built.

An effective capital allocation process is critical to a healthy economy that promotes productivity, encourages innovation, and provides an efficient market for the purchase and sale of securities and the obtaining and granting of credit.

Such an efficient allocation process would not be possible without financial disclosures, because adequate and high-quality information helps investors to judge the opportunities and risks of investment choices accurately.

Good accounting and auditing may not readily grab the general public’s attention, but they are essential to our livelihoods. Whether a long-term Main Street investor[1], investment professional, or retiree, individuals make investment decisions—or rely on others to make decisions for them—based in part on audited financial statements. Recent business failures suggest we all benefit when we learn from and strengthen our system of business and financial reporting that underpins decision making within our financial markets.

High-quality financial reporting starts with companies. In companies subject to U.S. federal securities laws, management is required to keep and maintain books and records in reasonable detail.[2] From those books and records, management prepares financial statements according to a general purpose financial reporting framework, so that the reporting is comparable, verifiable, timely, and understandable by investors and others. If the starting point of the financial reporting process does not begin with management using high-quality financial information for its preparation of financial statements, then what could result are increased risks and costs in each subsequent phase of financial reporting.

When required, an annual audit or interim period review performed by an independent auditor provides investors with confidence that a company’s financial statements are presented in accordance with the financial reporting framework. The strength of financial reporting—and of our capital markets—depends on thorough and objective audits performed by auditors who are ethical, independent, skeptical, and who apply the diligence necessary to meet professional and regulatory standards.

When an audit committee is effective, each of management’s and the auditor’s functions is strengthened. The collective goal of all participants in the financial reporting architecture must be for the information to be reliable, the first time it is provided to investors.

It is in this context that the ICAEW, along with my fellow regulators and other leaders, serve such an important role. Founded by farsighted accountants in 1880, ICAEW is a world leading professional membership organization that promotes, develops and supports chartered accountants worldwide. You serve alongside and in collaboration with other professional organizations, such as the American Institute of Certified Public Accountants, in advancing financial reporting by providing qualifications and professional development; sharing knowledge, insight and technical expertise; and protecting the quality and integrity of the accountancy and finance profession.

And so, it is a privilege to speak to you this afternoon in the Chartered Accountants’ Hall about an appropriately tailored topic for this audience: the intersection of financial reporting and innovation.

I also acknowledge the importance of the discussion occurring in the U.K. about the role and relevance of financial reporting and the accountancy profession, with a recent report on Carillion published by select committees of the U.K. Parliament.[3] Among many other points to prompt discussion, the report offers recommendations relating to strengthening the external audit. The recommendations should stimulate critical dialogue and root-cause analyses covering each phase of financial reporting (that is, preparation, audit, delivery, and use), with possible solutions examined in the first instance according to their impact on the advancement of quality of audited financial statements upon which investors (and lenders) rely. Investor (and lender) trust, including in the numbers, impacts the extent and level of their participation in the financial markets. [4] Of course, there are other necessary considerations for sensible solutions, such as an assessment of the costs, benefits, and consequences (both intended and not) to the right expectations of investors and others.

Before I continue, let me remind you that the views expressed today are my own and not necessarily those of the U.S. Securities and Exchange Commission (“Commission”), the individual Commissioners, or other colleagues on the Commission staff.

Let me also express a word of gratitude to the entire OCA team for their work in providing advice to the Commission regarding accounting and auditing matters arising in the administration of the U.S. federal securities laws. I want to also acknowledge Emily Fitts for her valuable assistance in preparing me to make today’s remarks.

Also in the spirit of acknowledgment, let me mention the valuable assistance of Ying Compton in preparing three charts that depict the overall financial reporting structure that frame the reference to the phases of the financial reporting system in the U.S.[5] The charts are available under the OCA section of the SEC’s website.

Our markets: highly connected global investing

Technology and trade have made our world considerably smaller. Issuers operate in a global market and seek capital globally. In fact, today in the United States, more than ever before American investors are investing directly in the securities of foreign private issuers and companies based outside the United States and registered in non-U.S. jurisdictions. At the end of 2016, U.S. investors have invested $9.9 trillion (of which U.S. mutual funds have invested over $4.3 trillion, and U.S. pension funds have invested over $1.3 trillion) in equity and debt securities listed in non-U.S. jurisdictions.[6] Also, as of the end of 2016, according to one industry ranking of the world’s largest asset managers, U.S.-based asset managers occupy the top four positions and eight out of the top 10 slots.[7]

This global capital market presents both opportunities and challenges to the securities regulators in executing their mandates to protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation. The possibilities include greater competition among markets. Also, investors may diversify their portfolio risk across borders more effectively and at less cost. And, companies may seek the lowest price of capital wherever it might be.

Of course, with greater opportunities come greater challenges. The same technologies that allow retail investors to look abroad for investment opportunities also allow fraudsters to look across borders for victims. Additionally, some of the risks that a globalizing capital market poses are not necessarily different from the risks the Commission faces domestically.

Financial reporting information in our markets

Fundamentally an investor (or investment advisor) is trying to decide whether a particular investment is likely to be worth more or less in the future than it is now. The decision-makers are limited to the information contained within financial statements when making investment decisions. They use other types of information (in no particular order of significance) as well, such as:

  • Company reputation, strategic direction, and goals;
  • Company developments, outlook, and position in the marketplace, such as management changes, product introductions, and acquisitions;
  • Company stock performance; and
  • Risks to which the company is exposed and industry outlook.

As my illustrative list suggests, many investors consider, and absorb, information from a wide variety of sources for investment decision-making.

Those involved in financial reporting

Even though decision-makers rely on information other than the financial statements, audited financial statements are a vital element of the overall information architecture that underpins our capital markets. The quality and quantity of the available financial statement information in an economy influence the efficiency of resource allocation and the cost of capital.

We, in OCA, developed three renditions[8] of an overview of organizations involved in the structure of financial reporting in the U.S. markets[9] to help visualize and thereby understand the necessarily complicated system. The versions, of course, also contribute to an analysis of less-obvious aspects. For example, they help identify the multiple points of oversight, review, and advice that both preserve and advance general purpose financial reporting.

I encourage each of the organizations involved in the overall structure to consider how they might use the financial reporting information (or other information) to identify ways on an ongoing basis to prevent failures and add value for investors including by asking what we can do today to support the financial reporting of tomorrow, such as:

  • How can we bolster coordination and collaboration among the organizations involved in financial reporting?
  • What can we learn from previous financial reporting failures to evaluate whether and how each organization could more effectively contribute to the prevention of reoccurrences/future failures?
  • What more could be done to understand and coordinate technological issues (and the technology languages used) within and across each phase of the financial reporting structure?
  • What information should be provided in the financial statements to meet the needs of investors, lenders, and other creditors, even as the context of demographics, technology, and market structures change?
  • Can more be done to help identify expectations and minimize expectation gaps, both globally and variations within particular markets?

What are expectations gaps?

Having just mentioned expectations gaps, let me discuss the topic further. Expectations are normative. An expectations gap is typically referred to as a difference between the levels of expected performance such as the differences in expectation between what some investors might expect from general purpose financial statements and what some accountants might be able to communicate within those same financial statements. The information in financial statements may also be of interest to other groups who are non-capital providers, but the information is not designed to meet their objectives.

The sources of expectations gaps are varied. For example, the sources may be in the design of the standards, their application by accountants or auditors, or invalid expectations. The expectations of investors and others reflect the realities that multiple groups of stakeholders have differing and competing informational needs and desired outcomes. The complexity of expectations only increase when accounting or audit standards are used across the diverse business, legal, social, cultural, and political environments in our world. These are the realities that should be at the forefront of identifying and managing expectations.

So with the framing of expectations gaps in mind, I would like to discuss next several of the conceptual underpinnings of general purpose financial reporting that provide further context to the charts. I aim to contribute to the broader awareness that can help minimize expectations gaps over time. Any similarity to the financial reporting conceptual frameworks is intentional.[10]

Whom do the standard setters consider when developing general purpose financial reporting?

General purpose financial reporting is a core element of the disclosure of business and financial information to investors. Its objective identifies the decision makers. The objective is “to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.”[11] While other parties, such as those charged with governance, regulators, and members of the public other than investors, lenders, and other creditors, also may find general purpose financial reports useful; those reports are not primarily directed toward these other parties.

Special purpose financial reports, by contrast, are prepared using a particular framework to address specific needs of specific users who intend to use it which can include, among other things, aiding members of a board or regulatory supervision team. They have more specific purposes and uses than general purpose financial reports.

I make the distinction between general and special purpose objectives to emphasize the value of keeping and maintaining general purpose financial reporting free from other objectives. Standard-setters for general purpose financial reporting are concerned with, among other things, the qualities of information that relate to broad classes of investment and credit decision makers rather than to particular ones.

When formulating standards for general purpose financial reporting, the IASB and the FASB do not seek to influence the outcome of investor capital allocation decisions or actions taken by management; instead, the boards’ design standards that provide better information to inform those decisions and actions. The alternative, whereby standards are designed to privilege specific objectives, economic activities, financial products, or market participants, could diminish confidence in the accuracy or quality of reported information, which could thereby impair capital formation, and in turn, negatively impact economic activity. Again, by keeping general and special purpose financial reporting objectives distinct, without merging the two, each can serve best their respective purposes and minimize expectations gaps among the parties involved.

As I have mentioned, the need for information on which to base investment, credit and similar decisions underpins the objectives of financial reporting. Each decision maker judges what accounting information is useful, and that judgment is influenced by factors such as, the decisions to be made, the methods of decision making to be used, the information already possessed or obtainable from other sources, and the decision maker’s capacity (alone or with professional help) to process the information.

And yet, the baseline is broad, comprising needs of investors and investment advisers. That is, the optimal information for one user will not be optimal for another. Consequently, management with responsibility for making decisions and judgments about how to prepare information – and standard setters with responsibility for establishing standards to guide management’s decisions — must try to find the balancing point among many different users. This work of preparing information (or writing standards for preparation of information) is one of walking a fine line between preparing (or requiring) disclosure of too much or too little information for inclusion in general purpose financial information. This point arises in particular because information does not come to the preparer and user without costs or benefits, both direct and indirect.

This suggests the importance of financial literacy

Similarly, because information is not useful to a person who cannot understand it, financial education and literacy among all members of the financial reporting structure is critical. It also reinforces the importance of considerations regarding the relevance of accounting information regarding the capacity of information to influence investment decisions.

Information provided by general purpose financial reporting should be comprehensible to those with a reasonable understanding of business and economic activities who are willing to study the information with reasonable diligence.

This is to say that financial information is a tool and, like most tools, is of direct help to those who are able and willing to use it.

And, so what does general purpose financial reporting not address?

No matter how well we succeed in addressing the continued advancement of general purpose financial reporting, there will inevitably be limitations.

For example, it is highly unlikely that we could ever produce a balance sheet from which an investor could read off a figure and say: “that is what my shares are worth.” This is because the market capitalization of a company depends on a mixture of information. For example, if the shares of a company are being bought by a group that is determined to secure a controlling interest, the price of its shares can rise above what the value of the net assets on the balance sheet would suggest. Similarly, the liquidation of a large block of shares can drive the market price down below what might be expected from an analysis of even the best of financial information.

These expectations and any gaps are best addressed when the best thinking is shared

The involvement of everyone in the financial reporting structure in supporting the work of the accounting and audit standard-setters is critical. In doing so, standard-setters can maintain a long-range vision, mission, and strategic goals that are consistent with continued advancement of general purpose financial reporting.

Additionally, the collaboration of everyone involved in the financial reporting structure should transcend geographies. In my view, it is essential to continue a policy of ongoing coordination and collaboration on national and international standards, practices, and needs so that the best thinking is identified, shared with each other, and can prompt action. In the same sense, we also should redouble our efforts for coordination within and across each phase of the financial reporting system – preparation, audit, delivery, and use.

These steps will allow us to continue to advance quality in financial reporting.

Critical Role of Audit Regulators and Audit Standard-Setters

Still, there is a second phase of the overall structure of financial reporting: the audit. When it comes to advancing audit quality and related expectations, prevention (as a complement to detection) is a worthy investment so that investors receive reliable financial information the first time. It is critical that all key stakeholders, including the audit standard-setters and audit regulators, assist in the advancement of audit quality.

One crucial preventive measure is the development of high-quality audit standards, which aid, but can never wholly replace, the role of decision making and judgment by auditors. Both local and international audit, assurance, ethics, and education standards (“audit-related standards”) are relevant to the U.S. and its capital markets participants.[12] The quality of international audit-related standards, for example, is relevant to U.S. investors and asset managers that hold or manage foreign equity and long-term debt securities.

The quality of international audit-related standards is also relevant to U.S. based multi-national companies. For example, in many cases, U.S.-based multi-national companies have local country statutory and other reporting obligations in jurisdictions outside of the U.S. that are met by the audit reports from audit firms that applied international audit-related standards as a starting point for the execution of the consolidated audit. Moreover, the U.S. based audit team may also use the results of the statutory audits as part of their audit risk assessment for the audit of the consolidated financial statements.

Many U.S. accounting firms are members of various global networks that incorporate international audit-related standards as part of a common audit methodology, training, and governance, with an aim to increase the consistency of audit execution and reduce the risk of audit failure.

Additionally, the U.S. accounting profession through the American Institute of Certified Public Accountants Auditing Standards Board (ASB) has a strategic objective to converge its standards with those of the IAASB for audits that are not conducted using the PCAOB standards.[13] The standards of the ASB may be used in conducting governmental and pension plan audits, as well as audits of individual entities with SEC filing obligations, such as in the following instances:

  • Examination engagements under the Custody Rule;
  • Review and audit engagements under Regulation Crowdfunding; and
  • Audit engagements under Regulation A.

High-quality audit standards make audits—and the work of audit committees and others that oversee the audits of companies on behalf of investors—considerably more effective.And so, we all have an interest in the accountability and inclusiveness of the international audit-related standard-setters.

Role of Monitoring Group in advancing international audit-related standards

Given the importance of international standards to the expectations of the U.S. and its capital markets participants, the importance of the Monitoring Group, and the risk of fragmentation, I was honored to be asked to serve as an IOSCO representative to the Monitoring Group. I look forward to this new role and advancing our shared goal of fostering quality judgments and decision making by auditors through high quality international audit-related standards.

Last year, the Monitoring Group issued a consultation paper on strengthening the governance and oversight of the international audit-related standard-setting boards in the public interest. I look forward to working with the other Monitoring Group members to find a way forward on the potential changes to the structure through an inclusive discussion about the issues and choices.

The Monitoring Group’s work is important to the oversight of the development of international audit-related standards, in part since international audit standards are not binding of their own accord. The standards are advisory, but these standards can and do affect audits by obtaining general acceptance among practitioners, by influencing the content of binding standards adopted by local jurisdictions, or by being used in part or whole as binding, local standards.

Role of the PCAOB in protecting investors through audit oversight

I want to pause here to touch on advancements at the PCAOB. Earlier this year, SEC Chairman Clayton and I congratulated incoming PCAOB Chairman Bill Duhnke and Board Member Kathleen Hamm, as they began to serve in those roles as the PCAOB continues its vital mission to promote investor protection through oversight of audits.[14] Then, in February, Jay Brown joined as a new board member, and Jim Kaiser followed in March. Finally, in April, with the arrival of Duane DesParte, the five member board became complete.

Collectively, their backgrounds span the entire spectrum of the financial reporting process and include public company preparer, auditor, governance, investor, and oversight experience. This breadth of knowledge will help advance the board as a body with fresh and diverse thinking. More importantly, each board member has affirmed his or her commitment to promoting audit quality and, in so doing, to protecting investors and furthering the public interest in the preparation of informative, accurate, and independent audit reports.

While the continuity of the PCAOB’s core activities remains one of the Board’s highest priorities, they are focused simultaneously on defining the pillars of the Board’s vision, strategy, and operational plans for the next five years.

Notably, the Board has decided to reach both within and beyond its own four walls for input into what strategic direction to take to improve audit quality through surveys, interviews, and other outreach. The Board is demonstrating a belief, which I also hold, that consistent and meaningful engagement with key constituencies is critical to effectively shaping the PCAOB’s future direction.[15]

Critical role of auditors

The quality of an auditor’s interim reviews and annual audits are also crucial to meeting investor expectations. Auditing is about confidence and trust in financial information. Trust in the audit is nurtured as the profession consistently delivers audit quality and value to audit committees and the investing public. Trust can be nurtured or broken—it is neither static nor assumed.

The audit profession continues to evolve and, as a recent IFIAR survey suggested, deficiencies cited in regulatory inspections remain high but are decreasing.[16] The audit profession must continue to focus, and in some respect do more to meet expectations.

In previous remarks, I have discussed the role of audit firm governance and culture in continuing to advance the quality of annual audits and interim period reviews.[17] Audit firm governance serves a vital purpose in maintaining an effective, proportionate firm-wide (enterprise) risk management system, as a framework to anticipate and mitigate the risk of breakdowns and failures.

Auditor choice

Audit quality is a touchstone to our capital markets. Secondary to audit quality, there are also considerations regarding whether with increased concentration of audit firms there may be a lack of choice among audit firms. While the number of available firms remains higher in the private company, not-for-profit, and governmental sectors, the same is not true in the public company markets. These issues mostly go beyond the scope of my remarks today and are evolving, particularly in the U.K. While acknowledging the importance of scale so that audit firms can audit the largest public companies, I also believe analyzing sensible ways to foster the growth of smaller firms is also worth considering. For example, would collaborations across firms of all sizes on people development, methodologies, and technology build capacity and competitiveness among audit firms of all sizes in the public company markets, thereby increasing auditor choice for audit committees? Collaboration is just one approach in an evolving discussion, of which I am sure there are many questions.

The integrity with which auditors, as well as all other stakeholders in the financial reporting process, execute their responsibilities is foundational to the enduring confidence of the investing public in our capital markets, and maintaining the confidence of investors is vital. The counterpart to this point is that even in meeting the rightfully high expectations and needs of investors, lenders, and other creditors, audits are not capable of providing absolute assurance—a guarantee—of the integrity of management’s financial statements or the viability and soundness of a business model. It is essential for all of us to fully understand what audited financial statements can provide and not suggest that audited financial statements provide investors with more information than such statements are designed to provide.

Auditors of tomorrow

We must also keep an eye on the talent required to sustain the role and relevance of the audit. In this room, some of you went through college with limited or no exposure to computers. Others of you, how can we forget, learned computers using punched cards. Then there is also among us the first generation who had to buy a personal computer for college. Moreover, today, even my six-year-old son is adept at using a smartphone to send me emails.

Today’s students – tomorrow’s investors – are going to require faster, more timely dissemination of quality information, on a global basis. Tomorrow, in fact, may be here now. In that regard, audit firms and others should consider the impact of technological developments to this ever-changing profession. For example:

  • While audit firms hire some of the brightest graduates, are the audit firms planning sufficiently for retention and succession planning so that the skillsets needed for a changing profession are available at the right time in the future?
  • What mechanisms are in place to promote sufficient technical expertise, including within critical quality control functions such as a national office?
  • What is the best way to reward auditors for high-quality work?
  • How will the audit profession identify and find ways to respond to the quickly changing needs of investors and the technologies they use?

These are illustrative questions. I believe the profession’s ability to attract and retain the best and brightest talent will continue to be impacted by how well leaders identify solutions that inspire the best candidates to invest in a career of adding trust and integrity to the financial information that underpins the world’s capital markets.

Addressing these questions requires all stakeholders—including academics—to take an active role. For example, as I said in another forum last year, the research that accounting academics perform has made (and will continue to make) significant contributions to the accounting and reporting practice.[18] Additionally, academics help foster the necessary skills that the auditors of tomorrow will need, and help determine how audit firms can attract and retain the best professionals. The most useful academic research, in my opinion, identifies solutions to problems, more than just suggesting a problem itself.

Even as we work to safeguard the public’s confidence in financial reporting, we must also position ourselves and future generations of accountants, auditors, standard setters, and regulators to innovatively identify and solve the challenging and complex issues facing investors. It is critical for the livelihood of the profession for all members of the profession to take an active role in defining the profession’s future.

Conclusion

Let me close. It has been my pleasure to speak with you today. In our time together, I have provided thoughts on how we can continue to give investors quality financial information for their use in making informed investment decisions.

The financial reporting system’s strength is the result of the shared and weighty responsibility of all stakeholders in providing investors the right financial information the first time.

We are witnessing a whole succession of technological innovations, but none of them will do away with the need for integrity in the individual or the ability to think.

Thank you.


[2] See Section 13(b)(2)(A) of the Exchange Act.

[6] See “U.S. Portfolio Holdings of Foreign Securities” as of December 31, 2016 by U.S. Department of Treasury, Federal Reserve Bank of New York, and Board of Governors of the Federal Reserve System, at page B-8 (October 2017), available at http://ticdata.treasury.gov/Publish/shc2016_report.pdf.

[8] The three renditions on the financial reporting structure include: (1) Blue Print – an illustration of the players involved; (2) Flow Chart – a simplified representation of the blue print; and (3) Segment Chart – variations in financial reporting requirements in three different market segments: domestic issuers, foreign private issuers, and private companies.

[10] See Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Concepts No. 8,Conceptual Framework for Financial Reporting, (September 2010) and International Accounting Standards Board (“IASB”)Conceptual Framework for Financial Reporting, (March 2018).

[11] See Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Concepts No. 8,Conceptual Framework for Financial Reporting, paragraph OB2 (September 2010) and International Accounting Standards Board (“IASB”)Conceptual Framework for Financial Reporting, paragraph 1.2 (March 2018).

[12] Over 125 countries are using or are in the process of adopting or incorporating International Standards on Auditing (ISAs), issued by the International Auditing and Assurance Standards Board (IAASB), into their national auditing standards or using them as a basis for preparing national auditing standards.

[17] See Remarks before the 2018 Baruch College Financial Reporting Conference: “Working Together to Advance Financial Reporting”, Wesley Bricker, Chief Accountant, U.S. Securities and Exchange Commission (May 3, 2018), available at https://www.sec.gov/news/speech/speech-bricker-040318.

https://www.sec.gov/news/speech/speech-bricker-060618

Staff Letter: Investment Company Institute

Investment Company Act of 1940 – Section 22(e)
Investment Company Institute

June 1, 2018

Response of the Chief Counsel’s Office
Division of Investment Management

Your letter dated May 30, 2018 requests our assurance that we would not recommend enforcement action to the Securities and Exchange Commission (the “SEC” ) against a registered open-end investment company (a “mutual fund”) or its SEC-registered transfer agent[1] under Section 22(e) of the Investment Company Act of 1940 (the “Act”)[2] if, in the limited circumstances and subject to the conditions described in your letter, the transfer agent, acting on behalf of the mutual fund, temporarily delays for more than seven days the disbursement of redemption proceeds from the mutual fund account of a Specified Adult held directly with the transfer agent based on the transfer agent’s reasonable belief that financial exploitation of the Specified Adult has occurred, is occurring, has been attempted, or will be attempted. You represent that financial exploitation of seniors and other vulnerable adults is a serious problem, with substantial amounts lost annually to senior financial abuse.

You note that FINRA Rule 2165, adopted last year, enables a FINRA member (i.e., a broker-dealer) who has a reasonable belief that financial exploitation of a Specified Adult has occurred, is occurring, has been attempted, or will be attempted, to place a temporary hold on the disbursement of funds or securities from the Specified Adult’s account, in accordance with the conditions set forth in FINRA Rule 2165.[3] You further state that some mutual fund shareholder accounts are held directly with the mutual fund and serviced by the fund’s transfer agent (“direct-at-fund” accounts). For such accounts, the transfer agent is typically responsible for opening and servicing the accounts, maintaining account records, and serving as the fund’s point of contact with those shareholders. You represent that, given its relationship with direct-at-fund shareholders, the fund’s transfer agent may be best positioned to detect financial exploitation of certain of the fund’s senior and other vulnerable adult shareholders. You state that mutual fund transfer agents may wish to protect Specified Adult shareholders from financial exploitation to the same extent that broker-dealers may do so under FINRA Rule 2165.

Based on your facts and representations, we would not recommend enforcement action to the SEC against a mutual fund or its SEC-registered transfer agent under Section 22(e) of the Act if, in accordance with the terms and conditions described in your letter, the transfer agent, acting on behalf of the mutual fund, temporarily delays for more than seven days the disbursement of redemption proceeds from the mutual fund account of a Specified Adult held directly with the transfer agent based on a reasonable belief that financial exploitation of the Specified Adult has occurred, is occurring, has been attempted, or will be attempted. This response expresses our views on enforcement action only and does not express any legal conclusions on the questions presented. Because our position is based on the facts and representations in your letter, different facts or representations may require a different conclusion.

Jennifer O. Palmer
Senior Counsel


[1] Section 17A(c) of the Securities Exchange Act of 1934 and the rules thereunder require that transfer agents register with the SEC or, if the transfer agent is a bank, with a bank regulatory agency. See 12 CFR 9.20(c); 17 CFR 240.17Ac2-1-3.

[2] Section22(e) of the Act prohibits a registered investment company from suspending the right of redemption or postponing the date of payment or satisfaction upon redemption of any redeemable security in accordance with its terms for more than seven days after the tender of such security to the company or its agent designated for that purpose for redemption. 15 U.S.C 80a–22(e).

[3] The terms “Specified Adult,” “account,” and “financial exploitation” as used in this letter have substantially the same meaning as those terms are defined in FINRA Rule 2165, Financial Exploitation of Specified Adults. A Specified Adult is: (A) a natural person age 65 and older; or (B) a natural person age 18 and older who the transfer agent reasonably believes has a mental or physical impairment that renders the individual unable to protect his or her own interests. See FINRA Rule 2165(a)(1). Account means an account for which a Specified Adult has the authority to transact business. See FINRA Rule 2165(a)(2). Financial exploitation means: (A) the wrongful or unauthorized taking, withholding, appropriation, or use of a Specified Adult’s funds or securities; or (B) any act or omission by a person, including through the use of a power of attorney, guardianship, or any other authority regarding a Specified Adult, to (i) obtain control, through deception, intimidation or undue influence, over the Specified Adult’s money, assets or property, or (ii) convert the Specified Adult’s money, assets or property. See FINRA Rule 2165(a)(4).


Incoming Letter


The Incoming Letter is in Acrobat format.

http://www.sec.gov/divisions/investment/noaction/2018/investment-company-institute-060118-22e.htm


Modified: 06/01/2018

http://www.sec.gov/divisions/investment/noaction/2018/investment-company-institute-060118-22e.htm

Niel Martin Nielson and Carolyne Susan Johnson

The Securities and Exchange Commission yesterday charged two executives of a microcap company with defrauding retail investors in a penny stock scheme involving an Ohio-based electronic-waste recycling company.

The SEC’s complaint, filed in federal court in the District of Columbia, charges Niel Martin Nielson, the CEO of E-Waste Systems, Inc., with defrauding investors by orchestrating a scheme to artificially increase the company’s share price and volume. The SEC alleges that Nielson entered into a series of sham contracts, made materially false and misleading statements, and booked false revenue to create the impression that E-Waste was rapidly expanding across the United States, Europe, and Asia. The complaint alleges that E-Waste in fact had virtually no operations. The SEC’s complaint alleges that Nielson carried out this scheme with the aid of Carolyne Susan Johnson, the Secretary and Treasurer of E-Waste, who consented to entry of a final judgment in the Southern District of Ohio on these and charges related to other issuers.

The SEC’s complaint charges Nielson with violating Section 17(a) of the Securities Act of 1933, and Sections 10(b), 13(b)(5), and 16(a) of the Securities Exchange Act of 1934 and Rules 10b-5 13a-14, 13b2-1, 13b2-2, and 16a-3 thereunder, and aiding and abetting E-Waste’s violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder. The SEC’s complaint against Johnson charges her with violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, aiding and abetting Nielson’s violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and aiding and abetting E-Waste’s violations of Section 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act. Without admitting or denying the SEC’s allegations, Johnson consented to entry of a final judgment imposing permanent injunctions. Johnson also agreed to be barred from serving as an officer and director of a public company and a penny stock bar, and to other conduct-based injunctions. The settlement is pending approval by the court.

In a separate order, the SEC found that Arthur Kaplan, the executive assistant to Edward Panos, whom the SEC previously charged with defrauding investors, also participated in a related fraudulent scheme by recruiting participants for sham private offerings and facilitating the transfer of shares to accounts that Panos controlled. Kaplan, who cooperated with the SEC’s investigation, agreed to cease-and-desist from violating the antifraud provisions of the federal securities laws. Kaplan agreed to the settlement without admitting or denying the findings.

The SEC’s investigation was conducted by Virginia Rosado Desilets, Sonia Torrico, Michael Hoess, and Jennifer Clark, with assistance from trial counsel Suzanne J. Romajas and supervisory trial counsel Jan M. Folena, and supervised by David A. Becker. The SEC’s investigation is ongoing. The SEC’s litigation against Mr. Nielson will be led by Ms. Romajas and supervised by Ms. Folena.

The SEC appreciates the assistance of the Financial Industry Regulatory Authority in this matter.

https://www.sec.gov/litigation/litreleases/2018/lr24151.htm

Perry A. Gruss

Litigation Release No. 24150 / May 24, 2018

Securities and Exchange Commission v. Perry A. Gruss, Civil Action No. 11-cv-02420 (RWS) (S.D.N.Y.)

On May 4, 2018, the Honorable Robert W. Sweet of the U.S. District Court for the Southern District of New York entered a final judgment, on consent, against defendant Perry A. Gruss, the former chief financial officer of D.B. Zwirn & Co., L.P. (DBZCO), a now defunct investment adviser, permanently enjoining Gruss from violations of Section 206(2) of the Investment Advisers Act of 1940 and imposing a civil money penalty of $227,500.

The SEC’s complaint, filed in April 2011, alleged, among other things, that Gruss aided and abetted DBZCO’s improper transfers of monies between its privately managed client funds, including transfers of $576 million to allow one of the client funds to make its investments, and transfers of $273 million to allow the same client fund to repay its revolving credit facility.

By order dated March 28, 2017, the court granted, in part, the SEC’s motion for summary judgment and held that Gruss aided and abetted DBZCO’s violations of Section 206(2) of the Advisers Act resulting from the improper transfers of monies between the client funds for investments and repayment of the revolving credit facility. The court also granted the motion for the imposition of civil penalties in the amount of $227,500. The final judgment entered on May 4 makes these findings final and, as part of the settlement, the court granted the SEC’s request to voluntarily dismiss, with prejudice, all additional claims against Gruss.

Separately, the SEC instituted settled administrative proceedings against Gruss in which Gruss acknowledges the district court’s finding that Gruss aided and abetted violations of Section 206(2) of the Advisers Act, and consents to a Commission order that he be barred from association with any investment adviser with the right to apply for reentry after three years.

For further information, see LR-21923 (April 8, 2011)

https://www.sec.gov/litigation/litreleases/2018/lr24150.htm

Gregory M. Bercowy

Litigation Release No. 24149 / May 24 , 2018

Securities and Exchange Commission v. Gregory M. Bercowy, Civil Action No. 8:18cv792-T26-CPT (M.D. Fla. filed April 3, 2018)

On May 22, 2018, the U.S. District Court for the Middle District of Florida entered a judgment against St. Petersburg, Florida, resident Gregory M. Bercowy in a case involving a scheme to manipulate the stock price of Aureus, Inc., a penny stock company incorporated in Nevada. Among other things, the court ordered Bercowy to pay a civil penalty of over $500,000.

The SEC’s complaint, filed on April 3, 2018, alleged that between August 4 and August 15, 2016, Bercowy, who during the relevant time period was associated with a state-registered investment adviser, sold shares of certain Fortune 500 companies, including Abbott and Apple, in his relative’s brokerage account in order to buy over three million shares of Aureus at a total cost of more than $2.8 million. According to the SEC’s complaint, while Bercowy was accumulating these shares of Aureus, he entered (and later cancelled) a large number of orders to buy Aureus shares at prices higher than the then-current price of the stock. The orders allegedly were intended solely to maintain or boost the stock’s price. The price per share of Aureus securities increased from $0.52 on August 4, 2016, to $1.62 on August 16, 2016. According to the SEC’s complaint, Bercowy stated in recorded phone calls with a representative of a brokerage firm that he and others were trying to boost Aureus’s stock price.

The final judgment, which was entered against Bercowy by default, enjoins Bercowy from future violations of Section 17(a)(1) and (3) of the Securities Act of 1933 and Sections 9(a)(2) and 10(b) of the Securities Exchange Act of 1934 and Rules 10b-5(a) and (c) thereunder. The judgment also orders Bercowy to pay a civil penalty of $507,513 and permanently bars him from participating in an offering of a penny stock.

https://www.sec.gov/litigation/litreleases/2018/lr24149.htm

Bud Genius, Inc. and Aaron “Angel” Stanz, Taylor Moffitt, Carlos Febles, and U.S. CoProducts, LLC

On May 21, 2018, the Securities and Exchange Commission charged Bud Genius Inc. and its CEO with defrauding investors by making exaggerated and misleading claims about the medical marijuana company’s business operations and financial condition.

The SEC’s complaint, filed in federal district court in the Southern District of California, alleges that Bud Genius and Aaron “Angel” Stanz issued false and misleading press releases about a purported licensing agreement with comedian Tommy Chong. In one press release, Stanz allegedly described Chong as a “partner,” and in a subsequent blog post, he described the purported licensing agreement as a “crowning achievement.” The agreement never materialized, and the defendants allegedly knew at the time that, in light of Bud Genius’s weak financial position, it was extremely unlikely that an agreement would ever be reached. The defendants’ false and misleading claims about the purported agreement were picked up by multiple media outlets. The defendants also are alleged to have published fraudulent financial statements and to have facilitated an unregistered offering of Bud Genius securities.

The unregistered offering is the subject of a separate action filed by the SEC in the Northern District of Iowa against Taylor Moffitt, Carlos Febles, and U.S. CoProducts LLC. The SEC alleges that the defendants acquired, offered, and sold billions of shares of unregistered Bud Genius stock for a total profit of more than $540,000, approximately $140,000 of which was paid to Bud Genius and Stanz.

Without admitting or denying the Commission’s allegations, Stanz agreed to a judgment enjoining him from violating Sections 5(a), 5(c), 17(a)(1) and 17(a)(3) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, imposing five-year officer-director and penny stock bars, and ordering disgorgement and prejudgment interest of $158,829. Without admitting or denying the Commission’s allegations, Bud Genius agreed to a judgment enjoining it from violating Sections 5(a), 5(c), 17(a)(1) and 17(a)(3) of the Securities Act, and Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder. The settlements are subject to court approval.

Without admitting or denying the Commission’s allegations, Moffitt, Febles, and U.S. CoProducts agreed to a judgment enjoining them from violating Sections 5(a) and 5(c) of the Securities Act and all three will be jointly and severally liable for $435,595 in disgorgement and prejudgment interest. In addition, Moffitt and Febles agreed to penny stock bars of three years and one year respectively, and to pay civil penalties of $35,000 and $20,000 respectively. These settlements also are subject to court approval.

The SEC’s investigation was conducted by Timothy Stockwell and supervised by C.J. Kerstetter.

https://www.sec.gov/litigation/litreleases/2018/lr24148.htm

Brent Borland, et al.

On May 16, 2018, the Securities and Exchange Commission charged Brent Borland and two of his companies with misappropriating close to $6 million in investor funds intended to finance an international airport in Belize.

The SEC’s complaint alleges that between 2014 and 2017, Brent Borland sold more than $21 million of promissory notes to dozens of investors, promising that the funds would be used as bridge financing for development of an international airport in Placencia, Belize and that the investments would be protected by pledges of real estate as collateral. Borland marketed and sold the notes through two companies, Borland Capital Group LLC, which purports to be active in “alternative investment,” and Belize Infrastructure Fund I, LLC, which purports to be in the business of construction finance.

The complaint alleges that Borland used millions of dollars of investor funds for personal expenses and unrelated business expenses, including mortgage and property tax payments on his family’s Florida mansion, multiple luxury automobiles, private school tuition for his children, $36,000 for his family’s beach club membership, and almost $2.7 million to pay off credit cards. Borland also allegedly deceived investors by pledging the same collateral to multiple investors.

The SEC’s complaint filed in the Southern District of New York alleges that Borland, BCG and Belize Fund with violating Section 17(a) of the Securities Act of 1933 (“Securities Act”) and Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder. The SEC seeks, among other relief, asset freezes as to Borland and his companies, an accounting of investor assets, disgorgement of Borland’s ill-gotten gains and civil penalties. The complaint also names as relief defendants Borland’s wife, Alana LaTorra Borland, and a corporation controlled by Borland and his wife, Canyon Acquisitions, LLC. The SEC seeks to recover investor proceeds that Borland transferred to the relief defendants.

In a parallel action, the U.S. Attorney’s Office for the Southern District of New York announced criminal charges against Borland who was arrested earlier in the day. The SEC’s investigation, which is continuing, was conducted by Andrew O’Brien and Donald Ryba and supervised by C.J. Kerstetter. The SEC’s litigation will be led by Benjamin Hanauer and Timothy Leiman.

https://www.sec.gov/litigation/litreleases/2018/lr24147.htm

Todd David Alpert

Litigation Release No. 24145 / May 18, 2018

Securities and Exchange Commission v. Todd David Alpert, No. 17-Civ-1879 (S.D.N.Y. filed Mar. 15, 2017)

On May 1, 2018, a federal district court entered a consent judgment against Kingston, Pennsylvania resident Todd David Alpert, for insider trading. According to the SEC’s complaint, Alpert, who worked as a security guard at the home of an H.J. Heinz Company board member, misappropriated material nonpublic information concerning the then-impending acquisition of Heinz by Berkshire Hathaway, Inc. and 3G Capital Partners Ltd. The complaint alleged that shortly after learning about the potential deal in the course of his employment, Alpert breached a duty of trust and confidence by purchasing 1,000 shares of Heinz stock and 30 call options. The morning that the deal was announced, February 14, 2013, Alpert sold these Heinz securities for total profits of nearly $44,000.

To settle the SEC’s charges Alpert consented without admitting or denying the allegations in the complaint to entry of a judgment that: (i) permanently enjoins him from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5; (ii) orders him to pay disgorgement of his profits of $43,873 with prejudgment interest of $1,627; and (iii) orders him to pay a civil penalty of $43,873.

The SEC’s investigation was conducted by Megan M. Bergstrom and Diana K. Tani of the SEC’s Market Abuse Unit, and was supervised by the unit’s then co-chiefs, Joseph G. Sansone and Robert A. Cohen. The SEC’s litigation was led by John B. Bulgozdy and Ms. Bergstrom.

For further information, see Litigation Release No. 23780 (March 15, 2017).

https://www.sec.gov/litigation/litreleases/2018/lr24145.htm

PixarBio Corp. et al.

Litigation Release No. 24146 / May 18, 2018

Securities and Exchange Commission v. PixarBio Corp. et al., No. 1:18-cv-10797 (D. Mass. filed April 24, 2018)

United States v. Frank Reynolds et al., No. 18-mj-6151 (D. Mass. filed April 24, 2018)

On May 18, 2018, a federal district court in Massachusetts entered a preliminary injunction against PixarBio Corporation, Francis M. Reynolds, Kenneth A. Stromsland, and M. Jay Herod, restraining the defendants from violating federal securities laws and maintaining an existing asset freeze until further notice.

The SEC’s complaint, filed on April 24, 2018, alleges that Reynolds and Stromsland misled investors with false claims about PixarBio’s progress in developing a purported method of delivering non-opiate, post-operative pain medication, including that they falsely told investors that the FDA had lowered PixarBio’s hurdles for regulatory approval. The complaint also alleges that Reynolds, Herod, and Stromsland engaged in a fraudulent scheme to acquire and merge PixarBio with a publicly traded company and to secretly manipulate the sales of shares in the new entity. From these sales, Reynolds and Herod pocketed about $400,000, and they used an additional $500,000 to keep PixarBio afloat as Reynolds misled investors about how much money they had raised in the unregistered offering.

The SEC’s complaint charges PixarBio, Reynolds, Herod, and Stromsland with violating Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. It also charges Reynolds and Stromsland with violating Section 15(a) of the Exchange Act, and Herod and Stromsland with violating Section 9(a) of the Exchange Act. The SEC is seeking permanent injunctions, disgorgement of ill-gotten gains with interest, penny stock bars, officer and director bars, and financial penalties.

For further information, see Litigation Release No. 24121.

https://www.sec.gov/litigation/litreleases/2018/lr24146.htm

Keenan Gracey

Litigation Release No. 24144 / May 17, 2018

Securities and Exchange Commission v. Keenan Gracey, Civil Action No.18-01872 (C.D. Cal, Filed May 10, 2018)

The Securities and Exchange Commission today announced the unsealing of fraud charges against a defendant who stole at least $400,000 from investors through the sale of non-existent pre-IPO shares of stock. The SEC also obtained emergency relief, including an asset freeze and a temporary restraining order to halt the offering.

The SEC’s complaint alleges that Keenan Gracey sold investors purported pre-IPO shares in Perspecta, Inc., a new company that will be formed as a result of the merger of three other companies. Although the merger is planned, Gracey’s claims of ownership of pre-IPO shares in Perspecta were false. As alleged in the SEC’s complaint, Gracey has no interest in the not-yet-formed company and no IPO is planned for its stock. The SEC alleges that Gracey used publicly available information about the merger and false claims about his supposed connections with the companies involved to convince investors that they would recover sixty times their investment if they purchased pre-IPO shares from him.

The SEC’s complaint filed under seal in federal court in U.S. District Court for the Central District of California on May 9, 2018 and unsealed today, charges Gracey with violations of Section 10(b) of the Securities and Exchange Act of 1934, and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act of 1933. The Court granted the SEC’s request for an asset freeze and a temporary restraining order against Gracey from further violations of the federal securities laws, as well as other emergency relief. The SEC complaint also seeks preliminary and permanent injunctions, return of any ill-gotten gains with interest, and civil penalties.

The SEC’s investigation was conducted by Alec Johnson and was supervised by Marc Blau. The SEC’s litigation will be led by Don Searles and supervised by Amy Longo.

The SEC encourages investors to be wary of any offer of pre-IPO shares, as further detailed in this investor alert.

https://www.sec.gov/litigation/litreleases/2018/lr24144.htm

William M. Jordan

Litigation Release No. 24142 / May 15, 2018

Securities and Exchange Commission v. William M. Jordan, No. 8:18-cv-00852 (CD Cal filed May 15, 2018)

The Securities and Exchange Commission today announced that investment adviser William Jordan of Orange County, California, has settled charges for perpetrating a multi-million dollar fraud on his clients.

The SEC’s complaint alleges that, from 2011 until 2016, as he raised more than $71 million from approximately 100 advisory clients, Jordan lied to investors about how their funds would be invested, about their investments’ performance, and about his own disciplinary history. Jordan is alleged to have overstated the value of the assets in several of his 16 private investment funds, and then to have used those inflated values and unrealized “profits” on other investments to overpay management fees and bonuses to himself and his entities. The complaint further alleges that the 16 funds were never audited, despite Jordan’s promises to investors. The open funds, along with other Jordan-affiliated entities, sought bankruptcy protection in May 2017 and are under the control of an independent Chief Restructuring Officer.

The SEC’s complaint charges Jordan with violations of the antifraud provisions of the federal securities laws: Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and (2) of the Investment Advisers Act of 1940. Jordan settled the action by consenting to the entry of a permanent injunction without admitting or denying the allegations of the complaint. The appropriate amount of disgorgement, prejudgment interest and civil penalties will be determined by the federal district court in Orange County, California.

The SEC’s investigation was conducted by Janet Rich Weissman and supervised by Ansu N. Banerjee, and the litigation as to the appropriate monetary relief will be led by Amy J. Longo, all from the SEC’s Los Angeles Regional Office. The SEC acknowledges the assistance and cooperation of the California Department of Business Oversight.

https://www.sec.gov/litigation/litreleases/2018/lr24142.htm

Francisco Abellan Villena, Guillermo Ciupiak, James B. Panther, Jr., and Faiyaz Dean

The Securities and Exchange Commission today charged four individuals for their roles in a fraudulent scheme that generated nearly $34 million from unlawful stock sales and caused significant harm to retail investors.

According to the SEC’s complaint, the defendants manipulated the market for and illegally sold the stock of microcap issuer Biozoom Inc.  As part of the alleged scheme, the defendants hid their ownership and sales of Biozoom shares by using offshore bank accounts, sham legal documents, a network of nominees, anonymizing techniques, and other deceptive practices.  The defendants also allegedly directed a wide-ranging promotional campaign and employed sophisticated, manipulative trading techniques to artificially inflate Biozoom’s share price.  The alleged scheme culminated in the defendants’ illegal sales of Biozoom, which netted them nearly $34 million in unlawful proceeds.

The SEC’s complaint, which was filed in federal district court in the Southern District of New York, charges Francisco Abellan Villena, Guillermo Ciupiak, James B. Panther, Jr., and attorney Faiyaz Dean with violating Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 thereunder, 17 C.F.R. § 240.10b-5, as well as Section 5 of the Securities Act of 1933 (“Securities Act”), 15 U.S.C. § 77(e), and Section 17(a) of the Securities Act, 15 U.S.C. § 77q(a). The SEC seeks monetary and equitable relief.  The SEC previously obtained a judgment against Abellan for his role in another market manipulation scheme. In separate actions, the SEC charged two registered representatives for their roles in the unregistered sales of Biozoom stock and a brokerage firm for supervisory and recordkeeping failures.

The SEC obtained a court order in 2013 freezing proceeds from the unlawful Biozoom sales.  It subsequently obtained a default judgment and established a fair fund, which has returned more than $14 million to harmed investors.  The SEC also previously charged a lawyer and officer of Biozoom’s predecessor entity.

The SEC’s continuing investigation is being conducted by Marc E. Johnson and Jennie B. Krasner with the assistance of the Enforcement Division’s Information Technology Forensics Group, and under the supervision of Deborah A. Tarasevich and Ms. Chion.  The litigation is being conducted by Duane K. Thompson and Daniel Maher, and supervised by Cheryl Crumpton.  The SEC appreciates the assistance of the Financial Industry Regulatory Authority, the British Columbia Securities Commission, the Comision Nacional del Mercado de Valores of Spain, the Cyprus Securities and Exchange Commission, the Hong Kong Securities and Futures Commission, the Ontario Securities Commission, and the Supertendencia del Mercado de Valores of Panama.

https://www.sec.gov/litigation/litreleases/2018/lr24141.htm