Chapter 17 - § 17.3 • REPORTING REQUIREMENTS UNDER THE 1934 ACT

• Jurisdiction: Colorado

§ 17.3 • REPORTING REQUIREMENTS UNDER THE 1934 ACT

Registration of the initial public offering is only the beginning of a continuing process of disclosure mandated by the federal securities laws. Under the 1934 Act, most public corporations are required to register and to make further reports and disclosures. Pursuant to § 12(g)(1) of the 1934 Act and Rule 12g-l thereunder, registration under the 1934 Act is required of any company that at the end of its fiscal year has both total assets exceeding $10 million and a class of equity security held of record by 500 or more persons. If the company's securities are listed and traded on one of the national stock exchanges, the company will have registered under the 1934 Act § 12(b) by virtue of such listing. In addition, the underwriting agreement may contain a requirement that a company register under the 1934 Act.

As a result of registration under the 1934 Act, the company will be subject to many formal reporting requirements under § 12(g) of the 1934 Act. Even before 1934 Act registration, the company will be subject to substantially the same reporting requirements under § 15(d) of the 1934 Act. In addition, the 1934 Act requirements include compliance with proxy rules and the Foreign Corrupt Practices Act.

A copy of the company's reports on Form 10-K, 10-Q, and 8-K must also be filed electronically with the exchange on which the securities are traded as long as any of the company's securities are traded on that exchange.

One of the most important aspects of the periodic reports is the "Management's Discussion and Analysis of Financial Condition and Results of Operations; Certain Investment Company Disclosures," which is to discuss past results and known trends for the future. It is the "investment analysis" by the issuer. The MD&A should "give investors an opportunity to look at the registrant through the eyes of management," including appropriate forward-looking information such as known trends, events, and uncertainties expected to have a material effect.⁵⁰ It is "intended to provide, in one section of a filing, material historical and prospective textual disclosure enabling investors and other users to assess the financial condition and results of operations of the registrant, with particular emphasis on the registrant's prospects for the future."⁵¹

Note 1 to Financial Reporting Release 36 makes it clear that the MD&A should contain a discussion of all material impacts, including information discussed elsewhere in the document.

Commissioner Richard Roberts has said that the MD&A disclosure constitutes the "heart and soul" of a company's SEC disclosure. He explained that this disclosure is intended to explain and put into perspective for the reader the company's financial statements, as a "non-accountant's guide to the financial statements and a shareholder's window to the boardroom."⁵² The SEC encourages the use of "forward-looking" disclosure, and has promulgated 1933 Act Rule 175 and 1934 Act Rule 3b-6 to provide a safe harbor for projections that are prepared in good faith and with a reasonable basis. As stated in Arazie v. Mullane,⁵³ the difficulty with forward-looking statements is that they "are inevitably inaccurate because things almost never go as planned."⁵⁴ The Arazie court further pointed out: "The safe harbor rules 'assume[ ] that readers are sophisticated, can understand the limits of a projection—and that if any given reader does not appreciate the limits, the reactions of the many professional investors and analysts will lead to prices that reflect the limits of the information.'"⁵⁵ For a more detailed discussion of the disclosure of forward-looking information, see Chapter 6.

For example, in Simon v. American Power Conversion Corp.,⁵⁶ the company became aware that a product defect would likely result in increased costs and lower sales. The discovery occurred after the end of a fiscal quarter, however. The court found that there was a duty to disclose this information, even though disclosure would not be required in the financial statements.

The MD&A is the place where forward-looking information is most frequently found, but also includes financial projections (such as appraisals and reserve analyses) and fairness opinions that may be discussed elsewhere. However, the disclosure of accurate historical data does not become misleading even if less favorable results might be predictable in the future.⁵⁷

When management has identified a "trend, demand, commitment, event or uncertainty," management must make two assessments in determining whether disclosure is required and the extent of such disclosure:

1) Is the known trend (etc.) likely to come to fruition? If not, disclosure is not required.
2) If this is not known, then what is the magnitude of the event if it does happen? If the magnitude is material to the issuer, then disclosure may be required in any event.⁵⁸

This is a balancing similar to, but not the same as, that set forth in Basic Inc. v. Levinson.⁵⁹ This balancing is extremely important in questions relating to the disclosure of possible or probable environmental liabilities or other possibly significant claims against the company.

The SEC uses the MD&A as a principal source when "prospecting" for financial fraud. According to the Director of the SEC's Division of Enforcement, William R. McLucas, Esq., "The premise of the MD&A section of the filing is to provide information to improve understanding of the enterprise, and to evaluate financial disclosures made elsewhere in the filing."⁶⁰

In the first enforcement action solely involving an annual report's MD&A, Caterpillar, Inc. settled Commission administrative charges that it failed adequately to discuss information and "known uncertainties" about a foreign subsidiary's operations.⁶¹ The proceeding emphasized the requirements of the MD&A to disclose "known trends and uncertainties" that can reasonably be expected to have a material impact on a company's operations or financial condition. In this case, Caterpillar had failed to disclose that nearly 25 percent of its net profits resulted from its Brazilian subsidiary. This in turn was improved as a result of non-operating items such as currency translation gains and export subsidies. Management apparently knew it was uncertain that the Brazilian subsidiary could repeat this performance in the following year. "Disclosure of the extent of [the subsidiary's] contribution was required. Moreover, the MD&A should have discussed factors contributing to the subsidiary's earnings. . . . Similarly, discussion of the uncertainties surrounding the subsidiary's earnings and possible material future impact on overall corporate finances and results of operation were required."⁶²

The SEC has stated several times that Caterpillar and other MD&A releases make it clear that "people at the most senior levels need to review the MD&A draft in order to truly pull the information together."⁶³

Subsequently, the SEC has taken a number of actions with respect to inadequate MD&A disclosure:

• In SEC v. Sony Corp.,⁶⁴ the SEC alleged that Sony had failed to disclose the significant adverse impact a subsidiary's operations were having on Sony during the period preceding a $2.7 billion write down due, in large part, to the subsidiary. The staff also alleged that Sony had failed to disclose the subsidiary's operations as a separate segment in an effort to dilute the adverse operating results of that business segment. In consenting to the SEC's action, Sony agreed to make its chief financial officer the principal in charge of preparing the MD&A and to retain independent accountants to examine the MD&A before it was published.
• In settling an administrative action against Coca-Cola, the district administrator of the SEC's Atlanta office said: "management's discussion and analysis requires companies to provide investors with the truth behind the numbers. Coca-Cola misled investors by failing to disclose end-of-period practices that impacted the company's likely future operating results" when they engaged in practices for the purpose of "pulling sales forward into a current period."⁶⁵
• In In re Kemper Corp.,⁶⁶ Kemper and its principal, without admitting or denying the SEC's findings, consented to an order requiring it to cease and desist from committing or causing any violation, and committing or causing any future violation of 1934 Act § 13(a) and rules thereunder. The SEC had found that Kemper had failed to adequately and accurately discuss its real estate investments, investment strategy, and real estate lending practices in its 1934 Act reports. The SEC also found that Kemper had failed to disclose adequately a relationship with a California developer and certain inherent risks, and negative trend information in areas where Kemper had significant real estate investments.
• In In re America West Airlines, Inc.,⁶⁷ AmWest, without admitting or denying the SEC's findings, consented to an order requiring it to cease and desist from committing or causing any violation, and committing or causing any future violation of 1934 Act § 13(a) and rules thereunder. In that case, AmWest had violated certain loan covenants and had difficulty in attracting sufficient passengers for increased revenues. Fuel costs had increased as a result of the Gulf War. AmWest failed to disclose these known trends and uncertainties in its 1934 Act reports.
• In In re Shared Medical Systems Corp.,⁶⁸ Shared Medical, without admitting or denying the SEC's findings, consented to an order requiring it to cease and desist from committing or causing any violation, and committing or causing any future violation of 1934 Act § 13(a) and rules thereunder. In that matter, the SEC found that Shared Medical had issued a pessimistic press release (business activity was "below expectations"), but the 1934 Act disclosure documents failed to discuss this trend, which Shared Medical "reasonably expected . . .

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