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Sunday, July 08, 2001













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Threats to information integrity

Laura S. Unger

A RECENT example of a case involving a stock-recommendation Web site came a few weeks ago as part of our fifth Internet fraud sweep.

In that case, a former roofer-turned-online-stock-analyst claimed he had access to a proprietary computer trading system, had over 14 years of investing experience, and enjoyed an 85 per cent success rate on trades he had previously made.

The SEC's action against this individual alleges that, in reality, he had limited personal securities trading experience, never received any securities training, never worked for an investment firm, and used a publicly-available software program which could be readily accessed over the Internet.

I have asked the Enforcement Division to be especially watchful for online stock-picking sites, particularly those employing the sort of flamboyant advertising that could signal the use of inflated track records, misleading disclaimers, or other improper techniques calculated to bait investors.

Integrity of financial information

The third area involves the integrity of financial information. Current market conditions may increase the pressure on companies to meet past or projected earnings levels. As a result, management may be tempted to engage in ``not so'' generally accepted accounting principles (NSGAAP). We have already seen a number of NSGAAP trends.

Quality of information: The first is a decreasing ``quality of earnings'' reported by companies. A lack of quality of earnings refers to distortions in financial statements resulting from undisclosed changes in underlying accounting assumptions. The undisclosed changes are being used to improperly inflate operating results. For instance, management may change an accounting estimate (such as the life of an asset), which will have the effect of increasing earnings. If that change is not disclosed, investors may wrongly assume that the earnings increase reflects improved performance by the company instead of a change in an accounting estimate. Using this type of smoke-and-mirrors to mislead investors ultimately will harm a company, as well as investors' confidence in our financial reporting system as a whole.

Pro forma information: A second troubling trend on which we are keeping an eye is the increasing use of pro forma information. Pro forma information is a tool companies have invented to disseminate an idealised version of their performance. It may exclude any cost or expense the company wants, yet it is presented in a form that suggests reliability and soundness. And that is the problem with pro forma financials. You do not really know what you are getting, except that it is what the company wants you to know. In fact, pro forma numbers are not audited and may not even be reconcilable with the financial statements companies have filed with the Commission.

Holes in success: Finally, one more practice for which the staff will be on the lookout. Companies are announcing that they will not meet their year-end earnings targets, apparently because throughout the year they had been, in effect, reaching ahead into next quarter's sales to meet their quarterly targets. Using techniques such as ``channel stuffing'' or offering deep discounts, companies motivate their customers to buy sooner rather than later. Unfortunately, while that may create the appearance of another successful quarter, it guarantees that the company is starting in a hole next quarter. When the end of the year comes, and the auditors discover what has been going on, the result is a shortfall for the fourth quarter and/or the year, and a shock to misled investors.

Integrity of fund advertising

The final area involves the integrity of certain information included in mutual fund advertising. Twenty years ago, only 5.7 per cent of Americans owned mutual funds. Today, some 88 million shareholders, representing 49 per cent of US households, hold mutual funds. These investors are entitled to rely on the integrity of the numbers included in the fund's advertising.

This is particularly important given current market conditions where performance information may change significantly from day to day. The Commission has seen instances where fund advertisements are in technical compliance with Securities Act requirements by disclosing the results of a fund's most recent calendar quarter, but where even more recent, but poorer, performance is not disclosed.

The staff is working on an interpretive bulletin to emphasise that technical compliance with Rule 482, the advertising rule, is not a safe harbour from the antifraud provisions. The bulletin will also point out that additional facts necessary to provide an investor with an accurate picture of the fund's performance may be necessary to avoid noncompliance with the antifraud rules.

The Commission always strives to maintain the integrity of financial and market information. Today I have shared with you how market conditions may impact where we devote resources to most effectively meet this challenge.

(This is the concluding part of the remarks made by Acting Chairman, US Securities and Exchange Commission, Ms Laura S. Unger, on `Protecting the Integrity of Financial Information in Today's Marketplace Remarks')

(Source: www.sec.gov)


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