From the War on Terror to the War on Wall Street, due process violations by government agencies are proliferating like nuclear weapons. Facilitated by widespread ignorance among Americans — general public, financial professions, and the federal judiciary — the pattern of abuse threatens not only American markets but the very foundations of American life.
In April 2009, the staff of the Securities and Exchange Commission took another bite out of due process by issuing without public notice or input a “Staff Accounting Bulletin” or “SAB” for the first time since December of 2007.
I stumbled on this unhappy fact after reading, somewhat in disbelief, the following text from Footnote 17 to HSBC’s March 31, 2008 Quarterly Financial Statements:
In November 2007, the SEC issued Staff Accounting Bulletin 109. . . which supersedes SAB 105 . . . SAB 109 revises the views expressed by the staff in SAB 105 to specify that the expected net future cash flows related to the associated servicing of a loan should be included in the measurement of written loan commitments that are accounted for at fair value through earnings. SAB 109 is effective for derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. The adoption of SAB 109 did not have a material impact on the HUSI consolidated financial statements.
Why disbelief? HSBC’s language assumes that SAB 109 is legally binding when, in fact, it is not. SAB 109 was written by SEC staff (not the Commission who have legal rulemaking power) without any attempt at complying with 5th Amendment due process or Administrative Procedure Act notice and comment requirements. The SEC staff openly admit that their SABs are not law with this coy disclaimer:
The statements in staff accounting bulletins are not rules or interpretations of the Commission, nor are they published as bearing the Commission’s official approval. They represent interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws.
Yet, the staff nevertheless proceed to unilaterally “amend” the Code of Federal Regulations to reflect the addition of SABs with language posted at the top of the SABs like this:
Accordingly, Part 211 of Title 17 of the Code of Federal Regulations is amended by adding Staff Accounting Bulletin No. 109 to the table found in Subpart B.
Registrants are thus confronted with stealth legislation written by SEC staff on their own initiative. The SABs have the aura of legitimacy without real authority. The SEC and its staff should know better, but registrants and audit firms should do their part by pushing back against this abuse of due process.
HSBC is an American company, incorporated in Maryland and headquartered in New York. Its officers — especially its attorneys — should know not to treat a mere SAB as if it were law. SABs are not “adopted” and have no “effective dates”. They are staff opinions, nothing more.
The SEC obviously knows this but they also know that Americans have forgotten the meaning of due process and are willing, in the interests of “protecting investors,” to wink at the SEC’s illegal rule-making behavior. It knows that corporate officers — cowed by congressional anti-fraud theatrics — are reluctant to take a stand against such abuse on the part of the sacred-cow SEC.
Enter SEC Commissioner Paul S. Atkins’ Feb 8, 2008 remarks to the Practising Law Institute. Atkins effectively dismantled SAB No. 99 with which the SEC staff attempted to define what is perhaps the most important term in the securities law lexicon: materiality.
Here are excerpts from Atkins’ speech, last paragraph copied first:
The process of issuing Staff Accounting Bulletins is organized to avoid “complications” with the Administrative Procedure Act. Is that how a full-disclosure agency should operate? The Commission never voted on the views espoused within any SAB, so it does not and cannot represent the views of the SEC. Worse yet, SEC staff developed SAB 99 without public input. Substantive policy ought not to be made by the staff in private meetings, and ought not to be made based solely on the wisdom and experiences of SEC staff. . .
. . . One of the most glaring examples of lack of predictability is determining what constitutes materiality. The crux of our federal disclosure system is that all material information must be disclosed — with an emphasis on material. Yet the age-old question is: What does it mean to be “material”?
Issuers, investors, and regulators have struggled with applying the materiality test since the enactment of the securities laws. Materiality is an objective test: the Supreme Court has said that something is material if “there is a substantial likelihood that a reasonable shareholder would consider it … as having significantly altered the ‘total mix’ of information made available.”
It is not enough that some investors may view a fact as important; rather, it must be important to the reasonable investor. In coming to this standard, the Supreme Court in 1976 in TSC Industries v. Northway, specifically overturned a test applied by the Second Circuit — that material facts include all facts that a reasonable shareholder might consider important. Can you imagine what prospectuses and proxy statements would look like if that standard had prevailed? TSC Industries is an example of the Supreme Court showing judicial restraint by not expanding the securities laws. Does this sound familiar? We have seen similar restraint in recent Supreme Court decisions this year and last in the area of securities law.
In TSC Industries, the Supreme Court clearly understood the problem of materiality. In the unanimous opinion written by Justice Thurgood Marshall, the Court observed that “[s]ome information is of such dubious significance that insistence on its disclosure may accomplish more harm than good.” The potential liability for a fraud violation can be great and, so Justice Marshall explained, “If the standard of materiality is unnecessarily low, not only may the corporation and its management be subjected to liability for insignificant omissions or misstatements, but also management’s fear of exposing itself to substantial liability may cause it simply to bury the shareholders in an avalanche of trivial information — a result that is hardly conducive to informed decisionmaking.”
The SEC allowed the waters to be muddied on the issue of materiality in 1999 with Staff Accounting Bulletin 99. Anyone who has tried to apply SAB 99 is left with little certainty. Regardless of how quantitatively tiny a disclosure might be, the answer to any materiality question seems to be “it depends.” (Of course, too often it is said to be clear later in 20/20 hindsight.) And yet that bulletin has been cited by courts, SEC staff, and lawyers as authority for materiality. As a result of SAB 99, issuers feel compelled to inundate shareholders with “an avalanche of trivial information,” which was precisely the fear of the Supreme Court almost 32 years ago. Often, when you read a 10-K, it is as if you are reading Greek. Maybe we do need Hermes, after all, to interpret the content!
Would it surprise you to learn that SAB 99 does not necessarily represent the views of the Commission? As the title implies, it is a Staff Accounting Bulletin. . . .
Little wonder that two days ago the Russian State newspaper, Pravda, published a commentary — “We the Sheeple” — ridiculing the people of the United States for so easily abandoning our Constitution and free markets in favor of a Russian-style Marxism.
It must be said, that like the breaking of a great dam, the American decent [sic] into Marxism is happening with breath taking speed, against the back drop of a passive, hapless sheeple, excuse me dear reader, I meant people.
The Russians should know. Meanwhile, Americans should demand that the federal agency charged with protecting investors and rooting out financial fraud cease and desist from the regulatory fraud of legislation without representation. Of all of the SEC’s regulatory failures (and there are many) this one may be the worst.