In the Matter of CATERPILLAR INC.

Mar. 31, 1992

Release No. 34-30532;

Release No. AAER-363

March 31, 1992

Administrative Proceeding File No. 3-7692

Respondent.

ORDER INSTITUTING PROCEEDINGS PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934 AND OPINION AND ORDER OF THE COMMISSION

The Commission deems it appropriate and in the public interest that public administrative proceedings be instituted pursuant to Section 21C of the Securities Exchange Act of 1934 (Exchange Act) to determine whether Caterpillar Inc. (Caterpillar) has failed to comply with Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 promulgated under the Exchange Act in connection with reports on Form 10-K and Form 10-Q filed with the Commission. Accordingly, such proceedings are hereby instituted.

In anticipation of the institution of these administrative proceedings, Caterpillar has submitted an Offer of Settlement for the purpose of disposing of the issues raised in these proceedings. Under the terms of its Offer of Settlement, Caterpillar, solely for the purpose of these proceedings and any other proceeding brought by or on behalf of the Commission or to which the Commission is a party, without any hearing (such hearing having been waived by Caterpillar), without admitting or denying any of the following, consents to the issuance by the Commission of the Opinion and Order herein.

The Commission has determined that it is appropriate and in the public interest to accept Caterpillars Offer of Settlement and, accordingly, issues this Order Instituting Proceedings pursuant to Section 21C(a) of the Exchange Act and Opinion and Order of the Commission (Opinion and Order).

On the basis of this Order and the Respondents Offer of Settlement, the Commission finds the following:

I. FACTS

Caterpillar is incorporated in Delaware and headquartered in Peoria, Illinois, and carries on operations in numerous locations in the United States and around the world. Caterpillar manufactures and markets engines and equipment for earthmoving, construction, and materials handling. Its securities are registered with the Commission pursuant to Section 12(b) of the Exchange Act and traded principally on the New York Stock Exchange. Caterpillar has not been the subject of any prior actions brought by or on behalf of the Commission.

B. Background

This matter involves Caterpillars failure in its Form 10-K for the year ended December 31, 1989, and its Form 10-Q for the first quarter of 1990 to comply with Item 303 of Regulation S-K, Managements Discussion and Analysis of Financial Conditions and Results of Operations (MD&A). 17 C.F.R. §229.303. Specifically, the MD&A rules required Caterpillar to disclose information about the 1989 earnings of Caterpillar Brasil, S.A. (CBSA), its wholly owned Brazilian subsidiary, and uncertainties about CBSAs 1990 earnings.

1.CBSAs 1989 Results

Caterpillar has had a Brazilian subsidiary since the 1950s. Nineteen eighty-nine was an exceptionally profitable year for CBSA. That year, without accounting for the effect of integration, CBSA accounted for some 23 percent of Caterpillars net profits of $497 million, although its revenues represented only 5 percent of the parent companys revenues. In 1989, CBSAs operating profit was in line with prior years but a number of nonoperating items contributed to greater than usual overall profit. Those items included currency translation gains, export subsidies, interest income, and Brazilian tax loss carryforwards. Many of these gains were caused by the hyperinflation in Brazil in 1989 and the fact that the dollar-cruzado exchange rate lagged behind inflation.

CBSAs financial results were presented on a consolidated basis with the remainder of Caterpillars operations. Thus, the impact of CBSAs operations on Caterpillars overall results was not apparent from the face of Caterpillars financial statements or the notes thereto. ¹

2.Managements View of CBSA

Caterpillar was and is a highly integrated organization. Its various divisions and subsidiaries were, and are, very interdependent. As a consequence, Caterpillar typically viewed and managed the organization on a consolidated basis. While unadjusted profit numbers for subsidiaries and divisions were available to management, they were not viewed by management as reliable indicators of that subsidiarys or divisions contribution to the consolidated enterprise. The various divisions and subsidiaries were not viewed as profit centers but rather as cost centers. Profit and results of operations were managed on a consolidated basis. Because of that management perspective, the profit contribution of each subsidiary or division has not historically been used as a basis for personnel, product sourcing or disclosure decisions.

In January of 1990, accounting department personnel began to separately analyze CBSAs 1989 results compared with its 1990 forecast. In the process of that analysis, the various components of CBSAs results were aggregated. The result of that analysis was conveyed to top management and then to the board. By the middle of February 1990--i.e., at least two weeks before Caterpillar filed its 1989 Form 10-K--Caterpillars top management had recognized that, to adequately understand Caterpillars 1990 forecast, it was necessary to understand CBSAs 1990 forecast. Management also recognized that CBSAs future performance was exceptionally difficult to predict--particularly in light of anticipated sweeping economic reforms to be instituted by a new administration in Brazil--and that there were substantial uncertainties whether CBSA would repeat its exceptional 1989 earnings in 1990.

The board of directors was told in February 1990 that Brazil was volatile and that the impact of Brazil is so significant to reduced 1990 projected results, [management] felt it was necessary to explain it [to the directors] in some detail.

Minutes of the February 1990 board meeting include the following about Brazil:

[Management] commented on results of operations in Brazil because of the significant [negative] impact they will have on overall results for 1990.

Beginning in February 1990 and continuing through the rest of the year management departed from its usual practice of viewing the company as a whole and provided projections to the board of directors which separated out the impact of Brazil.

During the interim between the February board meeting and the next board meeting, held on April 11, 1990, a new administration took office in Brazil. Fernando Collor de Mello, who had been elected president of Brazil in December 1989, was inaugurated on March 15, 1990, putting an end, as one Brazilian business journal put it, to weeks of intense speculation as to what economic measures he will actually announce. Collor immediately instituted sweeping economic and monetary changes in an effort to bring Brazils hyperinflation under control. Most observers had expected Collor to take drastic action to deal with Brazils economic problems; the specifics of his program, however, came as a surprise. The measures included reducing the amount of currency in circulation by approximately 80 percent and adopting a plan to devalue the Brazilian currency. Brazil was immediately thrown into economic crisis: even large companies were unable to meet their payrolls or pay normal trade payables. But CBSA continued to operate, meet its payroll and pay its obligations.

When the Caterpillar board met on April 11, management gave presentations in which it discussed, among other things, the likely negative effects the Collor plan would have on CBSAs sales and profits:

At our last meeting, we reviewed the impact that [CBSA] is expected to have on our 1990 results.... Brazil is volatile and difficult to predict. Their recently announced economic reforms have made the situation even more uncertain.

The impact of these reforms is not at all clear, so we have made no attempt to change the forecast. However, its difficult to see any short-term positives, so there is considerable risk that Brazils new economic plan could bring additional pressure on our 1990 profit.

[Management] ... also noted ... that the profit in Brazil will be substantially lower than in 1989.

Throughout April and May of 1990 Caterpillar continued to monitor the events in Brazil and their effects on CBSA, including the consequences of the Collor plan on Caterpillar. After the initial cash flow problems resulting from the Collor plan were resolved, sales dramatically increased, alternative methods of financing sales were devised, and the currency unexpectedly temporarily appreciated. The effects of these changes on CBSA were not immediately clear. However, after a review of April and May results, the company concluded the new economic policies would cause CBSA to suffer significant losses in 1990. It also concluded that those losses would not likely be balanced by gains in other parts of the world and consolidated results would be lower than originally anticipated.

At 8:00 a.m. on Monday, June 25, 1990, before the beginning of trading, the company voluntarily issued a press release explaining that the anticipated results for 1990 would be substantially lower than previously projected. The press release noted that more than half of the decrease in forecasted 1990 profit is due to a dramatic decline in results for [CBSA]. At 10:20 a.m. the stock opened at 61-3/8, down 2-1/8 points from the previous Fridays closing price. During a telephone conference with stock analysts beginning at 1:00 p.m. on Monday afternoon, with the stock trading at 59-1/4, Caterpillar revealed CBSAs importance to the companys 1989 earnings and indicated that the parent companys disappointing second quarter results were largely a product of circumstances in Brazil. On Tuesday, June 26, the day after the conference call, Caterpillar opened at 51-3/4, down 9-5/8 points from Mondays opening price.

3.Preparation and Review of Caterpillars Periodic Reports

The MD&A sections of the 1989 10-K and 10-Q for the first quarter of 1990 were drafted by employees in Caterpillars accounting department. ² Prior to the issuance of those reports, the language of the MD&A was reviewed by the Controller, Financial Vice President, Treasurer, and the companys legal, economic, and public affairs departments. After that, the language of the MD&A was reviewed by the top officers of the Company.

The board of directors reviewed the final draft of the 1989 Form 10-K, including the MD&A, at the February 1990 board meeting. At that time, the board, including top management who were members of the board, received a written opinion of the companys independent auditor that the financial statements complied with the rules and regulations of the Commission, ³ and also an opinion of the companys General Counsel that the Form 10-K complied with all the rules and regulations of the Commission.

In rendering their opinion on the financial statements contained in Caterpillars 1989 Form 10-K, the auditor had reviewed the disclosure set forth in the MD&A for inconsistencies with the financial statements but did not opine on the MD&A. The General Counsel was aware of managements concerns regarding Brazil, however, he disregarded managements statements about Brazil when reviewing and opining upon the MD&A disclosure regarding Brazil.

4.Caterpillars Disclosure Regarding CBSA

Neither the 1989 Form 10-K nor the first quarter 1990 Form 10-Q indicated the extent to which CBSA had affected Caterpillars bottom line in 1989, nor did they indicate that a decline in CBSAs future results could have a material adverse effect on Caterpillars bottom line in 1990. ⁴ Because CBSA was not a separately reported business segment, Caterpillars consolidated financial statements and accompanying notes for 1989 were not required to and did not disclose the disproportionate effect of CBSAs profits on the parent companys profits. ⁵

Nothing in the MD&A section of the 1989 Form 10-K suggested the disproportionate impact of CBSAs profits on Caterpillars 1989 overall profitability. Similarly, the 1989 Form 10-K and the Form 10-Q for the first quarter of 1990 did not adequately mention managements uncertainty about CBSAs 1990 performance.

II. APPLICABLE LAW

Section 13(a) of the Exchange Act requires issuers of registered securities to file periodic and other reports containing such information as the Commission by rule prescribes. Section 13(a) and Rules 13a-1 and 13a-13 thereunder require the filing of annual and quarterly reports that comply with the Commissions rules and regulations. The Commissions requirements for annual and quarterly reports are set forth in Forms 10-K and 10-Q, respectively, which require, among other things, an MD&A section.

A.Managements Discussion and Analysis as Required by Item 303 of Regulation S-K

For reports on Form 10-K, Item 303(a) requires the registrant to discuss the liquidity, capital resources, and results of operations of the registrant and to provide such other information that the registrant believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations. Item 303(a) also specifically requires

  specifically requ

[w]here in the registrants judgment a discussion of segment information or of other subdivisions of the registrants business would be appropriate to an understanding of such business, the discussion shall focus on each relevant, reportable segment or other subdivision of the business and on the registrant as a whole.

In discussing results of operations the registrant is to [d]escribe any unusual or infrequent events or transactions ... that materially affected the amount of reported income from continuing operations and in each case, indicate the extent to which income was so affected. Item 303(a)(3)(i). Furthermore, the registrant is to describe other significant components of revenues or expenses that should be described to allow a reader of the companys financial statements to understand the registrants results of operations. Id.

As a separate component of the discussion of results of operations, the registrant is to discuss any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. Item 303(a)(3)(ii). The discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results. Instruction 3 to Item 303(a). Registrants are instructed to discuss both new matters which will have an impact on future results, and matters which have previously had an impact on reported operations but which are not expected to have an impact on future operations. Id.

For interim reports such as a Form 10-Q, Item 303(b) requires a discussion and analysis of the results of operations to enable the reader to assess material changes in financial condition and results of operations that have occurred since the end of the preceding fiscal year. Item 303(b). Discussions of material changes in results of operations must identify any significant elements of the registrants income or loss from continuing operations which do not arise from or are not necessarily representative of the registrants business. Instruction 4 to Item 303(b).

B. The MD&A Release

In 1989, the Commission determined that additional interpretive guidance was needed regarding a number of areas of MD&A disclosure and published an interpretive release. Release Nos. 33-6835, 34-26831, IC-16961, FR-36 (May 18, 1989) (hereafter MD&A Release). Drawing on earlier releases, the MD&A Release noted the underlying rationale for requiring MD&A disclosure and managements core responsibility in providing that disclosure: The MD&A is needed because, without such a narrative explanation, a companys financial statements and accompanying footnotes

may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance. MD&A is intended to give the investor an opportunity to look at the company through the eyes of management by providing both a short and long-term analysis of the business of the company.

MD&A Release III.A (quoting Securities Act Release No. 6771 (April 24, 1987)). It is managements responsibility in the MD&A

to identify and address those key variables and other qualitative and quantitative factors which are peculiar to and necessary for an understanding and evaluation of the company.

MD&A Release III.A (quoting Securities Act Release No. 6349 (September 28, 1981)). The MD&A Release further notes,

The MD&A requirements are intentionally flexible and general. Because no two registrants are identical, good MD&A disclosure for one registrant is not necessarily good ... for another. The same is true for MD&A disclosure of the same registrant in different years.

MD&A Release IV.

As to prospective information, the MD&A Release sets forth the following test for determining when disclosure is required:

Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:

(1)Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.

(2)If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition.

Disclosure is then required unless management determines that a material effect on the registrants financial condition or results of operations is not reasonably likely to occur.

MD&A Release III.B. Where the test for disclosure is met, MD&A disclosure of the effects [of the uncertainty,] quantified to the extent reasonably practicable, [is] required. ⁷ Id.

C. Analysis

1. Overview

Regulation S-K requires disclosure of information necessary to understand the registrants financial statements. Item 303(a); MD&A Release III.A. Caterpillars failure to include required information about CBSA in the MD&A left investors with an incomplete picture of Caterpillars financial condition and results of operations and denied them the opportunity to see the company through the eyes of management. MD&A Release IV.

Specifically, by failing (i) in its Annual Report on Form 10-K for the year ended December 31, 1989 to provide an adequate discussion and analysis of the impact of CBSA on its 1989 results of operations as contained in its financial statements, and (ii) to adequately disclose in its 1989 Form 10-K and in its Quarterly Report on Form 10-Q for the first quarter of 1990 known uncertainties reasonably likely to have a material effect on Caterpillars future results of operations, due to CBSAs questionable ability to repeat its 1989 performance, Caterpillar violated Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder. ⁸

2. Inadequate MD&A Discussion of Caterpillars Results of Operations for 1989

Under Generally Accepted Accounting Principles, Caterpillar was not required to prepare its consolidated financial statements showing CBSA as either an industry segment or a foreign operation. ⁹ Therefore, in Caterpillars Annual Report on Form 10-K for the year ended December 31, 1989, CBSAs results were consolidated with the results for Caterpillar as a whole. Since separate information about CBSA was neither required nor provided in Caterpillars financial statements or the notes thereto, there was little, if any, information in the financial statements or accompanying notes that would inform a reader as to the importance of CBSAs earnings to Caterpillars overall results of operations. ¹⁰ Thus, absent appropriate MD&A disclosure, Caterpillars 1989 Form 10-K did not reflect the extent to which the companys 1989 earnings were derived from CBSA.

Given the magnitude of CBSAs contribution to Caterpillars overall earnings, disclosure of the extent of that contribution was required under the MD&A provisions of Regulation S-K since CBSAs earnings materially affected Caterpillars reported income from continuing operations. See, Item 303(a)(3)(i). Furthermore, the MD&A should have discussed various factors which contributed to CBSAs earnings including currency translation gains, export subsidies, interest income, and Brazilian tax loss carryforwards since such items were significant components of CBSAs revenues that should have been identified and addressed in order for a reader of the companys financial statements to understand Caterpillars results of operations. Id.

3. Inadequate Discussion of the Uncertainties Affecting CBSAs Prospects for 1990 and Their Possible Material Impact on Caterpillars Overall Results

By the time of the February 14, 1990, board meeting--two weeks before Caterpillars Form 10-K for 1989 was filed--management could not conclude that lower earnings from CBSA were not reasonably likely to occur, nor could management conclude that a material effect on Caterpillars results of operations was not reasonably likely to occur due to CBSAs lower earnings. It was at that meeting that management told the companys directors the impact of Brazil is so significant to reduced 1990 projected results, ... it was necessary to explain it [to the directors] in some detail.

By the end of the first quarter of 1990, before Caterpillars Form 10-Q for the first quarter of 1990 was filed, management had concluded that the profit in Brazil will be substantially lower than in 1989. Therefore, it became even more apparent that management could not conclude that lower earnings from CBSA were not reasonably likely to occur, nor could management conclude that a material effect on Caterpillars results of operations was not reasonably likely to occur due to CBSAs lower earnings. Thus, discussion of the uncertainties surrounding CBSAs earnings and possible material future impact on Caterpillars overall financial condition and results of operations was required.

4. Conclusion

Caterpillars MD&A disclosure was deficient in two respects. First, Caterpillars Annual Report on Form 10-K for the year ended December 31, 1989 should have discussed the impact of CBSA on Caterpillars overall results of operations. Second, both the Annual Report on Form 10-K for 1989 and the Quarterly Report on Form 10-Q for the first quarter of 1990 should have discussed the future uncertainties regarding CBSAs operations, the possible risk of Caterpillar having materially lower earnings as a result of that risk and, to the extent reasonably practicable, quantified the impact of such risk. MD&A Release III.B. The MD&A disclosure in the 1989 Form 10-K and the Form 10-Q for the first quarter of 1990 failed to adequately disclose the risk of lower earnings and did not attempt to quantify the impact of lower earnings from CBSA on Caterpillar.

III. FINDINGS

Based on the above, the Commission finds that:

1.Caterpillars Form 10-K for the year ended December 31, 1989, violated Section 13(a) of the Exchange Act and Rule 13a-1 thereunder.

2.Caterpillars Form 10-Q for the first quarter of 1990 violated Section 13(a) of the Exchange Act and Rule 13a-13 thereunder.

IV. OFFER OF SETTLEMENT

Caterpillar has submitted an Offer of Settlement, in which, solely for the purpose of these proceedings, or any other proceeding brought by or on behalf of the Commission, or in which the Commission may be a party, without any hearing and without admitting or denying any of the above, Caterpillar consents to the issuance of this Opinion and Order.

In addition, Caterpillar voluntarily implemented procedures to comply with the MD&A requirements, and has agreed to have the Opinion and Order specifically require that Caterpillar implement and maintain procedures designed to ensure compliance with the MD&A requirements.

V. ORDER

In view of the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer of Settlement of Caterpillar and, accordingly,

IT IS HEREBY ORDERED that:

pursuant to Section 21C of the Exchange Act, that Caterpillar permanently cease and desist from committing or causing any violation, and committing or causing any future violation, of Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 promulgated under the Exchange Act and that Caterpillar implement and maintain procedures designed to ensure compliance with Item 303 of Regulation S-K, Managements Discussion and Analysis of Financial Conditions and Results of Operations (17 C.F.R. §229.303).

By the Commission.

Jonathan G. Katz

Secretary

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