By questioning SunTrust's accounting practices on the eve of its merger with Crestar, the Securities and Exchange Commission is sending a strong message to banks: Aggressive "earnings management" will not be tolerated.
SunTrust Banks Inc. of Atlanta said that an SEC review of materials related to its pending acquisition of Crestar Financial Corp. of Richmond, Va., would delay a scheduled Nov. 19 shareholder vote on the deal.
The inquiry is not expected to quash the $7.5 billion takeover, which is still set to close this year. But SunTrust's disclosure on Tuesday sparked concern that the SEC is setting a new standard of scrutiny for banking companies' earnings reports.
Specifically, the SEC has raised questions about the conservative SunTrust's high levels of loan-loss reserves. The regulator said that by aggressively reserving for future loan losses, banks can make it difficult for investors to understand their true profit picture.
Christopher W. Ullman, a spokesman for the SEC, would not comment on SunTrust. But he said the agency is generally trying to "send a message that efforts to push the envelope in this gray area of what is acceptable earnings management" will not be tolerated.
"We believe a cultural change needs to take place," Mr. Ullman said.
Indeed, SEC chairman Arthur Levitt has recently called on his staff to increase their scrutiny of earnings management practices at all public companies. Mr. Levitt has said he fears many companies are manipulating earnings through several inappropriate strategies, including inflating loan-loss reserves to bolster future profit reports.
In a recent speech Mr. Levitt said the financial community is fostering a "climate in which earnings management is on the rise and the quality of financial reporting is on the decline."
The SEC's concerns about SunTrust's reserves surprised many in the industry, because the $60.7 billion-asset company is considered a stalwart of conservative banking. On Sept. 30 its loan-loss reserves amounted to 1.79% of its loan portfolio. That is in line with the industry average of 1.82% at the end of June-the most recent date for which data is available.
"It's very curious, it's not common at all," said Bear Stearns analyst Sean J. Ryan of the SEC's scrutiny of SunTrust's reserves.
But just as low levels of reserves are a cause for regulatory concern, high levels of reserves can also be a problem, according to the SEC. An abundance of reserves can help a bank inappropriately manipulate its earnings when core profits are not enough to meet Wall Street's expectations.
Moshe Orenbuch, an analyst with Sanford C. Bernstein & Co., said SunTrust has consistently drawn upon its loan-loss reserves when profits have not measured up to expectations. He said that even though credit quality is improving at the company, SunTrust is continuing to add to is reserves.
Sally Pope Davis, an analyst with Goldman Sachs, said she sees SunTrust's hefty reserves as a plus. But, she said, the SEC's point is well taken.
"I think the SEC is saying 'We just want earnings to reflect fair representation of the earnings environment.'"
In addition to concerns about loan-loss reserves, Mr. Levitt has laid out four other "popular accounting tactics" that will be scrutinized more closely: inflated restructuring charges, "creative" acquisition accounting, immaterial misapplications of accounting principles, and premature recognition of revenue.
Donna J. Fisher, director of tax and accounting at the American Bankers Association, said the SEC's actions are unjustified.
"This is out of the blue. I have no idea where the SEC is coming from," she said. "There is no problem. Banks are following the accounting rules, the regulators are coming and looking at their reserves and reviewing the adequacy of them. Auditors are signing off on them," she said.
"If the SEC wants to change the standards, then they need to propose a change in the accounting rules."