Below is an excerpt from “Full Disclosure: The Perils and Promise of Transparency,” published this spring by Cambridge University Press. By special arrangement, the authors—Archon Fung and Mary Graham of the Kennedy School of Government, and David Weil of the Boston University School of Management—have allowed Compliance Week to publish an excerpt on what makes transparency policies sustainable.
Compliance Week has no commercial relationship with the authors or Cambridge University Press, and has received no remuneration for publishing this excerpt; rather, the editors thought that Compliance Week subscribers would be interested in reading about how three researchers have assessed the financial disclosure reporting regime as compared to other disclosure systems.
We have seen this pattern repeatedly: Enron and WorldCom accounting
scandals trigger Sarbanes-Oxley reporting reforms. The chemical catastrophe
in Bhopal, India triggers toxic pollution reporting in the United States.
A rash of deaths from microbes in drinking water triggers a national water
safety disclosure. A wave of SUV-related deaths triggers a rollover rating
system.
Transparency systems are often tacked together in times of crisis. They
emerge out of high-stakes political debates driven by newly perceived needs
for public action. As a result, they often begin as half-baked compromises,
missing crucial elements and suffering from flawed design. After the crisis
passes from the headlines, the transparency system is typically neglected and
necessary improvements go unaddressed.
It is not particularly surprising that transparency systems fail, for two
reasons. First, transparency typically imposes costs on a small group of
information disclosers in the hope of generating benefits for a large and dispersed
class of information users. Since the stakes are higher for the potential
disclosers, they dominate the political processes that shape transparency systems
over time. Second, transparency conflicts with other core values – the
need to protect trade secrets and personal privacy, for example – that can tip
the balance toward keeping information confidential. Under these circumstances,
it is remarkable that some relatively robust targeted transparency
systems actually emerge from legislative deliberations and survive.
In fact, many targeted transparency systems that are flawed in the beginning
manage to improve over time and ultimately deliver the public benefits
that policymakers hoped for. This chapter investigates why some transparency
policies gain accuracy, scope, and use over time, becoming, in our
terms, sustainable, while others degenerate into costly exercises in paper
pushing or excuses for avoiding real action.
Crisis Drives Financial Disclosure Improvements
The accounting scandals at Enron, Tyco, WorldCom, and other large corporations
that rocked capital markets in 2001–2002 demonstrate that the system of
corporate financial disclosure in the United States – the nation’s most
respected and most mature targeted transparency system – is far from perfect.
Yet few would dispute that corporate financial disclosure has improved
markedly in scope, accuracy, and usefulness during the seven decades since
its adoption. Improvement has not followed a smooth and continuous path,
however. Instead, it has advanced by fits and starts, driven by the push and
pull of conflicting investor and corporate interests. Crises like the collapse of
conglomerates in the 1960s, bribes and illegal campaign contributions in the
1970s, and corporate accounting scandals have spurred episodic reforms.
A look at the checkered history of financial disclosure rules suggests how
transparency policies can become sustainable.
Improvements in financial disclosure have followed a common scenario:
Changes in markets produce new business practices, accompanied by creative
accounting methods that obscure risks to investors. Then sudden revelations
or market reversals direct public attention to the new practices,
producing a crisis of confidence. To restore public trust, government agencies,
institutional investors, and members of Congress demand more accurate
and complete information, and reformers seize the moment to make
permanent changes in the system. As a result, the scope of transparency
becomes broader, information becomes more accurate, and the number of
users increases.
One might predict that mandated disclosure requirements would be weak and would erode over time, especially when disclosers possess significant political power. Yet the history of financial disclosure is one of episodic but steady improvement. What factors explain its growing strength?
In the 1960s, for example, the scope of disclosure was broadened when
a sudden collapse in conglomerate stock prices after an unprecedented
wave of mergers created pressures for better information. Between 1962
and 1969, 22 percent of Fortune 500 companies were acquired in mergers,
during which the value of the combined companies was often inflated
by creative accounting methods. Conglomerates like Gulf and Western and
Ling-Temco-Vought produced instant earnings growth by using accounting
techniques that obscured the full cost of mergers. In addition, the profitability
of specific product lines, previously reflected in the accounts of separate
companies, became hidden after mergers.
By the end of the decade, government agencies, members of Congress,
increasingly powerful institutional investors, leading authorities on accounting,
and the media were all calling for broadened disclosure rules. The Federal Trade Commission
(FTC), charged with enforcing anti-trust laws, called
conglomerate accounting a “tool of deception” and urged the Securities and Exchange Commission (SEC) to outlaw it. Newsweeklies decried “profits
without honor.” In this crisis atmosphere, pressure from the FTC and other
regulators, institutional investors, and financial analysts proved stronger
than opposition by some large accounting firms and conglomerate interests.
Congress responded in 1968 with the Williams Act, which required
disclosure of cash tender offers that would change ownership of more than
10 percent of company stock. This law was strengthened two years later by
lowering the reporting threshold to 5 percent. In addition, the SEC required
companies to disclose product-line data.
Over time, the accuracy of disclosed information also improved, though
slowly. Congress gave the SEC authority to establish uniform accounting
standards in 1934. But for the next forty years companies continued to exercise
broad discretion in the way they reported assets and liabilities to the
public, and the SEC left accounting professionals broad discretion to interpret
government reporting rules. Until 1963, companies were not even
required to disclose the accounting methods they employed.
In 1969–1970, however, as the speculative fever of the “go-go years”
gave way to rapid decline in stock values and the Dow Jones average fell
35 percent, investors began to flee the market. To restore public trust in the
transparency system, the Accounting Principles Board, an outdated instrument
of accounting industry self-governance, was replaced by the Financial
Accounting Standards Board (FASB). The new board had broader representation
and funding, a larger professional staff, and a better system of
accountability.
New crises brought further improvements. In the late 1970s, congressional
investigations raised questions about FASB’s domination by big business.
In response, the board opened its meetings, began accepting public comment
on proposals, started publishing its schedules and technical decisions,
framed industry-specific accounting standards, began to analyze economic
consequences of proposed actions, and eliminated a requirement that a
majority of its members be chosen from the accounting profession.
Finally, users of accounting information increased as capital markets
expanded domestically and internationally. Institutional investors became
increasingly important players in public markets. Pension funds poured billions
of dollars into stock markets, and with those investments came greater
scrutiny of the practices and value of public companies. The demand for
financial information was further increased by the growth in the number
of financial advisers, media commentators, and, later, Web-based advisers
who sought to help individual investors – and themselves – make money
by providing assistance on the complexities of Wall Street. In the 1990s, increases in individual investing and the rise of online investing led the SEC
to adopt “plain English” disclosure rules, which required prospectuses to be
written in short, clear sentences using nontechnical vocabulary and featuring
graphic aids. In September 2006, the SEC announced that the agency
was adopting a dynamic real-time electronic filing and search system that
would make it easier for individual investors to analyze companies’ financial
data without expert advisers.
Viewed from a cost/benefit perspective, the history of financial disclosure
is a surprising one. The disclosure rules impose large costs on individual
firms, some of which have much to gain from concealing or misrepresenting
various aspects of their finances. At the same time, the benefits to investors
and other users of such information are very broadly diffused. Under the
circumstances, one might predict that mandated disclosure requirements
would be weak and would erode over time, especially when disclosers possess
significant political power. Yet the history of financial disclosure is
one of episodic but steady improvement. What factors explain its growing
strength?
Sustainable Policies
Transparency policies tend to evolve over time. Often, they degenerate, for
reasons we have discussed. Sometimes, however, they become more effective,
as illustrated by the positive response of financial disclosure to changing
markets, technology, public priorities, and company executives’ discovery
of loopholes.
Although it is difficult to find consistent ways to measure the dynamics
of transparency across the diverse range of policies that are the focus of this
book, we define a sustainable system as one that improves over time along
three important dimensions:
expanding scope of information relative to the scope of the problem
addressed;
increasing accuracy and quality of information; and
increasing use of information by consumers, investors, employees,
political activists, voters, residents, and/or government officials.
The transparency policies we have studied exhibit a range of improvement
along these dimensions. Some policies, like corporate financial disclosure,
mortgage lending disclosure, and school performance report cards, have
improved in all three dimensions. Other policies, like toxic chemical disclosure,
nutritional labeling, and campaign finance disclosure, have improved in some dimensions but not others. Still other policies, such as labor union
finances disclosure and workplace hazards reporting, have improved little
since they were enacted.
For reasons described in Chapter 4, policies that improve along all three
dimensions may still be ineffective. For example, the terrorist threat reporting
system has improved somewhat in accuracy since its creation in 2002.
Yet that system has so far produced only marginal changes in the targeted
behavior of individual users, although it has had a more significant impact
on first responders and other government agencies with security responsibilities.
Sustained improvement is, therefore, a necessary but not sufficient
condition for the success of transparency policies...
Humble Beginnings: Prospects For Sustainable Transparency
As we have seen, political pressures often lead to the creation of weak transparency
policies. But over time some policies do improve.Policies that evolve
so as to transform the typical imbalance between concentrated costs and
diffuse benefits can change the political dynamic in the direction of sustainability.
How does that happen?
First, transparency systems improve when some of their target organizations
champion more accurate, complete, and useful disclosure. There
are several factors that may push disclosers to press for improvements in
transparency over time. Of particular importance, competitive, political,
and social factors may convince some that improved transparency will give
them advantages over other disclosers. Disclosers’ divergent interests in providing
full rather than partial disclosure can create a dynamic that fractures
the political coalition opposing transparency.
Second, dispersed users of information may form political coalitions that
press effectively for better disclosure. New crises often coalesce users’ interests
in a national debate and force reexamination and improvement of disclosure.
Permanent user coalitions, represented by consumer or public health
groups, for example, can exert continuing pressure for improvement to gain
perceived economic or political benefits. Such groups are often formed or
strengthened in the wake of crises. Finally, because of their personal stake in
the issue, entrepreneurial politicians may choose to continue to act on the
behalf of information users in hopes of achieving political benefits.
HUMBLE BEGINNINGS
The graphic below is from “Full Disclosure: The Perils and Promise of Transparency”:
“Full Disclosure: The Perils and Promise of Transparency” (Cambridge University Press)
In the absence of either divergent interests among disclosers or the emergence of organized
user groups, transparency policies tend to remain trapped
in James Q. Wilson’s political dead end of dispersed benefits and concentrated
costs and have poor prospects for improvement over time. If those
conditions remain unchanged, policies will be underutilized, implemented
weakly, and subject to gradual erosion. But even these targeted transparency
policies can improve – and therefore become sustainable – when conditions
change in ways that undermine the common interests that concentrated
costs impose on disclosers or create mechanisms that allow interest groups
to integrate the diffused benefits to users.
One way of depicting the sustainability prospects of specific targeted
transparency systems is shown in Figure 5.1 [see box above, right]. The axes in this figure represent
two possible sources of political support: (1) the extent to which
disclosers reap benefits from the transparency policy (the vertical axis) and
(2) the extent to which user groups champion the policy (the horizontal axis). Figure 5.1 plots the fifteen U.S. targeted transparency policies we have
studied along both dimensions.
The two axes divide the space into four regions. Policies in the upperright
region (high political sustainability) enjoy political support from two
sources: user interest groups and subsets of disclosers who benefit fromdisclosure.
Because diverse coalitions that cut across discloser and user boundaries
frequently support these policies, they will, as a general rule, reliably
improve over time by expanding their scope, enhancing the quality of information
they provide, and enlarging the base of users.
Federal requirements for nutritional labeling of packaged foods fall into
this region because some food manufacturers have come to support the
disclosure policy, both to avoid having to disclose undermultiple state standards
and also because uniformlabeling opens new marketing channels for
healthier foods. These motivations have created common ground between
some food producers and public health and consumer advocates. Similarly,
under the mortgage lending disclosure system, some urban banks have become quite adept at serving high-risk borrowers and now are recognized
as leaders in the fair-lending arena by regulators and the general
public. These banks not only accept mortgage lending disclosure as part of
their regulatory environment but have occasionally offered public support
for the policy.
The lower-right-hand region (moderate political sustainability) is characterized
by politically organized user groups and a near absence of disclosers
who benefit from transparency. In this region, interest groups of users and
disclosers oppose one another politically. The result is usually a fitful pattern
in which disclosure requirements advance and retreat according to momentary
political advantages occasioned by issue visibility, friendly or hostile
officials, and crises of legitimacy.
Federal campaign contribution disclosure rules exemplify the policies in
this quadrant. Fewdisclosers (predominately incumbents in Congress) have
any incentive to press for improvement in the system absent political crises.
Instead they share a strong common interest in limiting disclosure. But a
wide array of groups representing particular political interests (from the
National Rifle Association, right-to-life groups, and the Christian Coalition
on the right to the AFL-CIO, Handgun Control Inc., and the Sierra Club
on the left) have an interest in improving disclosure. The resulting conflict
has led to infrequent but occasionally significant shifts in disclosure rules,
usually triggered by some new scandal.
The upper-left region (low political sustainability) mirrors the lowerright.
Transparency policies here benefit some of those compelled to disclose
information, but organized groups of users who support the policies are
lacking. Policies with these underlying political dynamics are unlikely to be
sustainable.
As we have discussed, a potential disclosure policy for hospital mistakes
emerged as a viable proposal briefly in this quadrant after release of an
Institute of Medicine report in 1999 documenting the significant extent of
medical errors in the United States.
Major purchasers of medical services, including companies like General
Electric and General Motors, had strong incentives to reduce errors.
They could have become advocates for a federal and state medical mistakes
disclosure system. However, within months, conflicting interests brought
about a political stalemate. The apparent consensus for national action
splintered into conflicts among the groups representing disclosers (doctors
and hospitals), which generally opposed disclosure, and amore diverse
and fractured group representing users (public health advocates, state interests,
insurers, employers, consumers, and trial lawyers). When the debate got down to specifics, the American Medical Association and the American
Hospital Association opposed the kind of hospital-by-hospital disclosure
of serious errors that would be meaningful to consumers. They feared liability,
embarrassment, and public misunderstanding, and expressed doubts
that any disclosure systemcould adjust adequately for differences in patient
populations. Large employers, potentially powerful advocates of a disclosure
requirement, instead chose to create their own advocacy groups for changing
hospital practices. The temporary alliance of users was not cohesive
enough to overcome opposition from potential disclosers.
As this story illustrates, transparency policies in this quadrant will usually
be unable to develop in a sustained fashion. In part, that is because disclosers
who benefit from transparency policies generally do so only after they have
accepted disclosure as part of their operating environment and developed
new skills and strategies in response. Significant incentives for disclosers to
support transparency do not materialize until a viable system is in place or
seems inevitable. The lower-left quadrant (lowest political sustainability)
is where transparency policies have the poorest prospects, since they are
supported neither by organized users nor by factions of disclosers. Though
policies in this region may be created by effective political entrepreneurs
following a crisis or scandal, the underlying politics will make it difficult
for them to improve over time. Absent changes by either users or disclosers,
these policies will be underutilized, implemented weakly, and subject to
gradual erosion...
Reprinted with permission. Copyright Cambridge University Press. For additional information, visit The Transparency Policy Project
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