Quality Financial Reporting for the General Counsel

PART THREE IN A SERIES

In the last two columns, we introduced the paradigm-changing strategy of Quality Financial Reporting that involves a whole new attitude toward providing financial information to the capital markets. While traditional thinking causes management to be satisfied with providing the least amount of information allowable under GAAP and SEC regulations as infrequently as possible, QFR calls for reporting larger quantities of more useful information with greater frequency.

The previous column described inadequacies of current practice and encouraged CFOs to quit assuming they reduce uncertainty by using PEAP, WYWAP, and POOP in their statements. (See Part Two). This week, we look at QFR's impact on the activities and thought patterns of a corporation's General Counsel and other legal experts.

Rules of Procedure

Understandably, a typical legal education steeps attorneys in how to operate within the boundaries of established legal due processes. In particular, the law defines the kind of evidence that is admissible in a court of law. Lawyers for defendants advise them to disclose information only under two circumstances:

Under compulsion by court order or by statute; and

When disclosure will tend to improve the defendant's case.

Everyone knows that defendants cannot be compelled to testify against themselves,

and that cases can be been dismissed when evidence is disallowed because it was gathered illegally.

And, we've all seen movies in which the judge instructs the jury to disregard a witness's outburst from the stand. In effect, rules of procedure establish an artificial decision-making environment in which great pains are taken to protect the defendant's rights while justice is being sought.

Given that juries are supposed to convict only when they believe defendants are guilty beyond a reasonable doubt, defense attorneys use the evidence to actually create uncertainty in jury members' minds. That process involves carefully crafting a plausible story using only some of the facts to confuse the jury about what really happened.

Doubt, Disclosure, and Economic Suicide

We are not writing to criticize these practices; indeed, they are a bedrock of the freedom we enjoy.

We do, however, have a problem when the general counsel or other legal advisers fail to realize that capital markets are not courtrooms, managers are not defendants, and stockholders are not juries.

Rather, the markets are a public forum in which huge amounts of information flow back and forth, some of it generated by management but much of it coming from other sources. Management's objective should be to build partnering relationships, not adversarial ones.

In this context, it is economic suicide to create doubt because its presence causes investors to, at best, discount security prices, or -- at worst -- not invest at any price because they simply don't want to endure the risk.

Bottom line, the confusion strategy that works so well in courtrooms is a recipe for disaster in capital markets.

The Legal Lens

However, we speculate that few attorneys recognize this disconnect. We speculate that they look at GAAP and SEC regulations through a strictly legal lens, which makes them totally reluctant to release any information beyond what the law requires.

After all, minimum reporting gives less ammunition to any potential courtroom adversary. Consider this quote from an article in the December 5, 2001, Wall Street Journal about Enron's efforts to create a false image in its financial statements:

"The company hired legions of lawyers and accountants to help it meet the letter of federal securities laws while trampling on the intent of those laws. It became adept at giving technically correct answers rather than simply honest ones."

The goal was minimum communication, not maximum information.

But for the tragedy, we would crack up over the unintelligibility of this footnote from Enron's 2000 annual report:

"In connection with the 1998 financial restructuring (yielding proceeds of approximately $1.2 billion) of Enron's investment in Azurix, Enron committed to cause the sale of Enron convertible preferred stock, if certain debt obligations of the related entity which acquired an interest in Azurix, are defaulted upon, or in certain events, including among other things, Enron's credit rating falls below specified levels."

Huh?

We may be wrong, but as experienced financial experts, we can't imagine that any investor or analyst -- sophisticated or not -- is going to react positively to that statement (doesn't exactly make you jump up and say "Wow! I have to buy stock in that company at any price!"). For all parties involved, a statement like the one above will -- at best -- raise eyebrows and force another read-through. At worst, it will force shareholders to reconsider their positions and investment decisions.

New Rules, New Territory

Victory is not won in the capital market by creating doubt, reasonable or otherwise.

Capital market participants are not limited by courtoom rules regarding evidence -- investors can ignore fine-spun tales and search out information from many other sources.

And investors cannot be instructed to disregard any credible evidence that comes from other sources.

They buy, sell, walk, or even run away on their own.

This view should cause managers and their legal advisers to enter new territory.

Instead of doing the least possible, executives should embrace voluntary disclosures of both good and bad news, thus adopting the mantra of Quality Financial Reporting.

The desired characteristic of QFR information is usefulness for rational decisions. Usefulness comes from the information's relevance, reliability, timeliness, clarity, and trustworthiness. As we have explained, these qualities don't come from minimum compliance with regulations at the lowest cost. Nor will they arise from deliberately shading the facts while walking a fine edge of the truth.

Perhaps more than any others involved in financial reporting, attorneys face the biggest paradigm change because they must give up the courtroom's rules of evidence, and the risk-averse tendency to withhold information at all costs.

That the shift will be hard doesn't make it impossible. Indeed, it can be accomplished by general counsels who realize they are supposed to do what is best for management and all stakeholders; namely, help get the securities priced appropriately for the underlying risk.

Their goal is to squeeze out the risk created by incomplete information. Thus, under QFR, the GC's job is to ensure that reported information is prepared in compliance with the law, yes, but that it is also true and useful.

After all, the truth is always the best defense against claims of fraud and deception.

And deception does nothing for management or shareholders when the truth, the whole truth, and nothing but the truth is ultimately unveiled.

In Part Four, the authors examine what adoption of QFR means for Investor Relations Officers.