One has to wonder if the old Shakespearean saying “timing is all” will become a guiding factor in which direction the Securities and Exchange Commission will go with a new administration and Congress.
We can reasonably assume that Congress will press the SEC to increase its enforcement efforts substantially, to go after those who manipulated the markets or failed investors intentionally or through negligence. There could also be an avalanche of new regulations resulting from problems that emerged from the financial crisis. And somewhere between those regulatory forces and angry investors will be corporations’ investor relations function.
A key lesson learned over the past year or so is that a lack of transparency and disclosure breeds distrust. Banks don’t trust each other. Directors claim they didn’t understand the complex derivative products such as credit default swaps and the risk involved with the collateralized debt obligations. Investors … well, they don’t trust anyone anymore.
Transparency will need to be addressed with additional regulation, some of which could be prompted by Congress. From an historical perspective, the burden of transparency and improved disclosure has been generally borne by the issuing companies. We saw this in Regulation Fair Disclosure, where executives covered by the rule could be sanctioned for selectively disclosing material non-public information, whereas the analysts or investors who used that information would not.
The thrust of the 25 recommendations by the SEC’s Advisory Committee on Improvements to Financial Reporting focused on how companies should make financial information more useful and understandable to investors. But transparency and disclosure must be addressed across the full spectrum of the securities markets.
On the investor side, mutual funds with more than $100 million in securities only have to disclose their equity holdings on a quarterly basis through Form 13(f) filings. Many times over the years, the issuing community has leaned on the SEC to require those filings more frequently, so issuing companies could identify their investors more accurately. These efforts have always met with resistance from the funds, who claim that more frequent filings will enable their competitors to discern their trading strategies. Yet, given the rate of turnover in mutual funds, quarterly filings provide less than relevant disclosure to the issuing companies.
Short sellers should be required to disclose their short positions in companies. This might curb the problem of short sellers spreading market rumors designed to drive down a company’s stock price. Another disclosure initiative should be a requirement that investors who borrow shares for their voting rights from funds willing to lend them must disclose this information with the SEC. That menace of “empty voting” in the proxy process needs the sunlight of disclosure.
Hedge funds that have been major players in the current financial crisis remain largely unregulated. While hedge fund performance has declined significantly this year, they are nonetheless a key factor in the marketplace but have virtually no relevant disclosure requirements.
Moving Ahead on Disclosure
In June, SEC Chairman Christopher Cox announced the 21st Century Disclosure Initiative to rethink fundamentally the way companies report and how investors acquire information. This is designed as a two-phase initiative. The first is an internal review by the SEC staff to be concluded by the end of 2008. The second phase is planned to have an external advisory committee examine “the way the SEC acquires information from public companies, mutual funds, brokers, and other regulated entities and the way it makes that information available to investors,” according to an SEC statement.
Chairman Cox selected Dr. William D. Lutz of Rutgers University to lead the Disclosure Initiative. Lutz is both a securities lawyer and an expert on plain-English, focusing on transparency. From 1995 to 1999, he played a significant role in drafting the SEC’s Plain English Handbook to help mutual funds and public companies prepare more understandable SEC filings.
As one who was a member of former SEC Chairman Arthur Levitt’s advisory committee that initiated the plain-English effort to make the mutual fund prospectus more understandable, I’ve since become somewhat skeptical of the SEC’s subsequent plain-English efforts. In 2003 the Division of Corporation Finance issued a guidance release on Management’s Discussion and Analysis, and in 2006 it issued the new executive compensation disclosure rules. With respect to MD&A, the SEC urged companies to adopt an executive summary stated in plain English. Yet, I’m aware that legal counsel for a number of companies advised against this out of concern over the liability of committing errors of omission, should material information on which investors might rely be left out of the summary, even though it was contained in the complete MD&A.
Another factor that resulted in little improvement in the plain-English effort was the SEC staff didn’t seem to get the message from on high that the intention was to eliminate repetitive information in the MD&A. Once companies received extensive staff comments on their MD&A, this brought on even greater involvement of the lawyers using more legalese in response.
A key lesson learned over the past year or so is that a lack of transparency and disclosure breeds distrust.
The SEC has been critical over the lack of clarity in the Compensation Discussion and Analysis in the proxy. In particular, many companies have avoided stating key performance goals for senior executives that investors can use to evaluate whether the compensation was deserved or not. I predict that the momentum behind proposals giving investors a say-on-pay vote in the proxy will only increase and could potentially invite Congressional action.
One of the key factors behind the 21st Century Disclosure Initiative is to eliminate forms-based filings. To that end, at an SEC disclosure forum on Oct. 21, a plan was unveiled by former SEC Commissioner Joseph Grundfest (now a professor at Stanford Law School), and Alan Beller, former director of the SEC’s Division of Corporation Finance (now of the law firm Cleary, Gottleib, Steen and Hamilton). Their proposal would replace a great majority of forms-based filings with an online, questionnaire-driven disclosure regimen. Once the company’s base line information is established, the company would report periodically material changes to that information as a way of eliminating repetitive information.
That’s a lot of progress so far, and over the course of phase two of the initiative, there will undoubtedly emerge other ideas on reforming the disclosure process. Several factors need to be considered. One is that we are operating in a global market, where the SEC needs to consider what other countries are doing with disclosure and their approaches to accounting standards. With International Financial Reporting Standards being the predominant accounting standard abroad and with the United States moving toward adoption of the IFRS, are we ready to move forward with a new disclosure initiative while we are making a dramatic change from rules-based to principles-based accounting?
The other question is whether the advanced technology that we have today is going to drive the SEC’s approach to disclosure, or will the Commission control the technology?
It would appear that the former is what’s happening with the XBRL initiative. At the recent XBRL International annual conference in Washington D.C., the participation was far and away dominated by the technology providers whereas the issuing companies, end users (the investors and analysts) were sparse in attendance. Yet, the XBRL rule was expected to go into effect for the larger-cap issuers on December 15. To the surprise of many, the SEC did not announce the new rule at the conference and now it might even be delayed.
Disclosing Freely
A key component of disclosure should be the ability of companies to use a “free form” means of communicating non-financial information. With more than half of the average company’s market value determined by non-financial factors, investors need to know and understand how these drive corporate value. There should be a way to do this in furnished information, as well as through the company’s more informal disclosure means such as the investor relations Websites, management presentations at investor conferences, and investor days.
The question remains: Once a new chairman comes on board and given the pressures to respond to Congressional initiatives and other market place demands, will this disclosure initiative remain a top priority? Timing is all, and the time will come shortly when the SEC will have to make some key decisions with respect to the best way to use its resources, whether to increase efforts to punish those who manipulated the markets and betrayed their investor trust, whether to bring more market discipline through increased regulation, or whether to take a broad brush and make marketplace information more transparent through modernizing the disclosure regimen.
Hopefully, Congress and the SEC will recognize that transparency and more open disclosure are at the heart of Wall Street’s problems and will make that the key priority.
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