The U.S. Securities and Exchange Commission is embarking on a much needed reform of public-company disclosure rules, largely to answer a simple yet critical question: What type of information do investors really want to make informed investment decisions?
Of course, it’s a question often asked by commissioners and staff. The SEC’s charge is to ensure that investors receive material information about public companies in a timely manner. But the commission’s point is to determine whether the amount of information available to investors can be streamlined, not expanded.
When Congress passed the Jumpstart Our Business Startups Act (JOBS Act) in 2012, Section 108 required the SEC to take a comprehensive look at Regulation S-K, the disclosure rules for various SEC filings used by public companies. The mandate was to look at reporting requirements as they relate to emerging-growth companies. Instead, the staff chose to do a full review for all public companies. As that review went on, the commissioners acknowledged in public speeches what had been apparent for years: Investors are burdened by “information overload.” The disclosures companies are required to produce have become chock-full of minutia, forcing investors to burrow into a daunting amount of published information to find those details most relevant to their decisions.
Lately, the SEC’s strategy to fix this problem has started to emerge. Following the Regulation S-K review, the staff recommended in December a “comprehensive” study of disclosure requirements, rather than a “targeted” approach. A comprehensive assessment will take more time, but to hone disclosure regulations to their most effective form requires a holistic approach and nothing less.
In February, the SEC’s Corporation Finance Division began interviewing companies and investors. How can the disclosure rules work better? What information do investors want? When do they want it? How can companies most meaningfully provide that information?
Since the mid-1990s, the SEC website has provided real-time access to company filings, and before that many companies were already using their own websites to convey information to investors. But the digital connection between companies and investors is even more dynamic today through social media. Certainly, at a time when companies can push information to tablets and smartphones, it’s reasonable to assume that investors can receive truly material news and reports. Can disclosure requirements be tailored to enable that transfer of information?
Furthermore, public companies come in many more shapes and sizes than before. The SEC has made accommodations for smaller companies, but there are many midsize companies for which scaled-back disclosure would lessen their burdens while not depriving investors of any particularly material information. Many of the disclosure distinctions for small versus large companies appear arbitrary and would benefit from a more thorough review about what really influences investors’ decisions.
Additionally, the SEC needs to address select disclosures that have prompted voluminous responses by companies, driven by factors unrelated to the SEC such as “best practices” in governance and shareholder lawsuits. An excess of information can produce little benefit and can even obscure news that is really useful to investors:
• Executive compensation. When the Dodd-Frank Act was enacted in 2010, it mandated that investors be given an advisory vote on executive compensation, also called “say on pay.” Consequently, companies have decided to provide more details about the rationale for their compensation decisions, swelling proxy statements. Compensation discussion and analysis sections frequently run 20 to 30 pages, raising questions about whether investors really need anywhere close to that amount of disclosure about why companies pay executives what they pay them.
In fact, Dodd-Frank included another disclosure rule on compensation that has not been followed. It requires companies to show the relationship of their CEOs’ pay to the companies’ performance, a far more important statistic than much of the information provided on executive pay (not to be confused with a separately pending rule under Dodd-Frank that would require disclosure of the ratio of CEO pay to the pay of a company’s “median” employee). If a company has done poorly and the CEO is getting raises, an explanation is in order. But, oddly, proxies don’t include this ratio. It would seem useful to determine whether the pay package is really out of control.
• Potential risk factors. In 1995, Congress enacted the Private Securities Litigation Reform Act. It basically provided liability protection to companies by creating a safe harbor for so-called forward-looking statements about information including projections and expectations such as of future financial results and expected developments, as long as such statements were accompanied by cautionary language about factors that could affect the likelihood of those forward-looking statements coming to fruition.
This language led to more disclosure, which was useful to investors. However, while companies already included so-called “risk factors” in certain SEC filings, the safe harbor led to an exponential increase in the length of this disclosure, as companies began to view it as cheap insurance, warning everybody about everything in the hope of avoiding a lawsuit if the projections didn’t work out.
Unfortunately, corporate fears about today’s litigious environment create a headwind to reform. No matter how often companies are assured that they can scale back on multiple pages of risk factors, they remain nervous about consequences. Still, it’s important to shorten the list, perhaps to the top 10 risks or something similar, to allow true concerns to be readily apparent to investors rather than hidden among those far less likely.
• Management’s discussion and analysis of financial condition and results of operations. The narrative description of a company’s financial state, focusing on the changes from period to period in a company’s financial statements, has become so bogged down in detail that it is difficult to discern what is truly important — namely, the trends going on in the company. This section is intended to cover known trends and uncertainties. What we’re often getting is a much more granular level of detail without regard to materiality. Frequently, information found in this section is also included elsewhere.
Since the 1960s, the SEC has undertaken several initiatives to review and update its disclosure and registration requirements, including one whose title — the Plain English Initiative — couldn’t put the problem more candidly. The projects ranged from targeted revisions of certain rules to comprehensive reviews. The SEC should be applauded for its persistence in tackling information overload. But this time the problem needs to be fixed.
Howard E. Berkenblit is a partner in the Boston office of Sullivan & Worcester and leader of the firm’s securities and corporate governance group.