When Full Disclosure Still Isn’t Enough

ince 2001, most publicly held companies have viewed their legal disclosure obligation through the lens of Regulation Fair Disclosure. Reg FD was designed to stop the disclosure of material, non-public information—particularly earnings guidance—to a select group of analysts or investors and to level the playing field in disseminating material information.

ABOUT THE AUTHOR

Louis Thompson Jr. is an internationally recognized expert on corporate governance and disclosure, having served for more than two decades as president and chief executive officer of the National Investor Relations Institute until his retirement in 2007. An adviser to the Securities and Exchange Commission and the New York Stock Exchange, Thompson is currently serving a second term on the NYSE Individual Investor Advisory Committee. Prior to joining NIRI, Thompson was assistant White House press secretary to President Gerald Ford. A veteran of the U.S. Command in Vietnam and the Office of the Secretary of Defense, Thompson has held executive communications positions for a number of organizations, including the American Enterprise Institute for Public Policy Research, and the National Council for Economic Education. A former journalist and news anchor, Thompson remains chairman of the advisory council for the Greenlee School of Journalism and Communication at Iowa State University, where he was the 2001 recipient of the James W. Schwartz Award for Distinguished Service in Journalism and Communication conferred by the Greenlee School. A former member of the Harvard University New Foundations Working Group on corporate governance, Thompson is a partner with business consultancy Genesis, based in Denver. He is also a managing director of Washington, D.C.-based Kalorama Partners, the advisory firm founded by former SEC Chairman and Compliance Week Columnist Harvey Pitt. More From Lou Thompson Click Here For Other CW Columns By Louis Thompson Jr. Related Resource Motorola’s Earnings Press Release (2007)

The evidence is pretty clear that corporations have figured out how to live with Reg FD, given that the Securities and Exchange Commission has filed only seven suits for violating the rule and the federal district judge for the Southern District of New York overturned the last one in 2005 (the second case against Siebel Systems).

But does fair disclosure mean full disclosure? Not really. In fact, companies may withhold material information if they determine that it is in the best interests of the shareholders for the company to do so. For example, a company may withhold information about a new product under development until it determines that news about the product is ripe for public release. In this case, it is also incumbent that “insiders” not trade on that specific information.

In raising the issue of full disclosure, the question is whether companies have an obligation to disclose more risk factors so shareholders—current or potential—have better information to make investment decisions.

The issues rising from the sub-prime mortgage crisis make it clear that investors lacked much-needed information about the risks involved in investing in collateralized debt obligations (CDOs) that constituted packaged sub-prime mortgages. Those CDO instruments were gobbled up by financial institutions, hedge funds, and other investors in anticipation of “guaranteed” high rates of return. Of course, that was based on the assumption that people would always pay their mortgages on time, that people would be able to do so when these mortgages were adjusted upward, and that housing prices would continue to increase.

Not only were investors burned when mortgage delinquency rates in 2007 reached 20 percent, but so were boards of directors of financial firms—who usually lacked the necessary understanding of CDOs to exercise their oversight responsibility. And the rating agencies also took their lumps over the inability to un-bundle CDOs and assess the risk of each mortgage bound into the larger bond instrument.

Surely there’s plenty of blame to go around for this crisis, starting with the aggressive originators of these mortgages, who pushed borrowers into mortgages they would not be able to afford once the interest rates adjusted upward and the borrower’s equity went negative. Currently, the forecast for this year is that 920,000 families will lose their homes; that’s two percent of the 46 million mortgages.

The shareholder lawsuits filed in the wake of the Bear Stearns collapse will surely underscore the point that investors did not have the proper information about risks when they decided to invest in the CDOs. And the information shortcoming goes well beyond the mortgage industry; manufacturers that have had to recall products determined to be a health risk have faced the question: What information did they know prior to announcing a product recall, and when did they know it?

In the wake of Sarbanes-Oxley, many companies have instituted various means of making risk assessments. But most of that information is maintained internally. (And one can only hope that this information is communicated to the boards of directors.) What is missing is some way to communicate such risk information externally.

A retired investor relations officer of a major financial institution (one involved in the sub-prime meltdown) tells me that his company created a risk-assessment task force after the firm completed a series of major write-downs. They had some heated debates internally on whether to disclose some of their risk-assessment information, but decided not to do so for fear of entering the analysts’ “killing zone,” where the stock price would be severely punished based on risk revelations.

CFA Institute President & CEO Jeffrey Diermeier likes to say that investors and analysts don’t welcome bad news, but they will get over it. Working as if your investors can’t be trusted to accept negative news is a fundamental flaw in thinking. It is often a convenient excuse for senior managers not to disclose important information to investors. Diermeier admits that on the surface, the market does react negatively to potentially adverse risk information, but insists that such thinking is seriously flawed at more fundamental levels. (Diermeier spent much of his career on the buy-side and was formerly chief investment officer for UBS.)

What can be done to encourage companies to disclose more risk information? I’m not suggesting a new Regulation “Full” Disclosure. Instead:

1. The SEC should encourage companies to include more risk information in the Management’s Discussion and Analysis portions of Forms 10-K and 10-Q, as well as in their informal means of disclosure—quarterly earnings releases, presentations before investor conferences, and the CEO’s annual letter to shareholders. In 2002, former SEC Chairman Harvey Pitt (and now a fellow Compliance Week columnist) conducted disclosure roundtables in New York and Washington, D.C. During the New York forum, panelist Warren Buffett said that when he reads a CEO’s letter to shareholders and the MD&A, he would like to feel as if he’s sitting across from the CEO who says: “Warren, these are the key issues that sometimes keep me awake at night.” Now that would be a refreshing level of candor and transparency—but the reality is that it’s probably beyond the comfort level for most CEOs and their general counsel.

2. The SEC may be heading in this direction through its proposal to tell companies that while they still need to use mark-to-market methods to price many of the instruments they hold, they may give investors a wider range of possible values for those securities.

3. Being more transparent with key risk factors should go beyond the usual boilerplate risk factors listed in the safe-harbor disclosure in corporate earnings releases and related documents. There should be a discussion of risk factors, even though they may be problematic. Analysts and investors must also recognize this and not penalize companies for saying these are potential factors that should be considered in making an investment decision.

4. There is a growing body of academic research indicating that greater transparency results in a lower cost of capital.

Companies should recognize that a candid, credible relationship with analysts and investors builds trust, so that even when bad news happens, the consequences are likely to be far less than when disclosure is limited and bad news comes as a surprise. Bottom line: Transparency builds trust.