United States: Less Is More

The SEC has a renewed focus on rationalising public company disclosure. There are some quick fixes that would reduce information overload.

The investing public is suffering from information overload. It's a diagnosis handed down by Mary Jo White, Chair of the US Securities and Exchange Commission (SEC), and caused by the pages of dense disclosure public companies produce each year to satisfy their ever-increasing SEC reporting obligations.

In recent months, White has been offering ideas on how public company disclosure could be streamlined to remedy the problem. Those ideas span from the obvious – like eliminating repetitive disclosure – to the transformative – like replacing today's periodic reporting model with a single company profile containing information that changes infrequently and real-time updates as new circumstances arise. Company profiles are an idea the SEC has thought about for years.

In December 2013, the staff of the SEC released the results of its study, mandated by the Jumpstart Our Business Startups Act (JOBS Act), of disclosure requirements for 'emerging growth companies'. Its purpose was to determine how the requirements can be updated to 'modernize and simplify' the registration process to make it less costly and burdensome for new public companies. The study went beyond the JOBS Act mandate and recommended a further, more comprehensive review of the entire disclosure regime for all public companies, not just emerging growth companies. That comprehensive review is on the SEC's agenda for 2014, and White's vision is ambitious. She wants the SEC staff to rethink not only what gets disclosed, but how and where it is disclosed, and how technology can be used to facilitate access and make information more meaningful to investors.

The good news is that a comprehensive review should result in a meaningful improvement to the public disclosure regime. But the bad news is, in the staff 's words, the comprehensive approach 'would likely be a longer-term project'.

How did investors get information overload?

The staff 's December report contains nearly 100 pages detailing the evolution of today's disclosure requirements. What is apparent from this painstaking historical account is that over the years, disclosure requirements have been re-shuffled, combined and added to as a result of comprehensive overhauls – including more recent reactionary legislation like the Sarbanes-Oxley Act and Dodd-Frank Act – with very little culling of rules that have become antiquated. The staff 's historical summary did not take into account other relevant factors such as disclosure requirements developed through SEC releases, staff guidance and informal interpretations, the SEC's enforcement history and the impact of court decisions – all of which will be studied as part of the staff 's comprehensive review. Pressure from institutional investors seeking more information on a variety of topics like corporate political contributions and the influence of proxy advisory firms on voting decisions also adds to the pages of disclosure. To makes matters worse, some of the most onerous new requirements are those that have been mandated by Congress to further political and social agendas.

Disclosure principles

The US system of public company disclosure forms the backbone of a transparent and functional trading market by providing investors with the information they need to evaluate an investment in a security. US disclosure requirements are built on the principle that 'material' information be disclosed to investors. Information is considered material if there is a reasonable likelihood that a reasonable investor would consider it important in making an investment decision. Determining what pieces of information meet the materiality standard is left to the judgement of a company's management, disclosure committee and lawyers. Layered on that basic concept are specific disclosure requirements found in the SEC's reporting forms and Regulation S-K, the framework of rules that specify by topic the disclosures required to be made in periodic reports and securities offering documents, as well as the SEC's financial statement requirements.

The process of creating a disclosure document, be it an annual report or initial public offering (IPO) prospectus, while helpful in vetting important issues, is also a significant contributor to information overload. The SEC reviews a company's SEC filings once every three years and reviews all IPO prospectuses, and asks questions through the comment letter process that often results in the addition of more disclosure.

From time to time the staff announces disclosure initiatives through bulletins or so-called Dear CFO letters. These focus on areas that have raised concerns for all public companies, like management's discussion of financial results or cyber security. These directives, while helpful in focusing companies on areas of concern, often result in new or clarifying disclosures. External factors like SEC enforcement actions and lawsuits alleging false and misleading disclosure also play a role in driving disclosure practices that focus more on minimising potential litigation risk than on communicating material information to investors. The disclosure process is rigorous – as it should be given its importance and purpose. But it has gotten bogged down in details that aren't all that relevant, marked by repetition and guided by fears that something important might get edited out which could expose the company to potential liability.

Where is disclosure reform headed?

In its December report, the staff offered a glimpse of where disclosure reform might take us in the future. First, they emphasised a principles-based approach to a new disclosure framework, but one that preserved the consistency, completeness and comparability of a rules-based approach. Second, the staff intends to look at the appropriateness of scaled-down disclosure requirements for some categories of companies, perhaps extending the benefits of the relaxed disclosure requirements afforded to emerging growth companies under the JOBS Act to a larger category of companies. Third, the staff will evaluate different methods of information delivery and presentation including the creation of a company profile (as described above). Lastly, the review will focus on ways to make disclosure documents more readable by eliminating redundancy, quantitative thresholds, and information that is readily available to market participants from other sources.

The staff also intends to consider economic principles in its of disclosure requirements. These principles would aim to improve the usefulness of disclosure to investors and, without losing sight of the importance of investor confidence in the reliability of this disclosure, would take into account:

  • the historical objectives of a particular rule;
  • whether information provided by a rule is readily available from reliable sources other than the company;
  • administrative and compliance costs;
  • the extent to which disclosure of proprietary information has competitive costs; and
  • the need to maintain the SEC's ability to conduct an effective enforcement programme.

There is no doubt that the staff 's comprehensive principles-based approach, areas of focus and consideration of economic principles will yield a much improved disclosure system that will alleviate some of the administrative burden and compliance costs while improving the clarity and usability of disclosure for investors. But this is a long way off. And in the meantime, there will be no incremental relief for public companies unless the staff acts informally on an ad hoc basis to advance its disclosure reform agenda. This seems to be happening. In his recent address to the American Bar Association, Keith Higgins, the director of the SEC's Division of Corporation Finance, called on companies and their lawyers to improve the focus and navigability of disclosure documents in the absence of rule changes by reducing repetition, focusing disclosure and eliminating outdated disclosure.

Quick fix reforms

One SEC commissioner recently expressed his preference for addressing discrete disclosure issues now rather than risk spending years preparing 'an offensive so massive that it may never be launched'. Chair White has already made a number of suggestions about what could be done to optimise disclosure requirements, some of which could be implemented in relatively short order if the staff were so inclined. The most obvious place to start is to question whether some information required to be disclosed under SEC rules is really necessary anymore. For example, White pointed to the disclosure of two years of the high and low trading prices of a company's common stock, a requirement that no longer serves a purpose in today's technology driven world.

Keith Higgins recently indicated that the SEC staff will no longer expect detailed disclosure about historical stock-based compensation practices in IPO prospectuses to support the reasonableness of a so-called cheap stock accounting charge. Today, it isn't unusual for companies to write pages about how they valued their common stock for purposes of pre-IPO employee stock option grants. This disclosure practice was not in response to any specific rule requirement, but grew mainly out of the staff comment letter process which sought details on company milestones that lead to valuation increases and methodologies used to support the analysis. This will be a welcome change for companies yet to file their IPO registration statements, but whether the staff can do much else to provide companies with incremental relief remains to be seen.

Duplication also adds to information overload. This problem still persists despite the SEC having enacted a rule in 1998 as part of its so-called plain English initiative that prohibits repetitive disclosure where it does not enhance the quality of the information. White has pointed to disclosure of a company's legal proceedings in multiple places as an example of redundant disclosure. One of the main drivers of repetition is the interplay between SEC requirements and the Financial Accounting Standards Board (FASB) loss contingency disclosure requirements. Financial statement disclosure is much more detailed, causing companies to struggle with disclosing less detail on the same subject elsewhere in the filing. The path of least resistance for many companies seems to be to simply duplicate the more detailed accounting disclosure elsewhere. Since 2009, the FASB has undertaken its own project aimed at improving the effectiveness of disclosure in the notes to financial statements (although not necessarily reducing their volume). It is unclear how any changes brought about by FASB's disclosure framework project will impact the rest of a company's filing. But without a clear effort on the part of the SEC and FASB to harmonise financial related disclosure requirements, overlap is inevitable.

Defensive disclosure practices also play a role in redundant disclosure. It will be very difficult for companies and their lawyers to stop duplicating paragraphs in various places throughout a filing without a push from the staff, as it is a relatively cost-free way of building an arsenal to ward off potential litigation threats. Keith Higgens recently gave that push. As a simple, quick fix for repetition in management's discussion and analysis, he suggested a cross reference to the corresponding financial statement disclosure.

Risk disclosure is another area that has become unwieldy, also largely as a result of efforts to forestall potential litigation. Risk disclosure spans from describing significant and fundamental risks, such as the lack of regulatory approval for the company's only drug product, to the truly baffling such as the risk that reduced disclosure requirements applicable to emerging growth companies might make the stock less attractive to investors. In many cases, the likelihood of the risk occurring, or that the same risk could apply to any company operating in any industry, does not seem to be taken into account. Chair White posits that the 1995 Private Securities Litigation Reform, which provided a safe harbour to encourage companies to disclose more forward-looking information, is partly responsible for the increase in the sheer volume of risk factor disclosure. This is because the protection is only available if the forward-looking statements are accompanied by 'meaningful cautionary statements'. There is little incentive for a company to scale back its risk disclosure. And other than better editing, there isn't likely to be a quick fix to ensure the cautionary statements highlight important – rather than all – factors that could cause the actual outcome to differ materially from a forward-looking statement.

While there may be some areas that could benefit from a quick fix, there are some aspects of information overload that may be out of the SEC's hands to remedy, even with a comprehensive overhaul of the system. Some of the most onerous and burdensome disclosure requirements in recent years have been the result of commandeering public company disclosure documents to advance the social and political agendas of members of Congress. In these cases, the SEC is between a rock and a hard place. It is obligated to adopt new rules to carry out laws enacted by Congress even if the SEC believes the disclosure mandate imposes increased compliance costs on companies while doing little to inform investment decisions.

For example, the Dodd-Frank Act requires companies to disclose their use of conflict minerals (tantalum, tin, gold or tungsten) that originated in the Democratic Republic of the Congo (DRC) region, if those minerals are 'necessary to the functionality or production of a product' manufactured by those companies. The rule is meant to exert pressure on companies not to deal with a region plagued by atrocious human rights violations. The goal is laudable, but the means to accomplish it are inconsistent with the core mission of the SEC; namely the protection of investors. The result is a massive supply chain due diligence effort by practically every US company that makes something so that they can report on a special SEC disclosure form whether they are using minerals sourced from the DRC. The hard and soft costs of compliance (effective May 2014) are significant, and the perceived benefits are indeterminable. Another such requirement is the controversial pay ratio rules mandated by the Dodd-Frank Act. These would require public companies to calculate and disclose the ratio of its CEO's annual compensation to the median total compensation of all employees in the company. These types of disclosure rules add a new layer of disclosure obligations designed not with a view toward adding meaningfully to the mix of information available to investors, but rather to act as a catalyst for social change.

The prognosis for today's epidemic of information overload is good, but given the scope of the staff 's disclosure reform project and everything else on the SEC's 2014 agenda, it may be years before we see a cure. In the meantime, public companies can forge their own path by following the most simple principles when writing public disclosure: tell the truth, tell the whole truth, tell it clearly, and tell what it means. Investors will get more from less.

Originally published in the May 2014 issue of International Financial Law Review.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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