Crackdown needed on US corporate disclosure

Author: IFLR Correspondent | Published: 21 Sep 2017
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Shareholders are faced with ever-expanding levels of corporate information, which is impairing their decision-making process. Focusing on the data that is material to investors could be the solution

1 minute read
One of the key issues that is negatively impacting shareholder engagement is the fact that proxy materials have become long and filled with details that they don’t have the time to read. Over the years, the length of such documents has grown to accomodate information that is not material including duplicate disclosures, disclosures mandated by various regulators, multiple risk factors and accounting requirements, even if they don’t have an impact on the company.

This over-disclosure can be remedied, but only if and when the regulator steps in to crack down on this abundance of sometimes unecessary disclosure.

In order to avoid any appearance of trading on the basis of non-public information to which I have access in the course of my law practice, I maintain my investments in accounts in which all trading decisions are made by financial advisers, without input from me. My principal account normally contains shares of 15 to 20 companies. I recently received an updated version of the managed account agreement relating to that account, and noticed that it said that shares are voted in accordance with ISS [Institutional Shareholder Services] recommendations.

I am familiar with recommendations made by ISS, and I disagree with many of them. Accordingly, I asked my financial advisor if there is any way I could avoid having my shares voted in accordance with ISS recommendations. I was told my account could be changed so I would control how shares are voted. I immediately envisioned being inundated with 50 to 200-page proxy statements, periodic reports to the Securities and Exchange Commission (SEC) and other documents that I would never look at. My financial advisor noted I could avoid this by electing to receive internet notices of availability of corporate documents instead of getting paper copies. This was a perfect solution. My shares would not be voted in accordance with ISS recommendations, and my waste baskets would not be cluttered with paper copies of lengthy, unread disclosure documents.

That's a sad story. I, like a large number of individual stockholders and many institutional stockholders, have little interest in voting. I don't have time to read lengthy proxy statements, and even if I read them, I would rarely have the background about the company required to make intelligent voting decisions. ISS, Glass Lewis and other proxy advisory firms were built on the unwillingness or inability of most stockholders to do what is necessary to be able to vote intelligently. For fees, they read the lengthy proxy materials and make voting decisions on behalf of large numbers of stockholders who have neither the time nor the interest to make their own voting decisions. Unfortunately, I disagree with many of the policies applied by ISS and Glass Lewis, and with the one-size-fits-all result of applying those policies to large numbers of companies. But I also do not feel able to make intelligent voting decisions. I usually don't know what stocks I own, and I certainly don't know enough about particular companies to know how I should vote my shares.

About Corporate Governance Quarterly
Growing shareholder activism and an increased focus on board responsibilities has put the world of corporate governance firmly in the spotlight. This quarterly feature by Goodwin Procter counsel David Bernstein has been looking at the practicalities of empowering shareholders, and other fundamental questions regarding corporate governance. The next instalment will appear in the February 2018 edition of IFLR magazine.

The problem

There are many causes of stockholder voting apathy, but high on the list is that proxy materials have become so long and filled with details that stockholders don't have the time to look for the information that might lead them to want to make voting decisions. The same is true for periodic reports to the SEC and to offering documents by which securities are sold.

SEC chairman Jay Clayton has publicly pointed to the cost of regulatory compliance as a reason the number of companies electing to do initial public offerings (IPOs) has declined significantly in recent years. The problem goes beyond the cost of compliance. Disclosure documents have become so complex and so detailed that, even for the people who read them, the really material information is often lost in a sea of minutiae.

The Delaware courts have made it clear that, for purposes of that state's corporate law, proxy statements do not have to include details that do not materially change the mix of information that is disclosed. For example, in dismissing a recent suit regarding a claim that a merger proxy statement should have included financial information about peer companies the company's financial adviser reviewed in determining that the merger would be fair to the company's stockholders, the Delaware Chancery Court said all that was necessary was that stockholders know the type of analysis the financial advisor had performed. It was not necessary for the company to provide all the information stockholders would need to perform their own financial analyses.

Disclosure documents were not always so difficult to read. As recently as 20 years ago, an annual meeting proxy statement relating to election of directors would be 10 to 15 pages long. Now it is likely to be 40 to 60 pages long or longer. A proxy statement relating to a merger or similar transaction will usually be 100 to 150 pages long – a form 10-K annual report to the SEC will be at least 75 to 80 pages long. A prospectus relating to an IPO will often exceed 200 pages.

How did it get this bad?

How did this happen? Are today's lengthy documents better disclosure than their predecessors, or is the volume of verbiage in current disclosure documents actually obscuring the truly important information? If, as many people would assert, the latter, can the problem be fixed?

One contributor to the length of disclosure documents is duplicate disclosures. It is not unusual in a form 10-K annual report filed with the SEC to find the same disclosure, essentially word for word, two or three or four times in the same report. A description of a company's material debt instruments will appear in the notes to its financial statements and verbatim, at least once and often twice, in the required management's discussion and analysis of financial condition and results of operations. Similarly, the identical description of contingent obligations will appear in the notes to financial statements, in the management's discussion and analysis, and sometimes in the risk factors section of the report. There are many other examples.

Another contributor is disclosures required by the Sarbanes-Oxley Act or the Dodd-Frank Act, or by SEC rules, to accommodate social advocacy groups or as responses to issues that were current years in the past. Examples are required disclosures of even minor governmental claims of violations of environmental laws, required disclosures regarding mine safety, required disclosure of any use of minerals that may have come from the Congo, and the soon to be required comparison of the chief executive's compensation with that of the median employee (who, depending on the nature of the company, may be a skilled craftsman or may be a dishwasher). Also, because of the accounting scandals of the early 2000s, every proxy statement is required by statute to include statements that the company's senior executives have reviewed the company's disclosure controls and internal controls over financial reporting, and that they are adequate.

Disclosure documents have become so complex and detailed that, even for the people who read them, the really material information is often lost in a sea of minutiae

A major cause of excessively lengthy proxy statements is required disclosures regarding executive compensation. Virtually since the SEC was formed in 1934, it has seemed obsessed with disclosure of executive compensation in proxy statements. Through the years, the required disclosures have grown and grown. In 2006, the SEC added a requirement that every proxy statement include a compensation discussion and analysis that describes in detail how the company determines the compensation of senior executives, including the specific formulas for awarding incentive compensation and how those formulas are actually applied. Currently, it is not unusual for a proxy statement to include 20 or 30 pages of detailed disclosures regarding compensation of executives, while devoting only three or four pages to the qualifications of the candidates for election as directors (other than their compensation). Yet, when securities analysts publish reports on companies, there is virtually never a reference to compensation of executives as a factor investors should consider in deciding whether to buy or sell securities of the company. And that is not surprising. Given a choice between buying shares of a company whose earnings and stock price have been rising steadily but that richly compensates its executives, or of a company that is losing money and whose stock is falling, but which only modestly compensates its executives, who would choose to invest in the latter?

An even more significant contributor to the length of disclosure documents is the risk factors disclosure that appears in annual reports to the SEC and securities offering documents, including documents relating to private offerings that are not subject SEC requirements. The SEC's required disclosure of risk factors is focused and reasonable. It reads:

'Where appropriate, provide under the caption "Risk Factors" a discussion of the most significant factors that make the offering speculative or risky.'

The requirement goes on to say:

'Do not present risks that could apply to any issuer or any offering.'

However, the securities bar (and the SEC staff) has ignored the admonition against presenting generic risks. The risk factors section of an offering document is often 50 or more pages long, even with regard to a company that has never done business. Risks that are described may be as universal as the possibility that if the company lends money, the borrowers may not repay everything they owe, or the possibility that if the company's credit ratings are lowered, the cost of the company's borrowings will increase.

The view of many securities lawyers is that disclosing a possible concern, no matter how remote or how generic, can't hurt, and might sometimes help. That view is incorrect. A statement in a disclosure document about the possibility of a problem can create a problem where none exists. For example, in a relatively recent Delaware decision, the Court of Chancery accepted the plaintiffs' allegation that a 17.3% stockholder controlled a company based solely on statements in the company's form 10-K annual report that:

'Our largest shareholder has significant influence over our management and affairs and could exercise this influence against your best interests' and

'Our controlling shareholder and other executive officers and directors are able to exercise significant influence over our company.'

The Court inferred that the 17.3% stockholder could 'control the corporation if he so wishe[d]'.

Another source of disclosures that are of little interest to the vast majority of investors is descriptions of new accounting requirements even if they will not materially affect the particular company. A company is required to include in the management's discussion and analysis of financial condition and results of operations, and, in most instances, also to include in the notes to its financial statements, descriptions of all recently adopted accounting pronouncements that have not yet been adopted by the company. In theory, a company is not required to disclose new accounting pronouncements that are not expected to have a material impact on it. However, the SEC staff has said that a company is 'encouraged to disclose that a standard has been issued and that its adoption will not have a material effect on its financial position or results of operations'.

Similarly, the footnotes to a company's financial statements must contain a description of the company's significant accounting policies (ie how the company applies accounting principles) and its management's discussion and analysis is required to discuss all critical accounting estimates (ie the judgments involved in making estimates and why particular estimates are subject to change). These could be important disclosures if they were limited to accounting policies that are not normal applications of accounting principles or judgments that are subject to uncommon risks. Unfortunately, the disclosures are not limited to abnormal policies or judgments. The disclosures frequently describe, in some detail, standard applications of accounting principles or judgments with regard to particular types of assets that are made in a customary manner and are subject only to normal risks. This type of disclosure may help the SEC enforcement staff if it turns out that particular accounting policies were not applied in a customary fashion or judgments were made without normal diligence, but investors have little need for them. The vast majority of investors will be willing to assume that accounting determinations are made in accordance with normal accounting policies and processes, unless they are told otherwise.

What next?

Can this over-disclosure problem be cured? Yes, but that will require the assistance of the SEC staff. Only it can harness the proclivity of securities lawyers and accountants to disclose everything that could conceivably be relevant to anybody. Also, it will have to remove requirements for disclosures that only infrequently are material to investors.

The starting point for curing the problem is recognition that more disclosure is not always better disclosure, and that filling documents with information that is not material frequently obscures the information that is important. With this in mind, the following are some specific suggestions:

  • Prohibit duplicative disclosures. If a disclosure is relevant in two or three places, make the company say it once, and refer to that disclosure in the other places.
  • Make it clear that disclosures of socially, but not financially, relevant information are not required, particularly if they don't apply to a particular company.
  • Eliminate the need to say that people did what they were required to do. For example, remove the need to say that the chief executive and chief financial officers reviewed the company's disclosure controls and internal controls over financial reporting. Don't remove the requirement that they perform the review, or the requirement to file certificates as exhibits to reports to the SEC. Just don't burden investors with statements that they did what they were supposed to do.
  • Sharply reduce the compensation disclosures and eliminate the compensation discussion and analysis. The currently required total compensation table contains all the information that is of importance to most investors.
  • Enforce the admonition that the risk factors section of disclosure documents 'do not present risks that could apply to any issuer or any offering'. To be sure this does not expose companies to accusations of inadequate disclosure, a risk factors section could begin with a statement such as: 'We are subject to all the risks to which companies in the businesses in which we are engaged normally are subject. In addition, we are subject to the following risks that are particularly significant with regard to us.'
  • Limit the risk factors section of a disclosure document to the 10 risks (or perhaps the five risks per business segment) that are most significant with regard to a particular company, unless the SEC staff approves, after a specific request, a description of a small number of additional specific risks.
  • Stop requiring (or encouraging) a company to disclose new accounting pronouncements that are not likely to have a material effect on it.
  • Stop requiring a company to describe standard accounting policies it applies or customary approaches it takes to making accounting judgments. If the SEC accounting staff wants the information, require that it be provided as supplemental information, rather than having it clutter disclosure documents that go to investors.

It is not likely that, even if disclosure documents are shortened and made more focused, large numbers of stockholders will begin to read proxy materials and periodic filings with the SEC. However, some will. And more importantly, stockholders and others who do read proxy materials and periodic filings will be able to find what is important to them without having to wade through pages and pages of detail.

As is said above, more disclosure is not always better disclosure. Sometimes it only obscures what readers really want to know. Please, let's limit required disclosure to meaningful information.

Bernstein David Bernstein
Goodwin Procter (New York)