Dale Oesterle has called Gretchen Morgenson a “national treasure.” Today Larry Ribstein exposes the treasure for fool’s gold. I’m with Larry on this one.
Morgenson’s article on executive compensation is yellow journalism at its worst (well, at least a far as business journalism goes. And really — what else is there?).
As Larry suggests, hatchet jobs like Morgeson’s can be quite costly:
To what extent do stories like this shape misguided public policy like the SEC’s recent compensation disclosure rule? What is the social cost of the useless reshuffling firms must do to minimize damage from sensationalist stories like this?
Excellent questions. To me this sort of story highlights one of the dangers of mandatory disclosure: That the information might actually be used. We’re all accustomed to thinking that shareholders are rationally apathetic, but rationality means nothing if it doesn’t mean that shareholders will be less apathetic [does that make them more pathetic? — ed.] when the cost of action goes down. It is, after all, the fundamental grounding for our securities regulatory regime.
And this may be bad. The problem is that forced, Plain English disclosure of pay packages along with Ms. Morgenson’s finely-honed commentary (“it’s outrrrrrrrrageous!”) may induce shareholder action — in precisely the sort of situation in which the shareholders’ collective best interests are served by specialized decision-making by the board and seriously-limited or no shareholder second-guessing of business decisions. When, that is, their hands should be tied.
One of the great strengths of our system of corporate governance is that it permits corporations to control the level of shareholder participation in the firm — which is to say, the exent to which shareholders may harm themselves. They are routinely denied access to proxies, constrained in their voting, and, of course, completely absent from all regular business decisions. It makes sense that firms should be permitted to select the appropriate level of shareholder action, to the extent it can be controlled. So why shouldn’t boards be permitted to control the flow of information, as well? To the extent that making information more costly functions just like restricting access to corporate proxies in constraining shareholder participation, isn’t it appropriately in the board’s control? Firms can’t always control what shareholders — or journalists — do with the information they disclose, but they can control the disclosure in the first place.
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Royce: That’s very helpful. I’m not convinced that the sections you cite provide an exemption from a requirement to disclose all material information in many circumstances. For instance, when a firm goes public and provides a description of its business, how could there be information that would be both material and yet not be “necessary to make the statements therein not misleading?� Isn’t the whole point of information being material that an investor would say about the information: “well, if I had known that, I might have thought otherwise,� and in the setting of an IPO, silence is not a permissible option. But it is good to hear the argument on the other side, even if I think you (and probably every one else) is resting a lot on the idea that one can omit material information and not have the resulting disclosures be misleading.
Mike:
The reason there is not a general obligation to disclose everything that is material flows from the language of the pertinent statutory provisions.
Section 11 creates liability where a registration statement “[1] contained an untrue statement of material fact or [2] omitted to state a material fact required to be stated therein or [3] necessary to make the statments therein not misleading.” (the Arabic numerals being supplied by me) What I have identified as [2] and [3] provide liability for omissions. These provisions don’t say that it is sufficient to create liability for there to have been an omission of something that is material. Rather, omission of material information is only actionable if–[2]–something requires the material information to be included or–[3]–something that was disclosed is misleading without disclosure of something else.
Similarly, liability under section 12 for an omission arises only where for an omission “necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading”.
I concur that the line between soft information that need not be disclosed and underlying facts that may need to be disclosed, addressed in part in the MD&A release of the late 1980s, is often a difficult one.
Having not taught securities regulation for a couple of years, I have not recently updated my research to see the extent to which Shaw v. Digital Equipment and Glassman v. Comptervision Corp. have been refined, if at all, in addressing disclosure of unaudited intra-quarter results. My experience (which predates these cases) was, however, that this is one area where some lawyers would pay very close attention and seek to require disclosure of information not expressly required by S-K.
I thank you for the kind reference to my work on SSRN, although I regret I could not work in a cite to a paper that is available for download.
Geoff: I think we both bemoan the fact that the SEC has failed to engage in a serious dialogue about mandatory disclosure, particularly since it continues to be the tool the SEC most heavily relies upon.
Royce: Is the choice not to disclose much of the information that is material consistent with common practice? Absolutely, as I think is even evident from your comments. What I am saying is that this common practice is in direct conflict with the clear language of the Securities Acts and related SCOTUS decisions. While it is true that, at least in the US, there is not an affirmative duty to disclose, when disclosure is made, particularly for an IPO or other general filing, where does it say you do not have to disclose all material information? You say you are only required to make “disclosure of any additional information necessary to make not misleading what is, in fact, disclosed.� How could this be reasonably interpreted to not include all material information, particularly in the case of a company filing an IPO or an annual report? You say “It has long been clear that the disclosure obligations under the Federal securities laws do not include all information that an investor might consider important.� How do you otherwise interpret the language in TSC v. Northway holding that information is material if there is “a substantial likelihood that a reasonable shareholder would consider it important?�
As a side note, lawyers when they talk about disclosure like to use the distinction between hard and soft information, but this is not a distinction that I find terribly useful. What does this really mean in the context of an operating business? Audited versus unaudited information, which is just a distinction about how information is reviewed; any information can become audited information. I think they meant to compare information that is can be easily quantified with information that it is more difficult to quantify. I agree that information that it is difficult to quantify is unlikely to be that useful to most investors. But there is a whole bunch of internal operating data, for example, that is very much “hard� data, that is information investors would absolutely want to see, and that firms do not disclose. This is common practice, but I don’t think it is supported by the language of the Securities Acts or court decisions.
Also, I expect some thanks for giving you a chance to plug a couple of your articles, which look quite good, though I would argue your scholarship addresses disclosure trade-offs on the margin, and does not address the issue of whether the baseline for disclosure is in the right place.
Mike: I don’t actually expect you to read the monstrosity! I did a check in all the places I thought I might find some expression of uncertainty, and I uncovered none. I don’t even think the requests for comments — at least not any that I looked at closely — demonstrate any question about the fitness of the rule, even though you might think they would. The “costs and benefits” section is a complete joke. (By the way — it’s also worth taking a gander at the early comments online here. Some real crackpots. And every single one strongly in favor of the rule, most with the naive belief that it must and will “cure” obscenely high pay).
I agree that LaPorta and a few other studies are more supportive of mandatory disclosure (if I recall, Farrell, for example, finds some good effects), and although I think the burden may have shifted, there is certainly room for serious debate.
Re comment 3:
I gather, then, that we are now not saying that the law generally authorizes a general, all-encompassing “competitive harm exemption.” (The confidential treatment procedures do not stand for such a proposition because the procedure that you indicate is used on only a limited basis–a conclusion consistent with my now somewhat dated practice experience.)
It has long been clear that the disclosure obligations under the Federal securities laws do not include all information that an investor might consider important. Rather, the way the securities laws are structured, they require express disclosure of certain identified matters and then, under Rule 408, require disclosure of any additional information necessary to make not misleading what is, in fact, disclosed.
Information, such as soft information, that investors wish for, and sometimes demand, is not always requried to be included in public filings. This information is “material” in the ordinary sense of the word (e.g., an IPO could not, based on the demands of the marketplace, be sold without it being disclosed in some way), but frequently, consistent with the law, has not been disclosed in the filed documents.
In sum, the law has not actually required disclosure of all information that a reasonable investor might find important, so the fact that in offerings seemingly “material” soft information was not disclosed is not necessarily surprising.
I think it is relatively clear that there are different standards of practice and approaches to disclosure obligations in different legal communities. See, for example, here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=323605 (providing empirical evidence bearing on certain factors influencing disclosure) and here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=481983 (addressing law firm quality and IPO pricing). It is to be expected that lawyers will vary in their performance of their gatekeeping obligations; professionals will vary as to the ways in which they perform their professional obligations. Absent evidence from a well-selected sample, however, I would be somewhat reluctant to conclude that excellent lawyers in all geographic regions are flouting their obligations by knowingly participating in offerings in which the parties omit disclosure of material information that is required to be disclosed.
Geoff. As always, all excellent points.
Two comments. First, I would say that we need to add the recently published LaPorta et al. (2006) article in the Journal of Finance to the mix in determining whether or not the burden should shift away from those who argue for eliminating mandatory disclosure. LaPorta et al. did a comparative analysis covering 49 countries, and found that more extensive mandatory disclosure requirements were correlated at a statistically significant level with more robust public securities markets. Now there are issues with their approach, but on a prima facia basis it does seem to support the significance of mandatory disclosure regulation. Second, can I get back to you on what’s good about the new executive compensation disclosure requirements? I’ve got a class to teach and a paper I’m working.
A couple of comments.
1. Recall my first disclosure post — I’m not trying to make a comprehensive argument that we should limit required disclosures (although I do think that is an implication of what I say). Im just pointing out that there are real costs, despite the perpetual stream of “at least disclosure isn’t costly” statements.
2. I dont really know why mandatory disclosure is omnipresent, but I certainly take issue with the implication that its mere presence is an indication of its worth. Study after study suggests that SEC-enforced mandatory disclosures were not an improvement over the pre-34 Act regime. The latest comes from Paul Mahoney. Paul’s study disclaims strong conclusions (like, “mandatory disclosure contributes nothing to long-term share value”), and I’m not saying even his study along with, e.g., Benston, Simon, Jarrell and Stigler prove mandatory disclosure rules are a waste. But certainly we may question their value despite their long-standing existence.
3. I, too, would like to know why mandatory disclosure might be beneficial. So far the answers I’ve seen have been unconvincing (as we’ve already discussed), but certainly not absurd. But if it’s taken this long to come up with a few plausible but not wholly convincing stories, hasn’t the burden shifted? Isnt it appropriate now to be asking why this regime should be perpetuated (or extended, as you have suggested) absent some real justificaiton?
4. I wish it were as obvious to others as it is to you that mandatory disclosure causes waste. Look at the SEC’s monster executive compensation proposal. I challenge you to find one iota of evidence that the SEC staff considers even the merest possibility that the rules could be wasteful. I know SEC staff isn’t the model of dispassionate, rigorous analysis, but they are, in fact, the ones making the rules.
I don’t think that the distinction between withholding information to prevent competitive harm and to keep information confidential is really that significant. The withholding of material information that goes on in practice is so much greater than what might be suggested by the limited number of requests to maintain confidentiality made to the SEC. What has become acceptable in practice is to disclose nothing close to an objective materiality standard. Look at the information that sophisticated investors use to evaluate companies and the information public firms actually disclose, and you’ll see a gaping whole. To think that public company disclosures approximate a materiality standard is to live in a fantasy world.
It is not clear to me that historically there has been a comprehensive, general “competitive harm exemption” to the disclosure requirements of the type and extent that the previous post suggests there is. There is, of course, a confidential treatment procedure (and there is a limit on disclosure of material implicating national security under Rule 171).
Let me try a different tack by sharing with you why I got interested in disclosure. At one point, I was a senior executive at a company going public. We worked with the best lawyers to prepare a public filing that complied with all the necessary SEC disclosure requirements. Did these public statements provide investors with too much, too little, or about the right amount of information? In my estimation, we were required to disclose, and chose to disclose, way too little of the information we had about our company. (Did we violate the materiality disclosure requirement? Maybe not, because of the competitive harm exemption, and if we did, so does everybody else.) Was a consequence of this under-disclosure substantially increased agency costs and other inefficiencies? Yes (I’m happy to report).
To point to the current disclosure system and identify ways in which it is over-inclusive and wasteful is easy. To argue that removing some or all required disclosures will reduce waste is obvious. The more interesting questions are, I think: if mandatory disclosure is so inefficient why does it appear to be an integral part of successful capital markets (see LaPorta 2006) and for so long (see Mahoney 1995)? If mandatory disclosure is beneficial, why is this so? And what would an optimal mandatory disclosure regime look like? If you want to reject mandatory disclosure, I think you need to address more than the fact that such a system is always going to be wasteful and inefficient in certain respects.