Saturday, May 2, 2020

Imperfect efficiency

Much of the SEC’s disclosure regime is predicated on the idea of market efficiency: it’s not necessary that companies constantly repeat publicly available information, because that information is already known to, and absorbed by, market participants.  The problem is, even the SEC is never quite sure how far to run with this. 

Case in point: the SEC’s proposal to eliminate Item 303(a)(5), which requires that registrants provide a tabular disclosure of contractual obligations.  As the SEC explains, “We do not believe that eliminating the requirement would result in a loss of material information to investors given the overlap with information required in the financial statements and our proposed expansion of the capital resources requirement, discussed above in Section II.C.2.   As many commenters pointed out, much of the information presented in response to this requirement overlaps with U.S. GAAP and is therefore included in the notes to the financial statements…”

 Both the SEC’s Investor-As-Owner subcommittee, and the Council of Institutional Investors, have objected to the proposal.  For example, the Investor-As-Owner Subcommittee says:

Investors and analysts, however, have informed the subcommittee that the information in the current tabular format is useful and material.  While much of the information can be derived from other places in a Form 10K, it is more complete and substantially less costly and less time-consuming for analysts to gather and analyze, and for investors to use, in its current presentation.  It is not apparent to us that the cost savings from the company side from the proposed change would be greater than the increased costs that dispersed analysts and investors would have to bear from having to gather the information themselves. 

Its potential materiality can be illustrated with a recent analyst report on the cruise line industry, which has been hit particularly hard by the coronavirus.  The report relied on the tabular presentation of contract obligations to compare and contrast cruise lines’ exposures to a mismatch between revenue shortfalls and their near-term obligations.  While a similar analysis could have been done by relying on information in financial footnotes, the substitute analysis would have been less complete and taken longer to execute.  In the current environment, less timely disclosure of this analysis would have been less useful to investors. 

CII says:

Investors find these tabular presentations to be extremely useful, as they compile information that is often scattered throughout the filing into one central location.  For example, in periods in which a company’s liquidity becomes of concern to investors, such as at the present moment, it is useful for investors to be able to turn to a particular section of the filing and readily see what a company’s future contractual obligations are, without having to hunt for each piece of information throughout the filing…

This is also, by the way, an ongoing issue with respect to non-GAAP financial metrics – as long as the GAAP numbers are there, what does it matter if the company releases non-GAAP financials as well?  And yet it does matter, which is why Congress and the SEC regulate non-GAAP disclosures

 I’ll note that even as both Congress and the SEC demonstrate some ambivalence about market perfection – not only through non-GAAP regulation, by the way, but also via “crash” damages in the PSLRA context and proposed diversity disclosures - (some) courts continue to assume market perfection and make that the basis of their analysis of securities fraud lawsuits.

Leaving all of that aside, however, one of the more interesting observations is CII’s point that:

We would also note that the preparation of the contractual obligations table is a useful management exercise as it summarizes the obligations in one location and provides management with a picture of such obligations.  We know that what gets measured and disclosed is what gets monitored by management. This is another reason to include the table and enhance as we describe elsewhere herein.  

In other words, it’s not just about whether investors can glean and absorb types of information; the disclosure structure imposed by the SEC dictates board priorities and therefore indirectly polices corporate governance.  This is not a new idea – commenters have long made similar observations – but CII is right that to the extent the SEC is attempting to move to a principles-based disclosure system, it is perhaps not fully recognizing the real governance tradeoffs that accompany more exacting disclosure requirements.

Ann Lipton | Permalink


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