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NORTHWESTERN UNIVERSITY SCHOOL OF LAW

LAW AND ECONOMICS SERIES • NO. 10-07

A Call to Reform
US Disclosure-Based Regulation

Simon C. Y. Wong
Northwestern University School of Law

Electronic copy available at: http://ssrn.com/abstract=1556542


A CALL TO REFORM US DISCLOSURE-BASED REGULATION
KEY POINTS
 The US approach to regulating the securities markets is underpinned by disclosure, Feature
and US policymakers have tended to respond to corporate and systemic crises by
strengthening disclosure requirements.
 US disclosure-based regulation, however, suffers from two critical failings. First, it lacks
coherence in that shareholder rights are presently too weak to compensate for the hands-
off regulatory approach. Second, disclosure has been deployed excessively as a regulatory
tool, resulting in inundation of information and other unintended outcomes.
 To remedy these deficiencies, US policymakers should strengthen shareholder rights
– perhaps by emulating the UK model – so that US investors will truly be able to hold
boards and management accountable.
 In addition, regulators should periodically review the continuing relevance of existing
areas of disclosure and consider requiring companies to prioritise discussions. US
policymakers could bolster the Securities and Exchange Commission’s (‘SEC’) authority
to impose substantive regulation so that it would be less reliant on disclosure to regulate
problematic conduct. Author Simon C Y Wong

A call to reform US disclosure-based


regulation
Disclosure lies at the heart of the US This article discusses the principal deficiencies of the disclosure-based approach
approach to regulating the securities to regulating the US securities markets and proposes remedial measures for
markets. A prominent law professor once consideration by US policymakers and regulators.
remarked that the core characteristic of
US securities laws is ‘disclosure, again
disclosure, and still more disclosure’. from two significant failings. First, it lacks or litigation – to ensure that boards are
Fearing excessive government intervention coherence in that shareholder rights are accountable. Despite recent changes, the
and believing that investors are able to protect presently too weak to compensate for the majority of American companies still elect
their own interests if relevant information is hands-off regulatory approach. Second, directors through plurality voting, where a single
made available to them, American policymakers disclosure has been deployed excessively as a ‘for’ vote is sufficient to get a candidate on the
have tended to react to corporate scandals and regulatory tool, resulting in inundation and board because ‘withhold’ votes are not counted.
systemic failures by strengthening disclosure poor quality of information as well as other A 2008 study by research firm The Corporate
requirements. In the aftermath of the Enron unintended outcomes. Moreover, disclosure Library showed that while a majority of S&P
and WorldCom scandals nearly a decade ago, has been ineffectively used to address issues 500 firms have adopted majority voting, only
the US Congress passed the Sarbanes-Oxley that are better tackled through substantive a minority of Russell 1000 and Russell 3000
Act (‘SOX’) to require disclosure of, inter alia, regulation. companies have followed suit.
the effectiveness of internal controls, codes of Disclosure-based regimes rely on investors Once they are on the board, it is extremely
ethics, insider share transactions, and financial – through influencing a company’s stock difficult for shareholders – due to their
expertise on the audit committee while the price or intervening on such matters as board inability under company bylaws to requisition
US Securities and Exchange Commission structure and executive pay – to impose a shareholders meeting, the requirement that
(‘SEC’) demanded more extensive disclosure discipline on boards and management. directors can only be terminated ‘for cause’,
of off-balance sheet arrangements and When a European investor asked recently and multiple-year board terms – to remove
executive compensation, expanded the list of if the SEC would ever impose a rule underperforming directors. At a US petroleum
items subjected to immediate disclosure, and requiring the separation of chairman and company, for instance, a shareholders meeting
accelerated filing deadlines. In response to CEO roles, a senior official responded that can be convened only by the board or company
the global financial crisis, the SEC adopted the Commission’s philosophy is to compel president and directors can be removed only by
new rules last December enhancing disclosure companies to furnish information on other board members and only for cause.
of risk oversight by the board of directors, matters that are critical to investors – such Furthermore, due in part to inadequate SEC
executive remuneration, and conflicts of interest as corporate strategy, financial performance, clarification, Regulation Fair Disclosure (‘FD’) is
of compensation consultants. board structure, and conflicts of interest widely perceived as preventing shareholders from
– and then leave it to shareholders to take the engaging in meaningful one-on-one dialogue
PRINCIPAL DEFICIENCIES OF US necessary actions to hold boards accountable. with boards of investee companies on corporate
DISCLOSURE-BASED REGULATION However, endowed with a weak set of governance and other matters.
Although US disclosure-based regulation shareholder rights, investors in US companies Some commentators support limited
has been emulated by a number of countries currently have limited means – apart from rights for shareholders on the grounds that
and continues to be well regarded, it suffers expensive and time-consuming proxy fights the US features an active market for corporate

Butterworths Journal of International Banking and Financial Law February 2010 77


Electronic copy available at: http://ssrn.com/abstract=1556542
A CALL TO REFORM US DISCLOSURE-BASED REGULATION

Feature

control and the depth and liquidity of its harmful if investors end up unable to identify from a general narrative discussion to
securities markets enable shareholders to sell the most pertinent facts. SEC Commissioner a more detailed, tabular disclosure on
their investments easily and generally at a Troy Paredes observed recently that different components of remuneration with
fair value. Adherents of this view maintain ‘investors today are inundated with volumes the objective of facilitating comparability
that market mechanisms such as stock price of information and, as a result, they get across firms. Although greater information
impose sufficient discipline on boards and overwhelmed or distracted, misplacing their on executive remuneration was intended
management because a company would be focus on less important matters.’ Others, principally for use by shareholders, it also
vulnerable to a hostile takeover or proxy fight meanwhile, have asserted that the quantity enabled executives to compare themselves
if its share price declines significantly. These and complexity of financial data sowed against peers. According to a veteran
threats, however, are suboptimal because they confusion and enabled critical information compensation consultant, ‘Many executives
typically arise after considerable value has pointing to a dangerous build-up of risk at want to be the top dog and, if someone gets a
been destroyed. Even then, poison pills and financial institutions to remain undetected by certain amount, then he wants to get the same,
other devices often constrain shareholders shareholders, boards and regulators. if not more. It is about equity and fairness.’
from holding boards to account. Poor quality of disclosure is also a Whereas the typical US chief executive made
Moreover, for the growing proportion of perennial problem. Regulatory filings, such 71 times more than the average worker in
investors that – due to the comparatively high as the annual report on Form 10-K, are 1989, this ratio surged to 275 in 2007.
management fees and underperformance of typically quite lengthy and dense. Littered Then there is quarterly reporting of
active funds – have moved to passive, index- with legalese, industry jargon, and boilerplate, financial results, which has led to excessive
based investment strategies, exiting individual they appear to be designed principally to aid a short-termism as management obsesses over
stocks is not a feasible option. Witness the company in the event of litigation rather than meeting quarterly earnings forecasts because
growing popularity of passively managed to improve the comprehension of investors. falling short of ‘consensus estimates’ could
exchange traded funds, which had nominal At Enron, for example, it has been argued hammer share price and discredit them.
amounts under management a decade ago but that the activities that contributed to its According to a recent academic survey, 55
nearly US$1trn today. demise were in fact disclosed by the company per cent of the 400 US chief financial officers
With disclosure as its primary regulatory but largely escaped notice by investors and polled indicated they were willing to delay
tool, the SEC has steadily expanded the scope other analysts because they were buried in investments in projects to meet short-term
and detail of disclosure requirements. This lengthy, ‘ jargon-filled’ regulatory filings. In its earnings expectations, even when it meant
has contributed to inundation of information, examination of management’s discussion and sacrificing long-term value creation.
poor quality of disclosure, and other perverse analysis (‘MD&A’) disclosures by Fortune Out of fear of stifling innovation and the
consequences. Notwithstanding materiality 500 companies, the SEC found that 90 per belief that the private sector can police itself
thresholds, annual reports and related cent of the language remained unchanged over effectively, US policymakers have also opted
disclosures have continued to lengthen a three-year period. Similarly, discussions in to address many important but complicated
(reaching several hundred pages for some annual reports and other documents about issues – such as conflicts of interest among
firms), resulting in ample data but perhaps less a company’s key risks are often quite long intermediaries – through disclosure rather
useful information. Furthermore, as a result but generic, with little variance between than substantive regulation. The SEC, for
of SOX and other reforms, items requiring the company and its peers. For instance, instance, issued regulations last December
prompt disclosure – such as the departure of a the 2004 IPO prospectus of a well-known to require companies to disclose fees paid to
director, waiver of a code of ethics, entry into high-technology company devoted 22 pages to compensation consultants that advise the board
material agreements, and matters relating to discussing risk factors, noting such banalities on executive remuneration while concurrently
Regulation FD – have expanded appreciably as the risk that current executives may depart serving management on other matters.
over the past decade. According to one study, the company, operating results may fluctuate, While the disclosure of conflicts alerts
‘real-time’ disclosures on Form 8-K by US and the company may fail to keep up with investors to potential impairments of
companies increased 500 per cent between technological developments. objectivity, it does not specify the degree to
2000 and 2004. In certain situations, expansion of which quality has been compromised. For
It is questionable whether investors disclosure requirements has brought about example, publication by a company of audit
are able to digest fully the vast amounts harmful repercussions. For instance, the and non-audit fees paid to an external auditor
of information that is available today. reforms enacted by the SEC in 1992 on is of limited use to investors because that
Behavioural research shows that people face individualised executive compensation information does not reveal which aspects
real cognitive limits regarding how much new disclosure are widely perceived to have of an audit should be treated with suspicion.
and complex information they can absorb and contributed to ratcheting executive pay at Given the severity of some conflicts – such
use. Given this, more information may not American companies in recent decades. as remuneration consultants serving the
improve investment decisions and could prove The changes introduced shifted reporting board and management contemporaneously

78 February 2010 Butterworths Journal of International Banking and Financial Law

Electronic copy available at: http://ssrn.com/abstract=1556542


A CALL TO REFORM US DISCLOSURE-BASED REGULATION
Feature
Biog box
Simon CY Wong is a partner at London-based investment firm Governance for Owners,
Adjunct Professor of Law at Northwestern University School of Law, and an independent
advisor. Earlier in his career, Simon was a US securities lawyer at Shearman & Sterling
and Linklaters. The opinions expressed in this article reflect the personal views of the
author only. Email: simon.wong@law.northwestern.edu

– disclosure may not be a sufficient remedy and Governance – recognising that large including by eliminating those that have
substantive regulation may also be required. investors typically have stronger incentives become less pertinent. Other possibilities
to monitor management – encourage regular include compelling companies to prioritise
POTENTIAL REFORM MEASURES interactions between a company’s board and disclosures by tiers, provide summaries, and
How then to improve the functioning of the its largest shareholders to discuss significant limit the length of discussion.
US disclosure-based regulatory system? In strategic and governance developments. Additionally, US policymakers could
terms of potential policy reforms, perhaps The regulatory framework also provides an bolster the SEC’s authority to impose
the most important is to strengthen environment that is conducive to informal substantive regulation – including on
shareholder rights so that investors will truly and candid discussions between these two corporate governance matters – so that
be able to hold boards and management parties. Participating investors, of course, it would be less reliant on disclosure to
accountable. From a broader framework are prohibited from trading on any material, regulate problematic conduct. Historically,
perspective, enhancing shareholder rights non-public information received. because the authority of the SEC to employ
will help to compensate for the hands-off Recent developments indicate a greater regulatory tools other than disclosure has
regulatory approach and strengthen the urgency to strengthen shareholder rights in been in dispute, litigation often ensued
coherence of disclosure-based regulation as the US. As discussed above, passive, index- each time the SEC sought to introduce
a whole. based investing has grown significantly over substantive regulation. In 1990, for instance,
To determine the specific rights that the past decade and these investors do not a federal appellate court struck down the
would be most critical to US investors, it may have the option of selling individual stocks SEC’s attempt to institute a one-share, one-
be instructive for US policymakers to examine when they are dissatisfied with a company’s vote rule, reasoning that it was a substantive
the UK model as the two countries share performance or corporate governance corporate law matter that fell outside the
a common legal tradition and their listed arrangements. Furthermore, the US appears SEC’s mandate of regulating disclosure.
companies typically feature dispersed share to be gradually embracing the UK’s ‘comply To reduce the potential for perverse
ownership. In Britain, director candidates or explain’ disclosure model. Under this outcomes, policymakers should examine
must receive a simple majority of votes cast system, a company failing to comply with – including through cross-border analysis –
to be elected. Equally important, when a substantive provision of the Combined how proposed disclosures would impact the
shareholders with aggregate holdings of 5 per Code – for instance, that at least half of the behaviour of affected parties. As discussed
cent or more nominate a director for election board should comprise independent directors above, quarterly reporting of financial results
to the board at an annual general meeting, the – must explain why it does not. Possessing has led to company management placing an
company must, at its own expense, circulate a strong arsenal of rights, shareholders in inordinate focus on short-term performance
to all shareholders information relating to the British companies are in a position to credibly while detailed disclosure of compensation
director candidate. By contrast, at present US monitor and enforce adherence to the Code. packages has magnified the importance of
shareholders must separately – and at their In the US, SOX similarly requires public pay and contributed to executives demanding
own expense – distribute to other shareholders companies to disclose whether they have ever-higher remuneration. Concerned about
materials relating to their board nominees. adopted a code of ethics and whether there inadvertently encouraging short-termism
To prevent entrenchment, UK is a ‘financial expert’ on the audit committee and informed by the experience in the US,
shareholders with a 5 per cent stake can – if not, companies must explain why. In the European Commission decided several
requisition a shareholders meeting at December 2009, the SEC introduced new years ago to scale back the information that
any time to remove incumbent directors, regulations to require companies to disclose companies must furnish quarterly.
irrespective of the length of time remaining whether they have combined the chairman
on their current terms. At the same time, and CEO roles and, if so, whether they CONCLUSION
British companies are not allowed to employ have appointed a lead independent director. Ultimately, the US disclosure-based
poison pills to repel unwanted suitors. Recently, the NASDAQ stock market regulatory approach was not effective in
US policymakers should also ensure conducted a public consultation on whether it identifying the pressures that coalesced
that existing regulations – particularly should adopt a ‘comply or disclose’ approach on to produce the market turmoil of the past
Regulation FD – do not impede investors a variety of corporate governance topics, such two years – much less in averting them.
from legitimately engaging with boards. as the separation of chairman and CEO roles As policymakers continue contemplating
Potential steps in this area include and limits on outside board appointments. measures to strengthen the US financial
clarifying the scope of Regulation FD To stem information overload, regulators system, they should give serious
or creating a specific safe harbour to should be required to periodically review consideration to reforming the existing
permit and facilitate one-on-one dialogue the continuing relevance of existing areas disclosure-based approach so that the US
between boards and shareholders. In the of disclosure and to prioritise disclosure regulatory regime will be more robust and fit
UK, the Combined Code on Corporate topics when they propose new requirements, for purpose in the future. 

Butterworths Journal of International Banking and Financial Law February 2010 79