Navigating the Rules of Finanacial Communication
By Robert D. Ferris
While no doubt significant fallout is still to come, there has nonetheless already been significant experience among companies grappling with the new reporting and certification requirements of the Sarbanes-Oxley Act of 2002.
At the same time, issuers have also had to cope with closer disclosure and corporate governance scrutiny of the Securities and Exchange Commission as well as the New York Stock Exchange and NASDAQ. All of this has come about as a result of various corporate abuses of investors’ trust as well as—let’s face it—the laissez-faire attitudes of boards of directors and the accounting community at large. All of us need a wake-up call now and then, lest we fall into a false sense of security and complacency. We need to be kept on our toes, with our eyes on the ball…doing the job and responding to the responsibilities entrusted to us.
For companies, SOX was that wake-up call—if not an out-and-out alarm clock. That reminder, signaled by SOX, or the new governance requirements of the Self- Regulatory Organizations (SROs) or the disclosure mandates of the SEC, for that matter, tells public companies—those owned by the investing public—to be ethical in their financial and social conduct and to provide full, fair and timely information. In essence, public companies are to be as transparent as practical in providing for an informed body of knowledge among the financial community and the investing public.
The decrees are not a new phenomenon. They represent, in essence, why the Securities and Exchange Commission itself was formed and why the Exchange Acts of 1933 and 1934 were enacted following the great crash of the U.S. stock market in 1929. And while Federal interaction and wake-up calls are undoubtedly needed to impress on people the seriousness of fiduciary responsibility, at the end of the day, you can’t legislate public trust; trust is basically an intangible that the market and corporate issuers have to earn through solid, meaningful corporate ethical standards and tangible, positive financial performance and integrity.
Yet, at the same time, SOX transparency is demanded by strict laws with potentially significant punitive consequences for nonperformance. But woven into every new rule that comes down the pike is the intent, indeed encouragement, for public registrants to comply with the spirit of the law, as opposed to the detailed, confusing and sometimes misinformed interpretations of the letter of the law. Keep in mind that the intent of all such regulations is to provide for an informed investing public and to maintain the public trust.
What generally happens following all these initiatives is an absolute state of confusion, misunderstanding and misdirection. Instead of providing for a better-informed investing public, such new rules have an immediate chilling effect which does warm up, to some extent, over time.
Before that thaw occurs, the new laws ironically tend to result in less communication, thereby reducing the market’s body of knowledge. Issuers (and, with SOX, boards of directors) turn directly to legal counsel for interpretation and marching orders; and frankly, since there often is no precedent for counsel to rest on, the reaction all too often results in constricting communications and transparency, rather than the other way around, (standing the spirit of the initiative, including SOX on its head).
Take, for instance the immediate aversion to one-onone conversations between issuers and institutional investors following the enactment of Regulation Fair Disclosure (Reg. FD). Yes, there was an immediate admonishment of management’s access to the very owners of the enterprise, to the extent that road trips were cancelled and telephone inquiries were answered with e-mails. Of course, in time, this became the exception and not the rule, but nonetheless, it’s a vivid example of overreaction and a clear misunderstanding of intent. And the reaction to SOX to some degree has been overblown as well…fueled by the thirst of lawyers, accountants and asset-management software companies (as well as sections of the act that are more than slightly confusing).
Make no mistake, there are benefits to the increased scrutiny of SOX and other corporate governance initiatives; but at this early stage, it’s hard to see whether the benefits will ever outweigh the cost of compliance (which, for one small-cap client this past year amounted to three cents per share!). Indeed, some naysayers of SOX have called it a regressive tax against small- (and lesser-) cap public businesses. Yes, recent new reforms (and some on the horizon) have no doubt helped to renew investor confidence in corporate financial reporting; and Securities and Exchange Commission chairman, William Donaldson, has said that this will eventually translate into greater credibility in the American capital market and attendant higher stock price multiples. We hope so!
But in response to a groundswell of commentary from business leadership regarding the unintended consequence of more procedures, more manuals and more assessments (internal and external), all resulting in more administrative nightmare, ambiguities and costs of compliance, Chairman Donaldson has responded forthrightly. He has said that the Commission is open to a modification of some regulations, including the controversial Section 404 of SOX, slated to be applicable to smaller U.S. companies and non-U.S. firms (whose stock or ADRs trade in the U.S. market) later this summer.
It’s important to note here that there has been a significant rise in the number of companies that have filed for delisting their shares (either “going dark” or pursuant to going private transactions), and that ADR listings have all but dried up. (We suspect this is so because of the natural aversion of foreign issuers to overregulated and costly markets. And while the SEC has continued to pursue non-compliance and corporate abuses with vigor (as it should), it is most interesting to note that as recent as October of last year, the Commission voted 5 – 0 in favor of beginning a reform process regarding the Securities Act of 1933 (particularly addressing the IPO market).
The Commission is contemplating allowing companies to provide live, online updates to their registration prospectuses, and to grant interviews to the media and otherwise inform potential investors about their new stock offerings (the demise of the so-called “Quiet Period”?). This prospective reform may also include pre-IPO dissemination of management philosophy, revenue predictions and other information as long as the information is kept updated (safe harbor) with the caveat, of course, that the company would be open to legal exposure if the data were inaccurate.
It is expected that a final rule, updating the ’33 Act, will be enacted later this year. Businesses and the financial community and investors are facing a lot of mixed signals from a variety of sources. It is to be hoped that, over time, common sense and the spirit of corporate fiduciary responsibility and public market efficiency will prevail. And the catalyst will be communication—communication transparency, which is in everyone’s best interest.
One of the more cogent statements I’ve heard in quite some time, regarding the issue of corporate governance and disclosure, was made during a symposium entitled “Investors, the Stock Market, and Sarbanes-Oxley’s New Section 404 Requirements”, hosted by Stanford Law School, in January 2005. Nell Minow is editor of the Corporate Library, an independent research firm providing corporate governance data, analysis and risk assessment tools.
Among other perspectives on Section 404 of SOX, Ms. Minow allowed how “the most underutilized asset the corporation has is shareholder communications.” She admonished, “Don’t let the lawyers write the disclosure, and don’t copy from someone else’s paper!” I suggest that this is the spirit of what the SEC has been saying over the years, and why they’ve provided safe harbors for management’s commentary on forward-looking information.
Transparency (not to mention credibility) occurs when management embraces the spirit of the law and makes open and timely disclosures of material happenings, and opines on business opportunity and its strategy for success, thus enabling investors to evaluate material weaknesses and strengths of the issuer and its markets, so that “informed” investment decisions might be made.