In December 2013, the SEC at the direction of Congress under the JOBS Act dutifully provided an initial SEC staff report addressing securities disclosure requirements for public companies to question whether the SEC’s detailed disclosure mandates for public company disclosure might be improved or simplified for the benefit of investors. In late 2014, the SEC’s Division of Corporate Finance sought lawyerly input, and heading into 2015, the SEC is methodically continuing this project, seeking comments and reviewing their own rules internally. Before plodding towards even more disclosure minutia read only by lawyers, we might question, is any of this carefully crafted disclosure at all relevant to what’s taught as important to investors by every leading business school in the country?
In leading business schools, students first learn that securities and investment valuation is determined by projecting future cash flows and profits of a company, then discounting the predictability of those forecasts by their timing and risks of realization, and finally applying a cost of capital to that investment evaluation. Building on basic valuation models, business school students then learn basic financial ratios that measure a company’s past, present and future performance. This fundamental investment research is equally essential for stock investors assessing a company’s earnings growth in future years or debt investors assessing a company’s ability to pay back its debts in future years.
Yet, what is taught as fundamental to business school students in making an investment decision is not taught to securities lawyers through learning detailed disclosure rules and extensive discussions of what’s “material” to investors under our securities laws. Lawyers are taught to studiously disclose detailed historical financial information, following intricate disclosure rules established more than 50 years ago and constantly made more detailed ever since. But focusing on disclosures about the past is only a small part of fundamental financial analyses that looks at the future.
Disclose the forecasts of future cash flows, which is essential to the fundamental analyses taught to business school students? Lawyers learn to advise that forecasts will be an invitation to prolonged, expensive, uncertain securities litigation, no matter if prepared in good faith, no matter how carefully assumptions and risks are spelled out, no matter how many times a company prominently cautions that the future is inherently uncertain, and no matter how many times the SEC, Congress and the courts attempt to reduce the risk of vexatious securities litigation based upon forecasts. The lawyer’s advice to avoid disclosure of forecasts in view of litigation risk is particularly disadvantageous for technology, pharma and emerging growth companies, where the investment thesis is future growth, not small past beginnings.
Disclose and quantify the risks and uncertainties of forecasts to enable investors to discount forecasts of future cash flows, which is essential to the fundamental analyses taught to business school students? Because securities lawyers learn to avoid forecasts, quantifying the timing and risks associated with these forecasts are consistently avoided. Quantifying risk and presenting sensitivity analyses under different risk scenarios is anathema to lawyers who are not comfortable with financial analyses, and fearful of prolonged securities litigation launched years later against those specific or quantified risk disclosures with the benefit of perfect plaintiff hindsight.
Disclose the basic financial ratios that business school students are taught to analyze a company’s prospects and compare them to other investment opportunities? The ratios are not required, and hardly ever permitted by the lawyers, especially any measures based upon forecasts, market data or non-accounting standards for the same uncertain future litigation risks. Disclosure of the financial ratios taught as essential to business school students are discouraged by the securities lawyers. And the one financial ratio required by the SEC with debt offerings, a very basic “fixed change coverage ratio” formulated in simpler times more than 50 years ago, is now being cited as a requirement that will probably be eliminated by the SEC.
Disclosing a cost of capital to assess a company’s return or investment? Because a cost of capital analyses taught in business school involves quantifying a company’s future and targeted financial hurdles and returns, risks and mixes of capital, again, in essence, projections, the securities lawyers learn never to disclose cost of capital analyses.
For lawyers, they learn to focus exclusively on reducing securities litigation risk, and in doing so, the securities lawyers learn to deny the information taught to business school students as fundamental for financial and investment decisions. This places individual investors, even if educated by the great business schools, at a tremendous disadvantage to large, staffed institutional investors, who have the resources to independently develop the fundamental analyses of investment opportunities that the business schools teach is essential but the lawyers learn not to provide to investors. Or this points investors towards hiring and paying expensive financial advisors to independently develop financial analyses that they are taught in business school they need, but do not receive from a company. There is a large disconnect between what financial investors know is important and what lawyers think is important to them. At all of the great universities with business schools and law schools next door, the walls are maybe so thick that their own ways of thinking about what’s important to investors simply echo within their own walls and are not discussed through or over those walls.
So none of the fundamental information taught by business schools as essential to investment and financial analyses for investors is required or effectively enabled by the securities law. Yet, while avoiding the information that is relevant for the financial teaching to investors, lawyers then overcompensate with lengthy risk factors. In Facebook’s celebrated IPO, Facebook’s prospectus led off with about 50 risk factors explaining to investors why they would be foolish to invest in Facebook, covering the initial 22 pages of the Facebook prospectus. Amplifying the distance of these lengthy risk factors from the fundamental analyses taught by the business schools, lawyers learn not to quantify the risks. And SEC legal staff, in reviewing prospectuses, discourage any disclosures by a company as to how the company might manage or mitigate the identified risks, as their view as lawyers is that such explanation and context reduces the bite of the dire legal risk disclosures. So after spilling every conceivable risk in front of investors, the basic tools for fundamental financial analyses taught to business school students is not provided to enable them to weigh, analyze and manage these risks.
If securities offerings so carefully drafted by lawyers are so heavily moored by securities litigation risk and do not provide investors with what’s important from the teachings in business school, then what is provided by the lawyers? Words, plenty of words. Facebook’s IPO prospectus had about 101,000 words, rivaling Dickens historical epic, a Tale of Two Cities (138,000 words). An investor who ploughed through Facebook’s IPO prospectus, and Facebook’s annual and quarterly reports and proxy statement for one year would be weighed down by close to 400,000 words, exceeding and indeed almost doubling Melville’s turgid masterpiece, Moby Dick (206,000 words). The great novels are carefully read over a full semester in great literature classes. Investors don’t have a full semester with so many words, especially words that don’t speak to what they are taught in business school is important to them as investors and financial analyses. Can reading securities filings, possibly as turgid as Moby Dick really be helpful to investors, especially average retail investors?
The preceding post comes to us from Jim Carlson, who is an adjunct professor teaching securities and capital market regulation at the New York University School of Law and is also an adjunct professor at New York University Leonard N. Stern School of Business.