Cutting Disclosure Frequency Is the Wrong Solution to the Wrong Problem

President Trump has directed the Securities and Exchange Commission to study whether a public company’s reporting requirements should shift from a quarterly to semi-annual schedule.  Doing so, according to the president, “would make business (jobs) even better in the U.S.” and “allow greater flexibility & save money.”

The president’s views fit within the larger debate over whether public companies focus too much on short-term results.  There can be little harm (or dissension) in studying the current reporting require­ments.  In fact, this may be one of those rare cases when Democrats and Republicans agree.[1]  Nevertheless, specifically directing the SEC to consider whether reporting should be semi-annual, rather than quarterly, looks at the wrong problem in the wrong way.

As some have argued, quarterly reporting may cause senior managers to focus primarily on short-term performance at the expense of long-term value—to defer making investments that raise short-term costs, or to recognize revenues that artificially boost short-term profits.[2]  Frequent reporting may induce managers to take actions that are more likely to produce quick (and positive) bottom-line results,[3] imposing significant costs by distorting management’s investment decisions.  Consequently, proponents for change argue that lower­ing the frequency—even by as little as three or six months[4]—will permit managers to select projects that are more likely to create greater value over time.[5]  Similar arguments have been made around the world, result­ing, for example, in the European Union and Great Britain moving away from quarterly reporting.

But the concern over short-termism is somewhat perplexing.  Underlying the concern is the presumption that pricing pressure from the capital market causes short-term myopia.  Share­holders use quarterly reports to assess the health and risks of their investments.  At the same time, the argument goes, impatient investors expect immediate results, and so managers are pressured to adopt short-term strategies in lieu of long-term value, failing which investors will sell their stock and cause a drop in price.  But, in that case, the next generation of investors, equally impatient, must decide what it will pay.  In doing so, the second generation will consider the price at which it can resell its shares—in other words, the second generation will price the shares based on what they expect the third generation to pay for them.  This relationship continues down the chain of investors, so that the price the first generation receives is tied to the long-term value of the shares to later generations.  Consequently, rather than inducing short-termism, the pressure from the capital market should promote long-term value.  Even though the firm’s share­holders may all be short-term investors, the managers have an incentive to adopt—and, through periodic disclosures, to be seen as adopting—long-term, positive-value projects.

This presumes, however, that the capital market is fully informed of the managers’ actions.  Typically, that is not the case.  As one CFO described, “‘[I]f you see one cockroach, you imme­diately assume that there are hundreds behind the walls, even though you may have no proof that this is the case.’”[6]  Since investors are not fully informed about how a company is managed, a short-term decline in profits may raise concerns—even if the decline is due to expen­ditures that will increase long-term value.  Managers, therefore, have an incentive to head off those concerns, which may induce a greater (and more inefficient) focus on short-term performance.  In other words, the problems with short-termism may not be due to greater or more frequent disclosure, but instead may result from less information being publicly available.

From that perspective, the better approach may be to increase disclosure rather than delay it.  The more information there is in the public markets, the greater the market discipline and the less likely a company will be penalized for pursuing long-term value.  But doing so—even if it addresses short-termism—may be costly and impractical.  For example, requiring greater disclo­sure is likely to be difficult and expensive to compile,[7] it could result in sensitive information being disclosed to competitors, and depending on quantity, it may be difficult for the market to digest and assess.[8]

Likewise, extending the reporting schedule from three to six months may be ineffective.  Delaying disclosure may not affect company managers if pension fund and other investors’ performance continues to be assessed quarterly.[9]  The trending decline in stock holding periods may also increase the pressure on managers to perform in the short-term.  Additionally, an overall drop in CEO tenures may favor a focus on short-term results—with executives looking to bump-up today’s performance, rather than wait to benefit tomorrow’s managers.  Finally, activist hedge funds may pressure company management to perform well in the short-term, even if long-term value suffers.

What this suggests is that concerns over short-termism are likely to arise when there are information shortfalls, and so cutting back on the level or frequency of disclosure is unlikely to help.  In addition, changing when companies report, from three to six months, may not have any appreciable effect on managers’ conduct in light of other influences that favor short-term behavior.  The frequency of company reports, therefore, is unlikely to be the problem, and changing the reporting schedule is unlikely to be the solution.

In fact, what is more likely driving President Trump’s concern may not be the SEC’s requirements at all.  Rather, the concern may be with a corporate practice—not required by SEC regulation—of providing quarterly earnings guidance.  Earnings guidance is a company’s predic­tion of its own profit or loss—a performance benchmark—stated as an amount of earnings per share.  A failure to meet short-term earnings estimates can be devastating, in part because those estimates were issued by the company.  In other words, due to the information gap between investors and companies, earnings guidance may take on a talismanic significance that would be less likely if investors could more directly assess a company’s performance on their own.  For investors, a failure to meet earnings may indicate that the company’s managers are ineffective, it may suggest an unexpected slowdown in operations, or it may indicate that the company’s reserves are so depleted that it has no choice but to miss its earnings guidance.  The result, in any case, may be excessive demands on management’s time—both in preparing the guidance and ensuring the company meets it, as well as addressing any shortfall if it later occurs.  Consequently, “[c]ompanies frequently hold back on techno­logy spending, hiring, and research and development to meet quarterly earnings forecasts that may be affected by factors outside the company’s control, such as commodity-price fluctuations, stock-market volatility and even the weather.”[10]

Here, there may be a valuable role for the SEC.  Regulation or other guidance that limits or restricts the issuance of quarterly earnings may permit public companies to move away in unison from earnings guidance.  No one company needs to be singled out.  In that case, even though market participants may create their own benchmarks,[11] the effect of those benchmarks on public company managers is likely to be less significant than if they failed to meet their own earnings guidance.[12]  Perhaps, more than reporting frequency, this should be a principal focus of the SEC’s study.

ENDNOTES

[1] See President Obama & Marilynne Robinson:  A Conversation—II, N.Y. Rev. Books, Nov. 19, 2015, available at https;//www.nybooks.com/articles/2015/11/19/president-obama-marilynne-robinson-conversation-2/ (quoting President Obama, “And because [businesspeople have] got quarterly reports to shareholders and if they’ve made a long-term investment that may pay off way down the line, . . . , a lot of times they feel like they’re going to get punished in the stock market.  And so they don’t do it, because the definition of being a successful business is narrowed to what your quarterly earnings reports are . . . .”).

[2] See, e.g., John R. Graham et al., The Economic Implications of Corporate Financial Reporting, 40 J. Acct’g & Econ. 3, 5, 32-35 (noting that 78 percent of surveyed executives would give up economic value in exchange for smooth earnings and 80 percent of surveyed participants would decrease discretionary spending on R&D, advertising, and maintenance in order to meet an earnings target).

[3] One of the most prominent ways of doing this is through share buybacks—decreasing the number of outstanding shares in order to inflate a company’s earnings per share results.  See Heitor Almeida et al., The Real Effects of Share Repurchases, 119 J. Fin. Econ. 168, 169 (2016) (finding that companies that would just miss their earnings per share forecasts by a few cents, absent a share repurchase, are significantly more likely to repurchase shares than companies that beat their earnings per share forecasts by a few cents).

[4] See Arthur G. Kraft et al., Frequent Financial Reporting and Managerial Myopia, 93 Acct’g Rev. 249, 250 (2018) (using data from 1950-1970, when U.S. firms transitioned from annual to semi-annual and then to quarterly reporting, finding that firms significantly reduced investments following an increase in reporting frequency).

[5] See, e.g., Frank Gigler et al., How Frequent Financial Reporting Can Cause Managerial Short-Termism:  An Analysis of the Costs and Benefits of Increasing Reporting Frequency, 52 J. Acct’g Res. 357, 361 (2014).

[6] Graham et al., supra note 2, at 29.

[7] Changes in technology, such as the use of blockchain to facilitate transparent disclosures, may lower this cost over time.

[8] There may be merit to studying whether the content of what is currently disclosed is useful to market participants.  No doubt, some parts—such as condensed financial statements and management’s discussion and analysis of the company’s financial condition—are likely to be valuable.  Other disclosures—such as market risk, legal proceedings, and unregistered sales of equity securities—may be less valuable.  In that case, some of the current disclosures can be omitted or streamlined so that only information market participants find to be most useful is required to be disclosed.

[9] See, e.g., Council of Institutional Investors, Press Release, Leading Investor Group Responds to President’s Tweet on Quarterly Financial Reporting, Aug. 17, 2018, at https://www.dandodiary.com/2018/08/articles/corporate-governance/time-end-quarterly-reporting/ (noting that the Council of Institutional Investors favors continued quarterly reporting).

[10] Jamie Dimon & Warren E. Buffett, Short-Termism Is Harming the Economy, Wall St. J. (June 6, 2018), available at https://ca.finance.yahoo.com/news/short-termism-harming-economy-020000606.html.

[11] Large investors often conduct their own earnings forecasts or employ researchers to assess a company’s earnings quality.

[12] Of course, not issuing guidance can also have real costs.  Recall what happened with Google.  Google declined to issue earnings guidance, and saw a sharp drop in stock price when its fourth-quarter results fell short of market expectations.  Had Google issued guidance, it might have been able to manage market expectations more easily.

This post comes to us from Charles K. Whitehead, the Myron C. Taylor Alumni Professor of Business Law at Cornell Law School.

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