The Role of Corporate Boards in Disclosure Policy and Enforcement

Managers have strong incentives to present a favorable image of their companies to investors, analysts, and the public, raising concerns about the credibility of voluntary disclosures. These concerns are particularly severe for unaudited forward-looking disclosures because they are often qualitative and difficult to verify. Clearly, the SEC is aware of this issue and holds corporate boards responsible for implementing effective disclosure controls. For example, in a recent highly publicized case involving Tesla, the SEC complained that “…Tesla had no disclosure controls or procedures in place to determine whether Musk’s tweets contained information required to be disclosed in Tesla’s SEC filings. Nor did it have sufficient processes in place to that Musk’s tweets were accurate or complete.”

Though the role of corporate boards in regulating financial reporting is well recognized, their oversight role with respect to qualitative voluntary disclosures is largely unexplored. In a new paper, we present a normative theoretical analysis of a firm’s disclosures when the board of directors sets and enforces its disclosure policy. We consider a model in which the board (i) has the authority to establish a disclosure policy governing unaudited disclosures (a policy role), (ii) has oversight responsibilities for compliance with the disclosure policy (a control role), and (iii) must contend with CEO over-reporting. These aspects of the model capture the notion that the board can set the tone at the top, establish codes of conduct, shape the firm’s disclosure culture, articulate expectations related to disclosures, and ensure compliance by asking the right questions, demanding information, and being vigilant.

This disclosure role is not typically attributed to the board. Nonetheless, boards can influence corporate disclosures, and our model captures that influence. The literature on board interlocks, for example, has established that firms that share directors are more likely to adopt the same disclosure policies, provide more accurate management forecasts, manage earnings, and implement tax avoidance strategies. Moreover, the board’s disclosure policy and control roles we focus on are similar in spirit to the role attributed to corporate governance in regard to financial reporting quality. We appeal in particular to models in the contracting literature that examine the principal’s (i.e., the board’s) choice of optimal performance evaluation and reporting systems.

We study a  model in which a firm operates in a competitive product market and faces an internal agency problem. The firm has proprietary information that the market and the competition are not privy to. This information could be about demand in a new market (e.g., a new geographical location) or a new product (e.g., a new weight-loss drug). Intuition suggests that disclosing such information would not be in current shareholders’ best interests because it will enable competition. However, not disclosing this information can potentially hurt the stock’s liquidity and increase bid-ask spreads.  Other stakeholders such as suppliers and potential customers can also benefit from disclosure transparency. We view the board’s role as putting in place and overseeing the firm’s disclosure policy that considers the trade-offs posed by product market competition and the demand for transparency.

We assume that a firm makes a qualitative disclosure about the conditions of demand, describing it as “strong” or “weak,” implying that the demand is in a certain range (e.g., demand is “strong” when it is between $15 and $20 billion, and demand is “weak” when it is between $5 and $15 billion). While such disclosures cannot be verified, they are to a degree vetted against the firm’s disclosure policy before being made public. The board establishes the firm’s disclosure policy at the outset and oversees compliance with the policy. The firm and a competitor make production decisions after the disclosure is made (Cournot competition). Our objective is to characterize the nature of the disclosure policy the board sets to manage how information about demand (based on the manager’s private information) is disclosed publicly – the board itself is not privy to the manager’s information.

We show that when we consider the aforementioned trade-off posed by product market competition and the demand for transparency, the optimal disclosure policy will not lead to the most informative disclosures. More importantly, we show that the board will sacrifice some transparency and implement a pessimistic disclosure policy that errs toward understating true demand conditions. Introducing managerial over-reporting into the mix has significant implications for this optimal disclosure policy. Interestingly, we find that even when the board can preclude such over-reporting by strictly enforcing its disclosure policy, it turns a blind eye by being lax in enforcement.

Our results underscore the board’s role in instituting disclosure policies that regulate what is disclosed and how it is disclosed. Despite the SEC’s insistence on adequate disclosure controls to allay credibility concerns, it cannot expect a well-intentioned board to emphasize transparency at the cost of ceding its competitive advantage in product markets. Litigation and reputation considerations can also promote transparency, but they are arguably less effective in disciplining qualitative disclosures (due to lack of verifiability).

This post comes to us from George Drymiotes at Texas Christian University, Zijun Liu at Rice University’s Jesse H. Jones Graduate School of Business, and Shiva Sivaramakrishnan at Rice University. It is based on their recent article, “Disclosure Policy and Enforcement: The Role of Corporate Boards,” available here.

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