The system of disclosure for public companies no longer meets the needs of investors and other stakeholders. Largely put in place by the Securities and Exchange Commission in 1982, the principles underlying the system have failed to keep pace with shifts in the market and dramatic changes in technology. The system requires a paradigm shift and fundamental alterations in the principles underlying the approach to disclosure.
The Current State of State of Disclosure
This is not the first time the system of disclosure has needed an overhaul. Congress gave the SEC the authority to regulate disclosure in public offerings in the Securities Act of 1933 and periodic reports in the Securities Exchange Act of 1934. The Commission constructed a system of disclosure that emphasized public offerings and provided only modest attention to the periodic reporting process.
In 1966, Milton Cohen, a former SEC staffer, launched a broadside at the SEC’s approach. In his seminal work, “Truth in Securities Revisited,” he criticized the disclosure regime as more a product of path dependency than deliberate design and for not keeping pace with changes in the market. Cohen argued for a systematic shift that placed greater emphasis on periodic reports than registration statements and integrated more fully the two disclosure regimes.
Cohen’s primary insight was that the SEC’s disclosure regime had ceased to meet the needs of investors by failing to evolve with changes in markets. In the aftermath of the article, the SEC rebuilt the disclosure regime along Cohen’s suggested lines, codifying the approach with the adoption of an integrated disclosure system in 1982 (“1982 System”).
In engineering the paradigm shift, the Commission placed materiality at the center of the system. Whether discussing a company’s business operations, physical assets, or legal proceedings, disclosure was mostly required only if important to a reasonable investor. The emphasis on materiality, however, came with limits. Principles-based materiality was to be company specific and a matter of judgment. Managers were expected to “evaluate the significance of the information” and “tailor” the disclosure to fit their unique operations and circumstances.
Fundamental Shifts
The principles underlying the 1982 System have largely remained in place despite dramatic shifts in market structure and technology. This has opened a growing chasm between what the SEC requires and what investors need. To align the disclosure regime with the interests of the market, at least three fundamental changes need to occur.
First, the disclosure regime must embrace and integrate the markets’ need for comparative information. The tailored approach to materiality essentially treats investment decisions as binary, a significant limitation in an era of portfolio theory and comparative analysis. Comparative information can provide improved insights into the company making the disclosure, reduce instances for opportunistic disclosure, and facilitate cross-company analysis.
Second, the disclosure regime must recognize the needs of investors who rely on passive investment strategies. Integrated disclosure was adopted when individual investors predominated and dissatisfaction with management was often expressed through the “Wall Street Walk.” Institutional investors now dominate, with “buy and hold” increasingly replacing “buy and sell” as the most prevalent investment strategy.
For buy and hold investors, engagement with management represents the primary means of improving share values. Yet the 1982 System does not have as an explicit goal the need to lower the costs of, and improvements in, engagement.
Third, the disclosure regime must take better account of the advances in technology that facilitate the production and assimilation of more granular financial information. The basic contents of financial statements were developed in an era of number two pencils and manual typewriters. Financial statements do not for the most part require common categories that facilitate comparisons, and they lack adequate disaggregation, imposing costs on investors and lowering the quality of earnings forecasts.
These dynamics are not the only source of pressure on the 1982 System. The expansion of the private markets has allowed large companies to avoid public disclosure more easily, reducing coverage. Changes in technology have lowered the costs for issuers in producing, and for investors of absorbing, information faster and even in real time, raising questions about a system focused on quarterly disclosure. Artificial intelligence has begun to affect the reporting process and to alter management’s approach to disclosure.
Steps Forward
These fundamental shifts need to be thoroughly integrated into the system of disclosure. Reorienting the SEC’s regime will not be easy. Nonetheless, there are steps that can be implemented immediately.
When considering changes to Regulation S-K and assessing materiality, the SEC should explicitly recognize that comparative information can be important to reasonable investors. In fact, the Commission acknowledged the central role of comparative disclosure in its climate change proposal but then mostly abandoned the approach in the final rule, contrary to the preferences expressed by investors.
The SEC should also reexamine its role with respect to the contents of financial statements. Although ceding to the Financial Accounting Standards Board (“FASB”) the determination of accounting standards, the Commission purported to retain control over the presentation of financial statements. Since aligning Regulation S-X in the 1980s with FASB standards, however, the Commission has largely failed to exercise this authority. The result has been financial statements that often lack standardized content and adequate detail.
The SEC should begin addressing the need for greater comparability and disaggregation of financial statements, rather than leave the task to FASB, which has been generally slow to respond to investor needs. The decision to add requirements to the notes in the financial statements in the climate change rule represents a small step forward in this area.
Finally, the Commission should consider jump-starting a discussion among relevant stakeholders about the need for more fundamental revisions to the 1982 System and the types of disclosure sought by investors, particularly those with passive investment strategies. Investors seeking to improve share values primarily through engagement would benefit from disclosure that better facilitated an understanding of risks to a company’s business and sustainability, including those posing long-term risks, and management’s supervision of these risks.
Concept releases are one way to jump start this process. So are advisory committees that include a cross-section of stakeholders. Cohen’s work was preceded by a detailed and thoughtful market study. At least two advisory committees provided input into the reforms ultimately embodied in the 1982 System. The SEC’s Investor Advisory Committee created by Congress in the Dodd-Frank Act is well-suited to spearheading this type of effort.
Conclusion
Engaging in fundamental reform of the disclosure regime will not be easy. Courts may throw a wrench into the process, deploying the major questions doctrine and other administrative law principles to limit the SEC’s authority over the content of public company disclosure. Invalidating the climate change rule on statutory grounds would establish a precedent for denying the Commission the authority to ensure that periodic reports include what investors needed to make informed decisions, an approach contrary to what Congress intended.
The concerns notwithstanding, delay in reexamining the 1982 System will have consequences. The importance of periodic reports and the supervisory role of the SEC will continue to decline, reducing comparability and reliability of corporate disclosure and imposing unnecessary costs on the investment process.
This post comes to us from J. Robert Brown, Jr., the Lawrence W. Treece Professor of Corporate Governance at the University of Denver Sturm College of Law. It is based on his recent article, “Revisiting ‘Truth in Securities Revisited’ The SEC Disclosure Regime in the New Millennium,” forthcoming in the Journal of Law and Political Economy, an interdisciplinary journal affiliated with the University of California, Berkeley School of Law. Professor Brown served as a member of the Public Accounting Oversight Board from 2018 until 2021.