You may be aware of the recent changes made to US disclosure, namely Regulation Fair Disclosure in 2000 and the 2002 Sarbanes-Oxley Act. Both aim to increase the transparency of companies for all their shareholders, and to eliminate preferential treatment for larger or more influential shareholders. To what extent are these aims being achieved?
Regulation Fair Disclosure (Reg FD) was spurred by the sell-side analyst scandals in the US, in which the independence and propriety of many analysts was brought into question. The regulation essentially said that US market-listed companies needed to be more conscientious about how, when and what information they release.
Companies may no longer exclude certain individuals or groups from conference calls or other communication events (such as investment conferences that used to be closed to the press). Other new rules are shortening the period US-listed companies have in which to file their results. Reg FD also strongly encourages the use of the internet, for example to facilitate prompt disclosure.
Sarbanes-Oxley is a child of Enron and WorldCom. The slew of accounting fiascos in the US led to this law being rapidly created and signed into life last summer. The main focus of the Act was to ensure that information disclosed to the public be entirely accurate. Heavy penalties (in some cases even prison terms) have been put in place for insufficient or inaccurate disclosure of price-sensitive information to the public. Furthermore, the Act brings an element of independence into the preparation of financial results via the introduction of an independent auditing committee on the executive board.
On the surface, all this sounds very positive. But how do these changes in US securities rules really affect US IR practice, and what has their influence been on the quality of information investors receive? Would it be wise for European companies to follow suit in fulfilling the US requirements, even though they may not be bound by them? Or could ignoring certain elements of the regulations actually make European companies more attractive to international investors?
While these rules were certainly designed to ensure a fair playing field for all investors and increase corporate transparency, have they succeeded? Numerous studies have been done, including a survey of 577 IROs by the US National Investor Relations Institute (Niri). Institutional Investor magazine surveyed 1,600 CFOs, while IR magazine interviewed 1,675 investment professionals for its US Awards in 2002. All raised questions about the quality of corporate information since the enactment of new disclosure rules.
In practice, it seems that companies – uncertain of exactly what they do and don’t have to disclose – are reacting to the regulations in two ways: either they are telling the public absolutely everything; or they aren’t telling anyone anything.
Both reactions have consequences. While disclosing too much information to the market is generally preferable from an IR point of view, it also has disadvantages. By bombarding the market with lots of immaterial information, a company creates an overload of largely unimportant information for many investors. This is a barrier to getting attention for those disclosures which really are important. In response, we see a change in the role of the equity analyst from ‘gatekeeper’ to ‘sifter of information’, boiling down the numerous disclosures to a relevant message for their institutional clients.
On the other hand, there are also many companies so concerned with avoiding selective disclosure that they are limiting their disclosure to the legal minimum. Some analysts even claim that certain companies ‘hide behind’ the regulations to avoid discussing information that had been disclosed in the past, but which analysts think ought to be expanded upon. In the IR Magazine Awards survey, 25 percent of analysts and fund managers surveyed said companies seemed to be withholding more information than before Reg FD. Niri’s survey supports this, as 24 percent of the IROs interviewed say less information is being given, while Institutional Investor’s CFO survey shows a whopping 50 percent disclosing less information.
One explanation for the substantial difference in the results of the surveys could be that as we get closer to the source of the information, we get closer to the truth. Perhaps CFOs are most aware of their personal liabilities these days, and are quietly decreasing the amount of information they are disclosing. Sell-side analysts also comment that many CFOs and IR officers are ‘terrified of violating regulation FD.’
Since these regulatory changes discourage non-public meetings with specific investors (known as one-on-one meetings), they are making it more and more difficult for companies to get to know their institutional shareholder base well. This is occurring just as recent studies reveal that the importance of institutional shareholders is much greater than was previously thought.
According to a McKinsey study last year (from the McKinsey Quarterly, Q2 2002), as few as 100 institutional investors are largely responsible for the development of a company’s share price at any time. McKinsey encourages companies to gather highly-detailed information about their institutional shareholders in order to be able to forecast each shareholder’s expected reaction to strategic developments. The cumulative effect of the various expected reactions of each shareholder (after lots of complicated calculations, which presumably can only be done by a McKinsey consultant) should give management an expected post-announcement share price. Based on what this figure is, a CEO can decide whether or not to go ahead with a certain strategic decision.
While McKinsey’s revelation is extremely valuable information for all those who occupy themselves with investor relations, it is clear from the article that extracting such detailed information about how each institutional investor would react to various strategic scenarios would be very tricky in today’s regulatory environment. McKinsey’s solution to this sticky problem is for companies to ask each major institutional investor sphinxlike riddles such as, ‘What did you think of competitor x’s recent strategy change?’ The danger is the investor may assume the company asking the question is hinting that it will adopt the same strategy change or, conversely, that it is planning something else entirely. This leaves open a huge area of miscommunication and misinterpretation. It is also dangerously close to selective disclosure, which is of course illegal.
However, as we see from the survey results mentioned above, very few institutional shareholders are receiving the same level of information as they did prior to enactment of these regulations. They are certainly ‘the losers’, together with a certain group of (previously) influential analysts.
Furthermore, now that we now know that so few institutional investors form a company’s share price, we wonder if an increased risk factor is being applied to equities to compensate for the decrease in strategic information these institutions are receiving, creating a structural devaluation of such companies since these regulations have taken effect. Of course, this theory is very difficult to test, as the effect of corporate and political events on the markets during the last two years is virtually impossible to measure independently.
In theory, retail investors should be the big winners here. As the group of investors with traditionally the least access to price-sensitive information, retail investors definitely enjoy more equal access to information since the enactment of the new regulations. However, does ‘equal access’ mean small investors are receiving more (relevant) details, whereby they now have access to just as much corporate information as their institutional cousins previously had? Or are companies merely disclosing only that information they used to give retail investors and no longer disclosing ‘extra’ information which previously went only to sophisticated institutional investors? It seems from the survey results quoted above that the latter is too often the case.
While Reg FD and the Sarbanes-Oxley Act have clearly had many benefits, at the end of the day many questions surround the value of these two developments: could the regulations be adapted such that the commendable objective of increased democracy in the market can be achieved, but without the negative effects on institutional investors? What are the effects of Reg FD and Sarbanes-Oxley on corporate valuations? To what extent should non-US listed European companies adopt these American practices in order to remain competitive in the capital markets? It is clear that Europe also needs to take regulatory action to improve transparency and disclosure, perhaps following the US model. However, elements of the US rules must be carefully reviewed and revised to avoid the negative consequences seen in the US.
Anne Louise van Lynden is executive director and Richard Feenstra is a researcher at Citigate First Financial, an Amsterdam-based strategic and financial communications consultancy which is part of the Incepta group
