Corporate disclosure, financial reporting and corporate communications in general are undergoing a sea change. On the surface, the two big drivers are a bumper crop of corporate scandals and the strong regulatory medicine that followed in its wake.
What has not changed – and is indeed the underlying force behind these drivers – is the conflict between investors and management over the control of corporate resources. Investors face a big information gap in trying to monitor management’s actions and the health of their investment, and aligning management’s incentives with owners’ interests can be accomplished only imperfectly. This defines the governance problem, and corporate communications is one important tool in the struggle to solve it. To be successful and add value, corporate disclosure should reduce uncertainty and minimize the information gap.
Thanks to more efficient capital markets, the internet and increasingly powerful tools that can look through accounting numbers, investors are in a better position than ever to address the owner-manager conflict. One example of this is the rise of hedge fund-led shareholder activism.With substantial capital and flexibility, these lightly regulated partnerships are closing the information gap by taking minority stakes and gaining board representation.
As vocal board members and investors, hedge fund activists also work to align management’s interests with those of shareholders, or at least the fund’s. Their participation can have a salutary effect on a company’s strategic clarity – any ambiguity regarding capital allocation and business focus is quickly eliminated.
To better understand the communication challenge given these new economic realities, it is helpful to remap corporate information channels. This also has the advantage of providing insight on how best to respond to the challenge in a way that is not only consistent with but also advances good corporate governance by reducing uncertainty.
Information transformation
In addition to more efficient capital markets and rapidly advancing technology, regulatory changes have dramatically changed the way information about a company flows between investors, analysts and intermediaries. The diagram opposite shows the various audiences to which quantitative and qualitative information flows in today’s corporations:
Mandatory disclosures: This channel has received considerable attention and corporate resources thanks to Sarbanes- Oxley. Indeed, there is a legitimate argument over whether a focus on getting the numbers right and ticking the right boxes has obscured more fundamental questions about the drivers of profitability, looming industry risks and how management allocates capital.
Voluntary disclosures: Quarterly earnings guidance is under fire. There is a growing recognition that guidance can lead to a bias toward short-term decision-making, financial fraud or value destruction on the scale of Enron. Michael Jensen, managing director at the Monitor Group, who has looked closely at governance and organizational failures, calls ‘managing earnings’ and ‘income smoothing’ forms of lying because they involve manipulation of financial reports. Although it is not likely to disappear altogether, this form of disclosure is in retreat.
Selective disclosure: Reg FD has presumably shut down this channel. Economic studies have shown that Reg FD has tended to impact small firms disproportionately as they have fewer resources for taking advantage of other channels and attract less interest by analysts and investors to begin with.
Signaling through corporate actions: Although not well recognized as a standard channel, the actions companies take can send strong signals to investors and analysts. Decisions to buy back stock or raise the dividend, for example, may indicate a company’s capital allocation plans, dearth of investment opportunities or commitment to financial discipline.
Information generated by sell-side analysts: The Sox requirement to separate equities research and investment banking has contracted this channel and left it in search of a revenue model. Thus, according to Reuters Research, only about 55 percent of all public companies are covered by Wall Street analysts, and of these, 75 percent are followed by one or two analysts.
Information generated by buy-side analysts: The buy side has tended to benefit at the expense of the sell side and has a more incentive-compatible business model. Because it trades on the information it generates, the buy side goes the extra mile to understand a company’s performance drivers, key risk factors and management use of discretionary cash. And for hedge funds taking a 10 percent to 20 percent stake in a company, the incentive to understand the value levers of a company is even stronger.
Shifting power
This remapping of the corporate information channels indicates that the balance of power between management and investors is shifting. The information asymmetry that defined the relationship in the past is giving way to increasing transparency as capital markets and technology throw more light on a company’s numbers, business logic and strategic plans.
Companies are adapting to this new communications landscape. Amy Hutton, associate professor at the Tuck School of Business at Dartmouth College, has documented innovative disclosure practices that firms have taken in response to Reg FD and away from earnings guidance. Hutton’s research highlights a trend by companies to either provide their business outlook or disclose operating metrics.
By removing the temptation to make short-run decisions to meet earnings targets, these practices also have the advantage of providing a renewed role for analysts: doing the hard analysis and making profit forecasts. By providing investors with a deeper understanding of their business, managers are more likely to be successful at closing the information gap. This should increase investor confidence and attract long-term investors. The alternative to an honest dialogue with investors is far less attractive.
