The calls for full disclosure grow with every accounting scandal. The domino-like procession of corruption including Worldcom, Enron, and Tyco back in the early 2000s brought manipulative accounting to the forefront for the first time, and prompted calls for legislation and accounting reforms all aimed at forcing corporations to make frank and full disclosure in their financials. Since then, high-profile accounting scandals with AIG, Lehman Brothers, and the massive Ponzi scheme involving Bernie Madoff have led to lengthy investigations.
The question is whether full disclosure is the answer to existing problems and what impact it would have on the market.
- Disclosure is the process of making facts or information known to the public, which can help identify and prevent fraud.
- Proper disclosure by financial firms is meant to make its customers, investors, and analysts aware of pertinent information and create fairness in markets.
- Even with only partial disclosure, one can easily be drowned in information.
- To make the most of full disclosure, investors need to become educated in investing theory to know what information they should be demanding to fit a given technique.
Limitations to Full Disclosure
There are "natural" limitations to the term "full disclosure." The primary limitation is that full disclosure would be defined and enforced by legislation. No matter how carefully a document is drafted, there will be room for companies to do the bare minimum. There are already companies that willingly disclose much more than what is required by law. Usually, these are the companies with strong management holding a majority position and thus risking nothing by telling the truth.
Take Warren Buffett's 2008 letter to the shareholders in which he admits to losing millions by acting slowly on closing the trading arm of reinsurer Gen Re, one of Berkshire Hathaway's wholly-owned subsidiaries. While Buffett was honest and disclosed this event, he also was not at risk of being fired or losing managerial control of Berkshire.
On the other hand, management with no significant stake in the company—that is management working for wages—will still be motivated to find ways to mute any bad results to the extent that the law allows.
While it would be refreshing for a company to state what challenges it faces and what worries it has—rather than simply presenting a glossy fairytale to investors peppered with enthusiasm—this type of disclosure will continue to be a personal choice of management. You can't legislate honesty.
The best one can hope for from full disclosure is to end the use of deceptive footnoting to hide important information and to ensure a more in-depth assessment of costs, investment risks, and so on. It's unlikely that a company could be legislated into disclosing its unquantifiable anxieties like looming labor problems or a lack of new areas for growth. Still, any additional information helps.
A clear explanation of the way firms calculate the risk of an investment went a long way toward heading off the toxic mortgage assets that companies were piling into based on overly sunny assessments. In short, full disclosure would simply mean more numbers to work with.
Increased Pressure on Analysts
One of the more noticeable effects of full disclosure would be increased pressure on analysts. With more information made public as it occurs, much of the attraction of whisper numbers would vanish. The simultaneous release of information to the public under Regulation Fair Disclosure (Reg FD) has already made analysts' jobs more difficult. Under this SEC rule, companies must make material information available to small, individual investors at the same time they make it available to large, institutional clients like brokerage houses, Wall Street analysts, and major shareholders.
Ironically, some believe Reg FD may actually limit disclosure in the sense that businesses may speak less freely with analysts for fear of violating the rule. Rather than removing analysts as information brokers and leveling the playing field, Reg FD may actually choke off an important information source. In a market with less substantial information, earnings surprises and quarterly volatility could increase.
The effect of Regulation FD was strengthened with the passage of the Sarbanes-Oxley Act of 2002. The "SOX" Act, which arose out of the Enron and Worldcom meltdowns, requires companies to publicly disclose key accounting issues such as off-balance-sheet transactions. These two rules combined effectively force companies to release need-to-know financial information to all parties simultaneously.
Even with true full disclosure, however, the fact-rooting analysts are necessary. To stay in business under full disclosure, analysts will have to make meaningful reports rather than relying on the information lag between Wall Street and average investors.
In the past, analysts have benefited merely from being on conference calls or able to tap other informal information sources. There will still be an important role for good analysts, namely those whose understanding of an industry allows them to condense vital information into time-saving and accurate reports for investors. Full disclosure would simply up the natural selection for analysts that are squeaking by on an information edge today.
Lower Cost of Capital
One of the possible positive effects of full corporate disclosure would be a lower cost of capital as a reward for honesty. With companies laying their balance sheets bare, lenders would be able to assess the risks more accurately and adjust their interest rates to match. Lenders usually add to the interest rate on a loan as a margin of safety against undisclosed risks.
The size of this margin varies naturally from industry to industry, but more complete disclosure by companies would allow them to differentiate themselves from other companies. Companies with strong balance sheets would have a cheaper cost of capital and those with weak balance sheets pay more as a matter of course. Companies attempt to do this on their own but banks are understandably skeptical from experience. Of course, banks may continue to charge a premium simply because even the strictest legislation will leave room for weak companies to hide.
Help for the Average Investor
One of the big questions about full disclosure is whether it would actually help the average investor. The impact of full disclosure depends on the type of investor. Momentum traders care little for deep info, whereas value investors constantly seek more meaningful numbers. Surprisingly, one of the great value investors, Ben Graham, lamented disclosure because he believed it made it harder to find undervalued companies before the general market. Would full disclosure kill value investing?
This is highly unlikely for the same reason that full disclosure wouldn't kill momentum trading. Even with full disclosure, the market would be moved to extremes by funds, trend chasers/traders, investor overreaction, and so on. If anything, full disclosure would make it easier for investors to make certain that what appears to be a value play truly is one. Working with more detailed numbers, an investor would be able to create customized metrics rather than depending on rather blunt instruments like P/E and P/B ratios. For a mathematically inclined investor, full disclosure would be a blessing.
It's the emotional investors that would pay a price for full disclosure, and all investors are emotional at times. For many, less information is an advantage because a deluge of information often leads to overload. More figures and more frequent reporting/press releases will no doubt lead to some investors second-guessing their investments and selling on market reactions rather than fundamental changes. These investors will have to learn to depend only on the financial reports and not the increased drone of financial news releases.
The Bottom Line
Full disclosure has a lot of possibilities, including decreased cost of capital, pressure on analysts, and more realistic financials, but it may not be the solution for all investors. You may find that the information is already there for the asking with most companies and, if not, perhaps the company isn't the investment you want.
By rewarding companies that voluntarily disclose more than necessary, and not in companies that do the bare minimum, you'll be casting your small but important vote in favor of fuller disclosure. Investor pressure for frank disclosure will do more to promote honesty in the stock market than any legislative change.