Andrew Yakovlev 5/26/2011 LAW 9104

Corporate Disclosure
Equity is not an asset. Its a fine sliver of hope between assets and liabilities. - Anonymous

1. Introduction
The issue of corporate disclosure is a dynamic one. Markets evolve through technology, economic theory, macro economic environment, legislature, and other elements. In fact, markets seen as signifiers of human economic enterprise, are the most dynamic systems observable to man and the pace of globalization has only sped up their progress and made them more volatile. In this system, corporate disclosure plays several major roles. At face value corporate disclosure is an issue of trust and the requirements for it serve the role of market protection. In fact, the original spirit behind the Act of 1934 was to protect the retail investors, the outsiders, by giving them access to insider financial and other material information (Shefrin and Statman, 1993). The laws have been tweaked with time, such as the recommendations of the Brady Commission following the 1987 crash (that echoed 1929), the introduction of Regulation Fair Disclosure (Regulation FD) by the SEC in 2000, and the Sarbanes-Oxley Act of 2002. One can argue though, that the consumer protection and market integrity aspects of the requirements are cosmetic to a degree, bubbles havent been prevented, retail (unsophisticated) investors, as

demonstrated by the events of 2008, are not considerably safer than they were before. The true economic function, and the reason that companies commit to disclosure, is the significant reduction in agency costs (Stulz, 2009). The regulations allow for a more efficient investment of capital for financial institutions, whether through equity purchase and especially through debenture allocation. The standardization of the reports, the presence of an enforcing agency, as well as that of ex ante and ex post controls, create an environment of trust that lowers risk, as well as lowering the need to individually negotiate capital allocation between the players (Leuz, 2010). Corporate disclosure requirements actually protect the sophisticated investor, and the enforcement of these laws gives companies a lower cost of capital. Information generation and acquisition costs are further lowered through the requirement for standardization. The paper is broken down into three sections. Section 1 discusses the history of corporate disclosure regulation in United States, starting with the Securities Exchange Act of 1934, and the consequent toughening of these requirements by Regulation FD and Sarbanes-Oxley. Section 2 looks at current trends that put mandatory disclosure rules under debate. In particular, the paper looks at the arguments under Portfolio Theory, Efficient Market Hypothesis, and the impacts of High Frequency Trading (HFT). The section also discusses the reverting trend towards financial intermediation, with institutional investors now accounting for 70% of market wealth. Section 3 addresses the impact of Globalization (which allows for regulatory shopping), the coming international adoption of International Financial Reporting Standards (IFRS), liberalization of financial markets, as well as the results of SEC Rule 12h-6 which allows for the voluntary deregistration (not delistining) by foreign firms on American exchanges.

2. Corporate Disclosure in United States

In the wake of the economic destruction of the Great Depression, the 1934 Act created the SEC, the agency responsible for the enforcement of a broad set of rules for the regulation of secondary markets in the United States. In particular, the Acts Section 13 imposed annual, periodic and continuous reporting requirements on publicly traded companies (Hazen, 2009). The disclosure requirements are outlined in Regulation S-K and their goals are to provide investors with the same protections as those found in the prospectus requirements of the 1933 Act. The registration rules created in the 1933 Act, which were drafted as part of the New Deal by a close group of Roosevelt advisors, are a much more consistent set precisely due to the intimate nature of the creation of the legislature, while the 1934 Act became a subject of considerable lobbying once the financial industry caught wind of the sweeping changes that the reform entailed. From Regulation S-K come the requirements to regularly file Form 10-K, the annual shareholder report, as well as From 10-Q, its quarterly version. The reports are meant to contain legitimate disclosure of financial statements (income statement, balance sheet, and cash flow) along with items outlining risk factors, properties, legal proceedings, market transactions, as well as the managements discussion and analysis (MD&A includes forward looking statements). These documents are supposed to be legible to unsophisticated investors (further evidence that they are the intended audience), and SEC introduced Plain English Requirements (started as a pilot program in 1933 Act Rule 421, effectively updated and adopted in 1998) which prohibit legal jargon, highly technical business terms, double negatives and call for short sentences, everyday language, active voice and legible presentation of complex material. In addition to Form 10-K and 10-Q, companies are required to file the current report Form 8-K to

announce major material events. In 2004, this reporting requirement was upgraded to include a significant amount of new items such as entry or termination of non-ordinary course agreements, events that trigger or accelerate material debt obligations, notices of delisting, as well as reviews of previously issued financial statements. Regulation S-K is a comprehensive prescribed regulation that seeks to maximize corporate disclosure without jeopardizing competitive positions of firms. Looking at an average stock chart one can easily discern when a company releases their disclosure forms. Markets always react accordingly to this new information, though the moves in share price do not always have to be dramatic; new information can come in in-line with analyst expectations. These predictions are based on trend and modeling analysis of the data from previous reports, as well as the previously issued corporate guidance issued in the MD&A. When theres a scheduled quarterly or annual report, the market picks up volatility in the days ahead and depending on the magnitude of the surprise to the upside or downside, the stock moves in matching degree. The crux of this activity are the reported earnings per share (EPS) versus those expected, along with their derivative, the management projected EPS vs the EPS expected by the market in the next quarter. While a retail investor is free to perform their own modeling and analysis, the expected values are dictated by financial analyst consensus. These professionals specialize in following a small group of companies and are considered experts. Usually they can be found in investment banks, hedge funds, mutual funds, and other financial institutions, though some have popular investment letters. A number of them make their findings free and public, these reports and calls have a significant impact on the share price when they are released.

Around these disclosable events market valuation changes significantly, but it will be a fallacy to attribute these changes as a cost: the markets are zero-sum and the loss of one investor, becomes the gain of another. Of course, if these changes can be anticipated through better, earlier analytical information then the market changes in price will not reflect the underlying value of the security correctly, in fact advanced knowledge is dangerously close to insider trading, the cheating of outsiders. This is where Regulation FD comes in. Adopted in 2000, it forbids the selective disclosure to analysts or other third parties (Hazen, 2009). The regulation applies to upper management and investor relations professionals. Though, an interesting caveat is that while disclosure to analysts and others who regularly communicate with market professionals and security holders is prohibited, it is possible to communicate the information to holders of securities if it is not reasonably foreseeable that the security holders will trade on the basis of the information. Perhaps the advent of so-called expert networks, whose early adopters were hedge funds, has occurred because of this loop hole. Theres a historic anecdote that goes like this: One morning in the mid 1990s Alan Greenspan, then president of the Federal Reserve, was taking a bath and contemplating the economic boom that the country was undergoing at the time; the stock market, the GDP were all pointing towards a sustainable trajectory, a new reality, yet he was troubled by the lack of growth in manufacturing. In fact, he was so perturbed that on December 5th, 1996 he brought the matter up with congress saying the two most ominous words in recent market history irrational exuberance. The markets reacted violently, Greenspan was forced to reconsider and concede that his model was not accounting for the productivity gains granted by computers and their networks. In the end, what he also failed to account for was enterprise corruption.

Sarbanes-Oxley and SEC Regulation S-X were a reaction to the revelation of widespread corporate fraud, particularly in the reporting of financial statements. Executives at companies like Enron, WorldCom, and Tyco along with their accountants and auditors had committed egregious fraud and put to question the integrity of the markets. SOX, among other aspects of the legislation, requires that company CEOs and CFOs personally certify that financial statements fairly present the companys financial condition, results of operations and cash flows with enhanced criminal penalties for corporate fraud (Hazen, 2009). Furthermore, in conjunction with requirements of 1934 Section 10A(b) greater requirements were placed on auditor independence and responsibility. Of note, is the requirement that the independent audit committees contain at least one financial expert, and the a absence of one should be disclosed to the investors. Due to the market failures of the last century and subsequent regulation, United States now has a regulatory system with the highest disclosure requirements in the world as well as the highest liability standard and best public enforcement having respective regulation scores of 1.0, 1.0 and .98 (Leuz, 2010). As an example United Kingdom scores .83, .66 and .68, other jurisdictions of comparably high integrity are Singapore, Hong Kong and Canada. Compliance has become a major aspect of corporate governance in America, and companies wishing to have access to American investors strive to meet the stringent requirements outlined in the section.

Section 2. Trends and Arguments

In late 70s and early 80s, the fifty-year old SEC corporate disclosure system came under significant attack (Zecher, 1985) from economists, and fathomably corresponding market interests. The major prong of the attack was the Portfolio Theory. Pioneered by the Nobel

laureate Harry Markowitz, the theory stated that it is possible to use mathematical formulas to create a diversified portfolio of stocks that in the long run would outperform individually picked stocks, with a more controllable risk i.e. volatility profile. Portfolio Theory gave rise to mutual funds, indexes, and exchange traded funds (ETFs.) Portfolio managers do not specifically look at the financial reports of individual companies, instead they focus on the returns of stocks, sectors and markets in generals, their formulas are based on the historic market price performance of the stock. The evidence that supports the argument of disclosure obsolescence are the observations that portfolio techniques work just as well for investing in foreign stocks (that dont have the same strict domestic reporting requirements) and that voluntary disclosures by firms tend to play a greater role in influencing stock price movements (Zecher, 1985). The Portfolio Theory is closely based on the Efficient Market Hypothesis, which in its strictest form states that financial markets are informationally efficient. That means that all there is to know about a company is already baked into its current market price, and any new information is reflected instantaneously, making disclosures redundant at best, and noise generating at worst. While these theories have recently fallen out of vogue, their impact is still present in the markets and therefore needs to be addressed. Markets have shown themselves to not be efficient; though they do operate rationally most of the time, outlier events, now popularly known as black swans can destabilize the markets ability to price an asset, causing wild swings and chaos. In fact, one can argue that it is precisely the absence of reliable information that creates these disturbances as market participants loose faith in the information available to them (as in the case of discovery of fraud or off-balance liabilities) and without new, legitimate information, the markets struggle to form a new understanding of the assets true value. The simple fact is that

a company will rarely hide good news, at least for long. On the other hand, if not required to disclose negative material factors, a companys management is motivated to keep the information secret. Eventually the bad news will also see the light of day, but the delayed revelation will be much more dramatic on the price, since the longer the market bases prices on negative news not existing the more distorted the market price vs. the true valuation will be. So, one can say that SEC disclosure rules actually facilitate the efficient operation of the markets, and in fact in 1978 The Committee ... concluded that, notwithstanding the arguments of economists and others that the efficient market hypothesis, the random walk theory, and the strength of market forces have rendered obsolete or unnecessary much or all of the mandatory disclosure system administered by the Securities and Exchange Commission, these arguments are not sufficiently compelling to justify dismantling the existing system at this time (Advisory Committee on Corporate Disclosure to the Securities and Exchange Commission (1978)). In retrospect this was a wise decision as the moral environment of those years was different from what would come to be to the ethical status quo in the decades ahead. Having nodded to the simpler days we turn to the present market environment of institutional intermediaries and the world of predatory high frequency trading algorithms. The best way to untangle this relationship, and see how disclosure as well as the unsophisticated investor fit into it, is to examine the stock market crash of 2008. In terms of equities, this was a 401(k) crash, an unprecedented destruction of retirement investments that was only paralleled by the devastation of home equity wealth. The majority of people who lost their wealth never peered into a 10-K or 10-Q, and having contended themselves with the cursory reading of a mutual fund prospectus, they made an economic decision to invest their retirement savings based on tax

incentives. These investors relied on financial analysts and institutional investment firms to be the middlemen, trusting their competency and the integrity of the markets that they stewarded. This was a historic shift from the traditional American outsider system (Leuz, 2010), one where regulations were meant to give access to corporate information to those who have no means of gaining it otherwise, and furthermore where there were mainly discretionary motivations (i.e. self serving) for companies to provide material information if not required by law. The shift from an outsider system was one towards a type of an insider system: an outside-insider system. In an insider system, the purpose of disclosure regulation, as in many Continental European countries, is to protect creditors (including suppliers) by restricting dividends and other payments from a corporation to residual claimants (Leuz, 2010). While in both outsider and insider systems the major benefit of standardization and disclosure requirements is the economic savings through the elimination of private information acquisition and the consequent duplication of efforts, it could be argued that this benefit is more applicable to an insider institutional system, because individual investors can never possibly, on their own, process the magnitude of publicly available information. Nevertheless, it is possible to theoretically project that the advances in Information Technology can mitigate this misbalance; small investors already have access to advanced stock screening technology on their retail trading platforms, and social networks like Twitter provide instant access to market opinions regarding any breaking development whether market wide or stock specific. The fact of the

matter remains though, that households have elected to delegate investment analysis and decision making to professionals creating the outsider-insider system1. This arrangement failed to foresee the systematic risk of the subprime loans in the financial sector, though this time complicit in the cover up were the ratings agencies, as opposed to the accounting firms. Sadly, accounting machinations were not absent either, as exemplified by Lehmans Repo 105, and it could be argued that if the debt instruments and derivatives, that came bearing so hard onto the market, were less opaque and subject to the same regulation as that of securities the market collapse would not have been such a shock. Today, financial institutions control vast amounts of wealth; more than 70% as opposed to less than 10% in 1930s (Leuz, 2010). For these giants trading is a laborious activity, as not only are they burdened by large block trades, but their movements are rule based: they have to rebalance to maintain required portfolio balances and weights, they have to quickly reflect inflows and outflows of capital, they are required to invest in certain types of equities and debentures as per their prospectus, and they operate on a schedule (especially in the case of pension funds). Volatility makes these funds vulnerable to high frequency algorithmic traders, usually these are hedge funds and proprietary trading desks of investment banks. At their most basic, HFTs front run trades by snooping out the block trades, they quickly move in to buy what a large fund has decided to invest in, or sell, often times in milliseconds, before a fund begins to dispose piecemeal of a holding. At their benign, HFTs can be said to create liquidity, though they do so by innocuous scalping. At their worst, the algorithms amplify market moves

1 An

important aside is that even though the institutions are the significant holders of the firms equities, they are still outsiders largely by their own volition, electing to not partake in the active governance and auditing of the firms in which they are invested, even though the size of their holding grants them the right (see A Theory of the Firm by M.C. Jensen).

and when a fray of super computers begins trading between each other they can move the price dramatically, usually down. The original financial shocks in 2008 were magnified by this activity, and the May 6th, 2010 flash crash was possibly caused by HFTs as well. In modern markets HFTs are a fact, and research shows that they are an integral part of the price discovery process and price efficiency participating in 77% of all trades (Brogaard, 2010). HFTs do not care about corporate disclosure, they focus on nanosecond derivative and price complimentary trading information such as volume and order patterns, they work to make an efficient market even more so. Meanwhile, financial institutions are bureaucracies focused on the long term, they rely on portfolio theory and diversification, and have little regard for the fates of individual companies, their Value-at-Risk (VAR) models prepare them for the worst, systematic risk is their primary concern. The individual investor has given up on trying to understand or beat the market leaving the task to match or outperform in the hands of professionals.

Section 3. The 24 Hour Global Market

On June 4, 2007 Rule 12h-6, which simplified rules for deregistration of foreign firms, took effect. Prior to the rule, a U.S-registered foreign firm could only avoid (through suspension) SEC reporting obligations, including the applicable provisions of SOX, only if its securities were held by fewer than 300 U.S. residents, or fewer than 500 U.S. record holders of foreign firms with less than $10 million in assets (Fernandes, Nuno and Miller 2010). The rule eliminated the onerous requirement to keep track of shareholders, and introduced a volume requirement of less than 5% during the previous 12-month period, along with several other minor alternative, and

easily met requirements. There was an observable market reaction to the rule change, and as documented by Fernades et. al it was shown that the market reacted negatively to firms that opted out and were located in countries with poor disclosure requirements, while the market reaction to firms that opted out, but whose domicile enjoys strong investor protection laws was neutral. The results of Rule 12h-6 are demonstrable proof that markets place a premium on disclosure requirements and other protections, while discounting securities that do not offer these guarantees. The question remains as to the degree of the regulatory influence, and future research will have to be made comparing the securities movements post-rule with the jurisdictional differences studied by Leuz. In todays globalized markets capital can move freely in search of best investment opportunities, firms as well can choose the optimal locations for their listings. Stock exchanges compete to offer IPOs by offering access to liquidity and market infrastructure, firms can choose to go public in Hong Kong, London, New York, or any other financial capital. Firms also choose based on the regulatory fit of a jurisdiction and the consequent expenses of compliance. Meanwhile, potential investors dont have to be located in the firms country of domicile, or even in the country of the exchange where the firms stock is traded to enjoy the protection of the locales securities laws. Its a 24 hour global market. While firms and investors are enjoying a degree of freedom to pursue regulatory arbitrage with valuations reflecting compliance risk, this state of affairs might not last indefinitely as two global standardization trends are simultaneously creating the opportunity for investors to gamble on compliance risk, while also contributing to a global regulatory convergence. The first trend, rooted in information technology, is the eXtensible Business

Reporting Language (xBRL) which standardizes the electronic format of financial reporting statements and is now required by the SEC, UKs HM Revenue & Customs (HMRC), and Companies House in Singapore. The second trend is a regulatory one; under the aegis of the IFRS accounting principle-based standards are coming to be globally conformed. The standard is already widely adopted by most major economies, and SEC has drafted a road map for the transition to it from U.S. Generally Accepted Accounting Practices (GAAP). The process has been put on hold due to the economic crisis, and its potential to expose vulnerabilities in American companies. Nevertheless, the transition will happen and investors will be able to compare and contrast any company in the world with any other. The vector of Globalization is creating opportunities, lowering costs, but also conforming national markets especially when it comes to disclosure.

4. Conclusion
On May 24, 2011 Yandex NV, the Google of Russia had a successful 11$ billion NASDAQ IPO. Russia has a vibrant stock exchange and a functioning financial regulatory authority, the Federal Financial Market Service (FFMS), the company could have went public there. And if it was a matter of access to capital, the firm could have chosen the standard Russian route and offered its shares in London. Yet Yandexs officers chose New York, and this example of voluntary submission to the most stringent regulatory environment in the world is the best defense possible for the SEC regulatory regime, including its corporate disclosure requirements. The standardized, regulated, dynamic, and enforceable rules of the SEC, though originally designed to protect the unsophisticated investors of the 1930s have come to work and in some

ways protect the corporations themselves (perhaps event from themselves) along with serving the dual purpose of safeguarding the efficiency of the markets. And even though whats traded in modern markets is size and momentum, index derivatives, and ensuing double derivatives, the relevance of humble mandatory corporate disclosures (the falsification of which are criminally punishable) is not lost. Evidence shows that markets put a premium on integrity, and the guarantee of validity of future cash flow information is the fabric that allows financial markets to have trust and ability to function. In the future as exchanges globalize, it is possible to imagine a scenario where nations securities laws compete in the same way that American states compete based on corporate law, or offshore countries compete based on banking regulation. In this environment, SECs leadership would prove to be a competitive advantage, and considering the cost of the financial crises as the price paid for these rules, its best to make full use of them.

References
Bird, Jane. Regulators Are Serious about Universal Financial Language. Financial Times, 7 Dec. 2010. Web. Brogaard, J.A. (2010). 'High Frequency Trading and Its Impact on Market Quality'. Working Paper, Kellog School of Management. Fernandes, Nuno, Ugur Lel, and Darius P. Miller. (2009). Escape from New York: The Market Impact of Loosening Disclosure Requirements. Journal of Financial Economics, 95: 129-147. Hazen, Thomas Lee. (2009). Principles of Securities Regulation. St. Paul, MN: Thomson/West. Leuz, C. (2010). 'Different approaches to corporate reporting regulation: How jurisdictions differ and why'. Accounting and Business Research, 40: 229-256. Shefrin, H. and Statman, M. (1993). 'Ethics, Fairness and Efficiency in Financial Markets'. Financial Analysts Journal, 49: 21-29. Stulz, R.M. (2009). 'Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization'. Journal of Accounting Research, 47: 349-390. Zecher, J.R. (1985). 'An Economic Perspective of SEC Corporate Disclosure'. Journal of Comparative Business and Capital Market Law, 7: 307-315.