Wednesday, September 5, 2007

Principle Based Disclosure for Investors

I’ve been thinking lately about the relationship between shareholders and company managements. The owners of a company are the shareholders. In a large publicly held company these shareholders are widely disbursed and do not have the capacity to manage the business. Company managers, on the other hand, are on the spot, relatively few in number and charged with running the company for the benefit of shareholders, although they own only a very small fraction of the company. In business school they refer to this as agency theory – management will act as agents for the benefit of the shareholders by running the company for them.

All of this is fine in theory, but unfortunately things seem to get muddled in practice. In reality, management tends to think of the corporation as “Mine” and shareholders who don’t like it can sell their shares and look for investments elsewhere. How else can you explain the outsized pay packages you see among America’s corporations today? Do you really think that multimillion-dollar compensation schemes unrelated to corporate performance are in the best interest of the owners? Or would it be more realistic to say that such pay packages are for the benefit of management?

Now, at about this point you may be asking, “What has this got to do with investor relations?” Well, I think there is a connection between the way management thinks and acts towards its owners and how they disclose information to their investors. If company managements think of the company as their own, they tend to view disclosure as simply a bothersome regulatory requirement. Management divulges exactly what the laws and regulations require, and not a single iota more. Given the standards of materiality outlined in current case law, this can leave an awful lot to the imagination.

On the other hand, what would be the outcome if management were to think of those pesky shareholders as owners? Perhaps they would be more forthcoming with information above and beyond the requirements of the regulations. A willingness to report on and continuously disclose information (either good or bad) about operations and initiatives would help the owners understand their investment with more clarity.

Here’s a quick example: Companies track their sales in a variety of ways, by customer type, geographically and by product type to name a few. Yet there is often a strong reluctance to share any of that information with shareholders. You hear a variety of excuses – proprietary information, don’t want competitors to know, if we discuss it the SEC will make us always disclose it, etc., but the fact of the matter is that companies don’t disclose such information because they’re not required to by regulation. Yet the managers sure want to know, so why wouldn’t the owners also want to know? You can bet that if the company were owned by private equity, the information would be available to the owners.

The point here is that disclosure of information should be principle based, not simply governed by regulation. The principle should be “The company will endeavor to continuously present all significant information to shareholders to enable them to make informed decisions regarding ownership of the securities of the company.” There are two concepts of note embedded in the principle: continuous and significant. Continuous should mean something more timely than quarterly, perhaps monthly. Every company I have known has a series of key metrics they track frequently, if not daily. Frequent updates of such information would be of great value to shareholders. Secondly. I would make the definition of “significant” considerably lower than materiality is today. There are many things going on at companies today which don’t by themselves rise to the level of materiality, but which have the potential to greatly affect the future profitability of the company. Shareholders should know about both the successes and the failures so they can make informed decisions.

The accounting rules and the regulatory scheme in place today are too complex and allow companies to hide behind the complexity. We need the emergence of some very simple principles to guide the disclosure of information. Just as in the old Federal Express commercials, those principles need to be simple enough so that even the CEO can understand them.

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