Please find the video to the lecture here.
Twelfth Annual A.A. Sommer, Jr. Lecture on Corporate, Securities and Financial Law
“The Philosophy and Practice of Disclosure”
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
October 27, 2011
Thank you for the generous introduction. And thank you to Fordham Law School for kindly inviting me to deliver the Twelfth Annual A.A. Sommer, Jr. Lecture on Corporate, Securities and Financial Law.
Before beginning my remarks, let me dispense with one formality and remind you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
Given all that has occurred since I joined the Commission in 2008 — from the financial crisis, to Dodd-Frank, to numerous rules and regulations that the SEC has advanced, to important Supreme Court decisions — I could speak to any number of current developments. Instead of choosing a topic that is uniquely “of the moment,” however, I have decided to speak about something that has been a constant — from 1933 when the Securities Act was adopted through today — when considering and evaluating the federal securities laws: disclosure.
As the professors here know, being a professor is a terrific job. You enjoy the fulfillment of teaching students and the enthusiasm that goes with researching and writing about whatever you want to tackle. During my time as a professor of corporate and securities law, a big part of my scholarly agenda focused on thinking about mandatory disclosure as a regulatory mechanism. What is the economic rationale for mandatory disclosure? Why not let voluntary disclosure do the trick? What exact information do investors need? How should what is disclosed be disclosed? How do real people make real decisions with the information they have? Is the assumption of rational behavior viable? As I took a deep dive into the relevant legal, economic, and psychological literatures, I came to a quick realization. Namely, I could not properly study the role of disclosure under the federal securities laws without reading the work and engaging the insights of Al Sommer.
In preparing for this lecture, I revisited some of Al Sommer’s speeches and other writings, including the landmark report that the SEC Advisory Committee on Corporate Disclosure, which he chaired, finished in 1977. With the more complete perspective that I now have — having now served for over three years as a Commissioner myself — I was taken by how smart, nuanced, and prescient Al Sommer’s ideas and observations were.
I never had the pleasure of meeting Al Sommer, but I have no doubt that I could have talked to him for hours and learned a lot. And I very much enjoyed meeting Starr and the other members of the Sommer family who have joined us this evening. Given my longstanding interest in the philosophy and practice of disclosure — about which Al Sommer shared so many important thoughts — I feel especially fortunate to have the chance to deliver this lecture in his honor.
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There is hereby established a Securities and Exchange Commission . . . to be composed of five commissioners to be appointed by the President by and with the advice and consent of the Senate.
So provides section 4(a) of the Securities Exchange Act of 1934. Until the SEC was created in 1934, the Federal Trade Commission had administered the federal securities laws, then consisting of the Securities Act of 1933. Much has changed since then.
Scores of influential developments have shaped the course of federal securities regulation over the SEC’s nearly 80-year history.1 Here is a sampling: After the ’33 and ’34 Acts came the Public Utility Holding Company Act of 1935, the Trust Indenture Act of 1939, and the Investment Company and Investment Advisers Acts of 1940. Other notable legislative developments have included the Private Securities Litigation Reform Act, the National Securities Markets Improvement Act, the Securities Litigation Uniform Standards Act, and the Sarbanes-Oxley Act. In 2010, following the financial crisis of 2008, Congress passed, and the President signed into law, the Dodd-Frank Wall Street Reform and Consumer Protection Act, which overhauls the regulatory regime that governs our financial markets, including significant changes to the federal securities laws.
Together, Congress and the President enact the relevant statutes, but the SEC administers them as an independent agency. It goes without saying that since its founding, the SEC has been an active regulator. Over the past few years alone, the SEC has advanced a number of initiatives — some related to Dodd-Frank and others not — concerning matters such as credit rating agencies; the election of board members; public company compensation and governance disclosures; shareholder “say on pay”; money market funds; the structure of our equity markets; short selling; broker-dealer risk management controls; municipal offerings; asset securitization; clearing agencies; over-the-counter derivatives; investment adviser disclosures; investment adviser “pay to play” arrangements; the custody of advisory client assets; whistleblowers; and the “Volcker Rule.”
The courts also have been instrumental in determining the reach and substance of securities regulation through their interpretations of the underlying statutes and rules and regulations. Consider, for example, the practical impact of U.S. Supreme Court cases such as Howey, Ralston Purina, Basic, Ernst & Ernst, TSC Industries, Blue Chip Stamps, Central Bank, Chiarella, O’Hagan, Dura, and Stoneridge. The Roberts Court has been particularly influential in shaping the regulatory landscape recently, having handed down in the past couple of years Jones (concerning investment advisory fees), Merck (concerning the statute of limitations in private lawsuits for fraud under Section 10(b) of the ’34 Act), Morrison (concerning the extraterritorial reach of Section 10(b)), Matrixx (concerning materiality), Halliburton (concerning class certification), and Janus (concerning the reach of primary liability under Rule 10b-5).
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Even as the superstructure of securities regulation has evolved over the decades with the accretion of statutory changes and new rules, regulations, and judicial opinions, the foundational cornerstone of the regulatory regime has remained fixed: It is disclosure. For over 75 years, the SEC’s signature mandate has been to use disclosure to promote transparency.
Louis Brandeis, whose ideas were a major influence on the disclosure philosophy of regulation that continues to animate the federal securities laws, summed things up as early as 1914: “Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”2 Nearly 20 years later, in his March 29, 1933, message to Congress, President Roosevelt built on Brandeis’s sentiment, stating:
Of course, the Federal Government cannot and should not take any action which might be construed as approving or guaranteeing that newly issued securities are sound in the sense that their value will be maintained or that the properties which they represent will earn profit.
There is, however, an obligation upon us to insist that every issue of new securities to be sold in interstate commerce shall be accompanied by full publicity and information, and that no essentially important element attending the issue shall be concealed from the buying public.3
Louis Loss, another key figure in the intellectual history of securities regulation, had this to say about disclosure: “People who are forced to undress in public will presumably pay some attention to their figures.”4
But the one who captured how disclosure can influence behavior most colorfully is Al Sommer: “Very simply put,” he said, “if every instance of adultery had to be disclosed, there would probably be less adultery.” 5
The essence of the disclosure philosophy of securities regulation is that, when armed with information, investors are well-positioned to evaluate their investment opportunities and to allocate their capital as they see fit. When investors are able to make informed decisions, it is more likely that the financial capital that circulates in our economy will be put to more productive uses than if investors did not have the benefit of useful information. Explaining the report of the Advisory Committee on Corporate Disclosure, Al Sommer made the point this way:
[T]he Committee recognized that in any society needs and demands will exceed available resources. When that is the case, as it universally is, it is necessary that the scarce resources be allocated. It is axiomatic that such allocation will be best achieved if those involved in allocation decisions have the benefit of reliable, timely and sufficient information. Thus, in making investment decisions, investors are likeliest to make efficient allocations of resources if they have available information with those characteristics.6
By ensuring that investors have the information they need to make informed decisions, mandatory disclosure, in turn, leverages market discipline as a means of accountability that obviates the need for more substantive government regulation of securities-related activities. Through their investment decisions, investors are able to bring pressure to bear on directors, officers, investment advisers, broker-dealers, and other market participants to serve investor interests. Market participants are incentivized to satisfy investor demands because investors “reward” and “punish” by how and with whom they choose to invest and transact.
Furthermore, although a disclosure-based approach to regulation may require certain disclosures, it does not prohibit issuers from raising capital just because the government is skeptical of the offering’s merits, dictate corporate governance arrangements, demand that enterprises be run in a certain way, or otherwise mandate or ban particular conduct.7 In other words, as a regulatory mechanism, disclosure privileges investor choice, favors private ordering over one-size-fits-all mandates, and encourages innovation and competition.
The disclosure philosophy of securities regulation does not presuppose that investors are perfect decision makers. Indeed, the more recent teachings of behavioral finance suggest the extent to which investors may err. Even when investors are empowered with extensive disclosures, for example, certain cognitive biases and decision-making shortcuts — so-called “heuristics” — may lead to unfortunate decisions. That said, disclosure regulation puts into practice the view that, overall, the collective judgment of the marketplace — disciplined as it is by market forces — should be respected as a worthy alternative to more substantive government control of private-sector conduct and capital flows. For the test is not whether investors are perfect decision makers; rather, the test is whether it is preferable to leave certain decisions to market institutions instead of relying more on government officials, who also err, to dictate results through regulation.
To be clear, even a disclosure-based approach to regulation contemplates a meaningful role for government. The federal securities laws, for example, mandate certain disclosures from companies, mutual funds, investment advisers, broker-dealers, and even investors. Plus, to be useful, disclosures need to be truthful, whether the disclosures are mandated by government or provided voluntarily in response to the demand of investors for more information. Here, the antifraud provisions of the federal securities laws, such as section 10(b) of the ’34 Act and Rule 10b-5 thereunder, are particularly constructive in promoting an effective disclosure regime.
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Since the agency’s creation, disclosure has been fundamental to what the Commission does. Accordingly, it seems sensible to call for more disclosure in response to any number of regulatory concerns. But mandatory disclosure is not costless, notwithstanding the considerable benefits that flow from transparency. Once the cost of disclosure is properly accounted for, whether to require even more disclosure becomes a more challenging regulatory decision. The SEC recognized this in asking the Advisory Committee on Corporate Disclosure some 35 years ago to “assess the costs of the present system of corporate disclosure and to weigh those costs against the benefits its produces.”8
If one carefully balances the costs and benefits of mandatory disclosure when it is put into practice, it becomes apparent that regulatory requirements that demand more disclosure in the name of transparency may not always provide the benefits needed to justify the costs. Leaving it to the marketplace to sort out what, if any, additional information should be forthcoming and under what conditions is sometimes preferable.
Two ready examples — one concerning small business and the other concerning “information overload” — help make the point, although I could have selected many other examples from many different contexts.
Out-of-pocket compliance costs, which can be considerable, are the most obvious cost of complying with mandatory disclosure requirements. In addition, time and effort committed to meeting regulatory demands can distract valuable resources from more productive efforts that, on net, better serve investors and our economy generally.
Financial and other regulatory burdens can be particularly challenging for small businesses. By disproportionately straining new and emerging companies, regulatory burdens can create barriers to entry and expansion. This is problematic because startups and maturing enterprises fuel economic growth, generate new innovations and technologies that improve our standard of living, and are an important source of competitive pressure that disciplines larger enterprises to run themselves more productively. Companies that today are household names can trace their origins to entrepreneurs and innovators of earlier periods who had the wherewithal and backing to start and grow a business. More to the point, if the regulatory regime stifles small business capital formation by making it more difficult and more costly for businesses to raise funds, investors enjoy fewer investment opportunities for putting their money to work.
The practical challenge for securities regulators is to strike a balance that avoids unduly stifling the formation and fostering of new and smaller businesses. Fortunately, the federal securities laws have long recognized the need to be measured, as there is a tradition of scaling federal securities regulation in important respects to provide small businesses relief from select burdens that may be especially onerous for them.
Consider Section 5 of the Securities Act of 1933. The registration requirements of Section 5 are the centerpiece of that legislation. Nonetheless, the full measure of Section 5’s disclosure obligations does not apply to smaller businesses in practice. Section 3(b) of the ’33 Act, for example, authorizes the SEC to adopt rules exempting certain small offerings from Section 5’s registration requirements, which can be demanding and time consuming. Under Section 3(b), the Commission, several years back, adopted Rules 504 and 505 of Regulation D. In easing disclosure burdens by allowing an issuer to forego a statutory prospectus and registration statement, our rules facilitate capital formation for startups and other small firms long before they consider going public. Rule 506 also has encouraged small business capital formation by providing certainty and predictability in the form of a safe harbor under Section 4(2) of the ’33 Act, which exempts private placements from Section 5.
More recently, in 2007, the SEC adopted a host of reforms designed to ease the disclosure burden smaller companies face once they are public.9 The Commission also expanded the number of companies that can avail themselves of the more streamlined and efficient regulatory regime.
In my view, there is room to do still more. We need to consider new opportunities to alleviate regulatory demands that stifle the funding and growth of small business. This means that we should press forward on refining the regulatory regime to allow issuers more flexibility to raise capital privately and that we need to consider regulatory changes that address the risk that the regulatory regime itself unduly dissuades companies from going public and listing on U.S. exchanges.
Accordingly, I am pleased by the recent discussions that have centered on such worthwhile ideas as:
- modernizing the prohibition on general solicitations under Regulation D so that businesses can raise funds more efficiently and at lower cost;
- increasing the 500 shareholder threshold at which a private company is forced to report publicly;
- substantially increasing the current cap on offerings permitted under Regulation A; and
- facilitating “crowdfunding” as a means for small business to raise capital more easily from individuals.
A number of bills have been introduced in Congress to help promote capital formation in these ways — a common theme of which is that the mandatory disclosure regime should be further scaled and refined. And I am pleased that the President has expressed his intent to “cut away the red tape that prevents too many rapidly growing startup companies from raising capital and going public.”10
We are all better off if businesses can raise the capital they need to undertake cutting-edge research and development, to commercialize new technologies, to expand their capacity, and to create jobs.
My second example concerns information overload. Simply put, it is possible for there to be too much information for investors and others to work through constructively. The risk of information overload, in other words, is a cost of mandatory disclosure.
Investors are inundated with volumes of information. As then-Commissioner Sommer put it in a 1974 speech, “the expansion of disclosure has gone forward unremittingly.”11 Al Sommer also expressed a measure of discomfort over the “quantity and complexity” of the information that investors face and have to try to digest.12
Suffice it to say, much more is disclosed today than ever before, be it because of government mandates or investor demand or because companies, in taking a defensive posture, decide to disclose more marginally-useful information to reduce the risk that they could be challenged in litigation for not having disclosed enough.
By way of quick illustration, take Dodd-Frank. The statute requires public company disclosures regarding board compensation committee consultants;13 executive pay at the company compared to the firm’s financial performance;14 the ratio of the median annual total compensation of the issuer’s employees (excluding the CEO) to the CEO’s annual total compensation;15 employee and director hedging of the value of the issuer’s stock;16 and whether the company has separated the positions of chairman of the board and CEO.17
The bottom-line risk with information overload is that investors will have so much information available to them that they will sometimes be unable to distinguish what is important from what is not. Too frequently, investors do not bother carefully studying the information that is available and get overwhelmed or distracted, misplacing their focus on less important matters. In short, the sheer amount of information can frustrate its effective use. The trouble is that when information is not processed and interpreted effectively, decision making may not improve with additional disclosure. Ironically, if investors are overloaded, more disclosure actually can result in less transparency and worse decisions.
Information overload is not a new concern. Consider what constitutes a “material” misstatement or omission under the antifraud provisions of the federal securities laws. Thirty-five years ago, in TSC Industries v. Northway,18 the Supreme Court held that a fact is “material” if “there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.”19 In rejecting the view that a fact is “material” if an investor “might” find it important, Justice Marshall, writing for the Court, warned against information overload: “[M]anagement’s fear of exposing itself to substantial liability,” Justice Marshall wrote, “may cause it simply to bury the shareholders in an avalanche of trivial information — a result that is hardly conducive to informed decisionmaking.”20
This leads me to a practical suggestion. Disclosure serves key regulatory objectives, but too much disclosure can be counterproductive. The Commission should account for this in fashioning its disclosure regime. We need to consider the impact on investors as disclosure obligations mount and investors are thus presented with more and more information to work through. It may be better for investors to have shorter, more manageable prospectuses and proxy statements, for example, that contain more targeted information instead of lengthy documents that are not fully digested and that in too many instances are entirely ignored. While new disclosures may be required from time to time, we should be open to the prospect that certain disclosures should be more narrowly focused or otherwise scaled back.
What is disclosed to investors should be presented, when practicable, in a more accessible way — such as charts, graphs, tables, and summaries — so that the information is more digestible and understandable. Technological advances like the Internet and smartphones allow us to consider new and innovative opportunities for how disclosures can be packaged and distributed to investors.
In sum, mandatory disclosure is viewed differently if one recognizes that more information is not always better than less.
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If time allowed this evening, we could consider how the role of disclosure informs other current policy discussions, such as the question of imposing a fiduciary obligation on broker-dealers; the impact of pre- and post-trade transparency on the over-the-counter derivatives market; the consequences of bringing more “light” to dark pools; what should be covered by Dodd-Frank’s ban on conflicts of interest in certain securitizations; and whether to further incorporate IFRS into the U.S. financial reporting system.
But time doesn’t allow, so let me leave you with this.
There is no disagreement that transparency, achieved through disclosure, is central to the federal securities laws. That said, when evaluating the practical effects of particular disclosures, it is not enough to emphasize the benefits of the disclosure; one also has to engage the costs. Citing the goal of “transparency” or noting the disclosure philosophy of securities regulation should not distract from a rigorous analysis of the competing costs and benefits. Indeed, all things considered, some mandatory disclosures may not be warranted.
1 A terrific timeline of leading events is available on the SEC Historical Society’s website at http://www.sechistorical.org/museum/timeline/.
7 For an interesting discussion of disclosure-based regulation in comparison to other approaches, see, e.g., Stephen Breyer, Analyzing Regulatory Failure: Mismatches, Less Restrictive Alternatives, and Reform, 92 Harv. L. Rev. 549, 579-80 (1979).
11 A.A. Sommer, Jr., Comm’r, U.S. Sec. & Exch. Comm’n, Differential Disclosure: To Each His Own, Address at the Second Emanuel Saxe Distinguished Accounting Lecture (Mar. 19, 1974), http://www.sec.gov/news/speech/1974/031974sommer.pdf at 9.
12 Id. at 18. See also A.A. Sommer, Jr., Comm’r, U.S. Sec. & Exch. Comm’n, Current Problems of Disclosure, Remarks Before the National Association of Securities Dealers, Inc. (Nov. 12, 1974), http://sec.gov/news/speech/1974/111274sommer.pdf at 10.