Disclosure improves when lawyers give IROs room to work.
Legalese is out at the SEC. If reformers have their way, so is jargon’s derivative: bifurcated communication. That is what can happen when lawyers fail to work closely enough – or at all – with IROs when preparing disclosure documents, resulting in proxy statements, 10Ks and other filings that are indecipherable or uninformative.
IROs have long been putting their stamp on unofficial communications like the narrative section of annual reports and press releases. But the National Investor Relations Institute (Niri) is now pushing for more IR involvement in the disclosure process. And CFA Institute and Business Roundtable have joined the effort.
‘We don’t expect everyone to write like Warren Buffett,’ says Matthew Orsagh, a CFA Institute senior policy analyst. ‘But the language in disclosure documents needs to be more plain English, more accessible.’
In a series of symposia, Niri, Business Roundtable and CFA Institute began rethinking what goes into SEC filings, how it gets there and who is best placed to put it there in the context of another problem: short-termism in investor outlook.
After hearing CEOs complain that they felt forced to give up ‘seed-planting’ activities like R&D and marketing to focus on quarterly expectations, the three groups looked for ways to encourage investors to take a longer view. They agreed investors would be better served if disclosure materials revealed more about companies’ value drivers and strategy.
The result of the discussions was a July 2006 white paper, ‘Breaking the short-term cycle: discussion and recommendations on how corporate leaders, asset managers, investors and analysts can refocus on long-term value’. Along with its controversial headline proposal to stop quarterly earnings guidance, the document highlighted disclosure written as though to ‘confuse, rather than inform, investors and analysts,’ and suggested that IR and legal functions should be better integrated.
‘I understand the lawyers’ position; it’s their job to make sure a company doesn’t get into trouble,’ Orsagh says. ‘But a short-term message gets shortterm investors.’
Trends and risks
The SEC previously tried to improve disclosure when it published guidance on writing management’s discussion and analysis (MD&A) in December 2003. Issuers were advised to provide a narrative explanation of the financial statements from the perspective of the CEO, focusing on the trends and risks ‘that keep him or her up at night.’
In a lengthy ‘how to’ guide, the SEC observed that MD&A rarely amounted to more than a boilerplate addition, with little analysis or discussion. Ostensibly coming from management teams themselves, the MD&A tended to recite the numbers from financial statements and disclose percentage changes in financial statement line items from period to period for a kind of ‘elevator analysis’ that was descriptive, but not informative, commissioners said. While there have been improvements in the last three years, the problem persists. ‘Companies resort to the most basic MD&A,’ says Donald Meiers, a securities partner with Steptoe & Johnson. ‘They look at any information they can readily glean from the numbers. That becomes the lowest common denominator disclosure.’
Reformers say management’s story would be more complete if it contained more forward-looking statements, better explained trends and uncertainties, and discussed in more detail the key drivers of the business.
Holding back
‘Why is it that everyone seems to be struggling with something that is not all that difficult?’ asks Meiers. ‘There are a few possible explanations: disclosure teams might comprise bad writers; CEOs might be nervous about revealing too much of their strategy; or the company might be purposefully obfuscating in order to conceal bad news.’
But the problem may also be systemic. ‘The reality is more often inadequate internal controls,’ Meiers continues. ‘A lot of lawyers just give up [trying to get a better picture]. In most cases, the processes are not in place and the companies are not investing sufficient time to make significant disclosures.’ Lou Thompson, former Niri president and CEO, says, ‘I feel very strongly that IR people need to get in and get in early. They should approach counsel to say the SEC is serious about improving disclosure. It’s a mistake to bring the IR people in at the tail end and say, Fix it.’
Thompson wants IROs on disclosure committees but Meiers is lukewarm to the idea, saying the essential team probably comprises the CFO, the controller, the general counsel and someone from the internal audit committee. ‘The IRO is the person who brings the greatest degree of continuity with regard to what was said previously,’ Meiers says. ‘But I’d want that person to be the quietest one in the room. I don’t think he or she is the best informed.’
‘That attitude on a lawyer’s part does not surprise me,’ Thompson responds. ‘Yet it’s true there are some companies where the IRO is not in the inner circle. In these cases, they are somewhat neutered.’
Filling out the picture
Whether on the team or off, the IRO can help to elicit the most appropriate disclosure. Karl Groskaufmanis, a securities partner with Fried Frank Harris Shriver & Jacobson, suggests reviewing draft disclosure with the IRO to determine whether a key trend is missing from the company’s filed reports. Acting as devil’s advocate can be an outside counsel’s role, too. ‘I throw out questions,’ Meiers says. ‘It’s like throwing spaghetti noodles at a wall. Some stick, some don’t.’ Some of the most illuminating information comes up in conference calls and transcripts are sometimes attached to official filings, leading some to ask why that detail isn’t put in the MD&A. In these cases, ‘you’ve got to wonder who is driving the ship,’ Thompson says. ‘CEOs are usually candid. But when material gets turned over to the lawyers, there’s a gap.’
Thompson recalls one CEO taking on a prescient question during an investor Q&A about the shortage of engineers and its eventual effect on his company. ‘That’s not something you’ll find in a spreadsheet,’ he says. ‘Instead of waiting for those questions, take them on [in the MD&A].’
Meanwhile, the SEC is taking a harder look at MD&As, and weak documents draw comment letters from agency staff. Recently, the commission criticized Hershey’s for omitting analysis of the effect of civil unrest in Ivory Coast on its cocoa supply. One analyst ripped apart the prospectus of Chipotle Mexican Grill for presenting a raft of slogans like ‘when a chain isn’t a chain’ and ‘one burrito at a time’ as meaningful insight into company strategy. Even Buffett’s Berkshire Hathaway, often cited as the gold standard in disclosure, had its MD&A flagged, albeit on a fine point involving a confusing description of loss reserves estimates.
One observation Thompson made during the symposia is that many companies like giving quarterly earnings guidance, a problem certain to mute reform efforts. ‘They believe guidance keeps channels open between themselves and shareholders,‘ he notes. ‘But guidance is not earnings. Firms need to get into non-financial factors like trends and standards of achievement.’
IROs, of course, are trained to think in this broader way – yet they can’t produce disclosures that companies are unable or unwilling to report.