Asymmetrical Information

From the desk of Mindles H. Dreck:

More on SEC & Reporting Reform

A thoughtful anonymous reader had the following comments on my reporting reform ideas (inserted in [brackets] for reference). I'm responding in an "interlinear" fashion, but do not mistake it for a you-know-what-ing.

1) [repeal IRS 162 limiting salaries] Agree

2) [revise regulation FD] Disagree. Transparency is not a goal of FD, equal access to information is. If the only value add the analysts had was to be able to wheedle material information out of the Company that no one else had, then they are only exposing the quality of the Company’s Investor Relations, not its operations. It seems to me that Wall Street analysts are a lot like CIA analysts; the problem is not too little data, but too little analysis. Let analysis stand on its own and be paid explicitly for the value it adds. Otherwise, it is, and always will be, only a marketing arm of the investment bank’s corporate finance department. And it will be worth what it is paid by those who pay it.

I think the reader shortchanges the role of questioning in analysis. Analysis consists of looking at the available information and using it as a guide for where to look next. In the case of a sell-side analyst, that would result in a request for an unreported metric (think book-to-bill and things like that) or nugget of information that exposes the weakness or strength in the company's outlook. Regulation FD makes providing that sort of information to analysts difficult.

I agree with my reader that there is already a sea of information there, and that Wall Street wasn't paying attention (remember, analysts need to figure out what people will pay, which may or may not be connected to the fundamentals....). FD may not have hurt quantity, but it hurt quality and the ability to look deeper.

3) [dilute primary earnings with outstanding options] Agree and raise you. It seems to me that fully-diluted shares should include all shares in option pools, regardless of whether they have been granted or not. Also, no fancy methods of computing number of shares, just primary and fully-diluted as if every share that could be issued were.

Yeah, although it might seem a little unfair if companies started issuing deep out-of-the-money options.

4) [supplemental disclosure of compensation] Disagree. Effective August 29, 2002 any change in beneficial ownership by a director, officer or 10% shareholder must be reported on Form 4 before the end of the second business day following the date on which the transaction was executed, with some exceptions for situations in which the insider does not control the date of execution, e.g. 10b-5(1) plans and other employee benefit plans. Form 4 shows the number of shares and the price for the transaction. What more do you want?

I agree that all the information is available in the footnotes and 10Ks and nobody looked (as discussed in this post). I'm saying value the option grants using Black-Scholes (rather than expense) and put it up front with earnings, just to satisfy the options hawks.

5) [auditors should disclose fees by category] Strongly disagree. The biggest problem with audit is that it has been degraded to a loss leader for consulting. Now, you want to put additional price pressure on them at the same time you want them to get rougher with management! I can hear the next board meeting now: Director A, “CFO, did you see on the web that Amalgamated is getting its audit for 80% of what we’re paying? Why are we paying so much?” CFO, “They had a lot of clean up work to do from the mess my predecessor left, but we’re going to drive them down to a reasonable level this year!” I don’t know if you have noticed it, but many of your proposals push the auditors and the government closer together. That may seem to make sense at first, but at the end, and we’re approaching it soon, we’ll get audits that look more like sales tax audits than evaluations and judgments by sophisticated, knowledgeable professionals on the accuracy and veracity of financial statements. Besides, do you really think auditors are adding value to a company’s financial reporting?

I agree that auditing has been commoditized (and I said so). Seriously, though, you don't think this already happened in a cozy phone call? It is up to the auditors to maintain price discipline. Disclosure might work both ways. In answer to the last question-rarely.

6) [disclose contracts with affiliates] I certainly need more information about this, but for starters, are you asking to have the entire contract disclosed? The in addition item is shutting the barn door after the horses have left. What ever rule you set up there, the crooks will find a way around it and it is a needles nuisance to the vast majority of companies that are not run by crooks.

This generation of horse has left, but their offspring have not. Revenue recognition methods produce a scandal every five years or so - from pre-fab housing to AOL. Contracts are a good way to transfer value in contingent liabilities and legal control instead of numbers. Large contracts involving affiliates should have their principal terms disclosed. Arms-length contracts would have to meet a materiality test. Certainly, any encumbrances should be disclosed.

7) [eliminate corporate taxation/double taxation] Couldn’t agree more, though, what I would do is not eliminate the corporate income tax, but limit it to a percentage of the net cash flow from operations less dividends paid within 90 days of the end of the tax period. Clean, neat, simple. If managers want more capital to operate the business, they should have to go to the capital market to make their case, just like any start up. They should not have this competitive advantage of a constant, captive, involuntary, free source of capital from retained earnings. In fact, they should be taxed if they fail to return earnings to the shareholders. This would force managers to be much more responsive to the needs of the market for information and give the market many more opportunities to gather information and discipline wayward managements.

Unfortunately, cash flow from operations can also be manipulated, especially if the company is active in the financial markets. Enron's were pretty opaque - they tended to run negative in the first three quarters and have a big fourth quarter.

The SEC provides little information that institutional investors could not get and no information that is of use to small investors. I doubt that the SEC did much to contribute to the quality of markets in the 50 years prior to 1990. Nor do I think the SEC had much to do with the excesses of the ‘90s. I think the most important factor in the debacle of the last decade is that there were less than 10 people left on Wall Street who worked there during the Crash of ‘29. And I will go way out on a limb and suggest that the next outburst of irrational exuberance will commence in 2070 and end in 2080, (both dates plus or minus 10 years). Following that I would list the GREED of every INVESTOR who thought they deserved venture capital returns on treasury bill risk. Thinking there was something the SEC could or should have done that would have prevented it is naive. Trying to prevent it in the future is futile. The best we can do is make the hangover less painful. And so far the ‘00’s are a lot less bad than the ’30’s.

Too true. We can try to club people over the head with the "right" metrics, but it's clear that the bread crumbs were all there. See Michael Lewis on this today. I think his point about the old economy biting back is valid.

I agree that transparency and the rule of law are necessary to efficient markets and there are opportunities for improvement.

First the rule of law. We have enough laws on the books now. What we do not have is enough enforcement. What the SEC should do is not to try to find the 1 in 1,000 business that are crooked by making life hell for 999 businesses. It should make sure that life for the 1 crook is a hell of disgrace, public humiliation and hard time followed by death in poverty. If found guilty, Bernie Ebbers and Andy Fastow should spend a substantial potion of the remainder of their lives at a maximum security prison, not Club Fed. If they get Jeffrey Dahmer for a cell mate, so be it. Who caused society more misery? So, the SEC should enforce the law by making the guilty, not the innocent, pay with great public fanfare to dissuade the other 999 from following in their footsteps.

I agree that there are plenty of existing laws to deal with most of the recent fraud. It's not so much enforcement as prosecution where we fall down. I'll leave it to the lawyers to figure out why we can't send white-collar criminals to jail.

Transparency? I think the virtual elimination of retained earnings together with weekly public reporting on cash and revenue, monthly release of financial statements and the elimination of the 10-Q would go a long way to assuring transparency. This is information that the companies are already producing for internal use so should be no incremental burden to the Company and substantial new information for investors.

Well - now he's sounding like me.

Posted by Mindles H. Dreck at October 26, 2002 3:36 PM | TrackBack | Technorati inbound links