Asymmetrical Information

From the desk of Mindles H. Dreck:

A Few Suggestions for Corporate Reform

Paul Krugman feels the administration has intentionally sidelined the corporate reform effort, thereby leaving the foxes in charge of the henhouse and making the world unsafe for democracy, etc. etc.

He has a point, although some would be more forgiving given the distractions of international politics at this precise moment. I take issue with the reflexive solution of simply growing the SEC's enforcement budget. Why throw money at something that isn't working? The SEC was pretty formidable prior to the end of the bubble, despite characterizations to the contrary.

Training and fielding additional examiners may actually be counterproductive. The SEC should take advantage of the fact that the marketplace itself is particularly interested in transparency and fraud avoidance at this time. The SEC regulates both listed companies and the brokers and investment managers that invest in them. My first recommendation is for the SEC to separate those regulatory functions in different agencies and enforcement personnel and have the company regulators ally themselves with the money management ("buy side") community as opposed to remaining the "cop" to both investors and investees.

Given the enormous increase in risk premia in the stock and bond markets, buy side analysts are focused on separating the wheat from the chaff in the corporate world. There is no reason the SEC can't leverage this marketplace pressure productively. Companies are incentivized to reveal as little as possible to "cops". They have substantially greater incentives, particularly now, to be transparent to the investor community.

So I am suggeting the SEC take advice from the money management community in seeking new disclosure and transparency requirements. In form, I would suggest the SEC not wait for FASB to change its rules, but establish a set of new disclosures that could be answered in a supplemental periodic public SEC interrogatory (part of the 10Q, perhaps), accompanied by an auditor letter (just like the annual report). In time, perhaps this interrogatory could become a "laboratory" for new accounting standards.

In addition, we probably need some changes to existing rules (both SEC, and Federal code). Many of them fall under the heading of "unintended consequences" of prior regulation.

Here are some proposed rule changes and potential interrogatory disclosures:

1) Repeal the laws (IRS 162) reducing tax deductibility of non-incentive-based compensation. Usint tax policy to discourage base pay packages in excess of $1 million (the amount where Congress apparently takes moral issue with pay) was partly responsible for the increase in use of options over the last decade. Actually, using the tax code to legislate morality is stupid anyway.

2) Revise regulation FD. While the intention of making all information available simultaneously to all investors was honorable, the result has been that many companies have chosen simply to disclose less (or rather less of material value, not necessarily quantity), based on scary legal advice like this. We were left with less transparency and a hoard of Wall Street analysts trying to figure out how to differentiate their research with their information edge gone. It was the added information from smart questions that institutional investors were willing to pay for (in the form of commissions). Since the lack of informational advantage left analysts without an institutional following, some fell back on their ability to tout the stock to large numbers of retail investors and others worked on M&A deals. You know the rest of the story by now.

3) Require that fully-diluted earnings include all perpetual or long-dated options or warrants, whether in-the-money or not. Bring back the old definitions of primary and fully-diluted EPS with this change to the "common stock equivalent" tests.

4) Require supplemental disclosure of compensation, including the market value of all options received.

5) Require the auditor to disclose in their cover letter all fees received and contracted for related to the subject company over the prior three years, breaking the audit fees out from all others.

6) Require supplemental disclosure of large contracts (>10% of period revenues), and the values of any contracts that include tying arrangements requiring vendors to purchase or use the company's products and payments in kind. In addition, require disclosure of contracts with unconsolidated affiliates (the notorious "special purpose vehicles") and all guaranties or hypothecations on behalf of those entities.

7) Eliminate differential treatment of dividends and capital gains (in fact, eliminate double taxation, but that's a whole 'nother post and it violates the expense restriction stipulated above). Jane Galt covered this issue well back in the good ol' days.

This post is a work in progress, so I haven't thought through everything above as thoroughly as if this were a professional journal (ahem) - but that was the point of posting it. I'll add some other items as I get the chance. In the meantime, I welcome your comments and any additional points you might offer about SEC structure and disclosure requirements.

UPDATE: You may be surprised by the regulatory ambition I display in this post. People who know me well know that my objection to regulation relates as much or more to an antipathy to bureaucracy than to the inevitable conclusion that free markets benefit more people in greater quantity than the alternatives. Transparency and the rule of law are necessary conditions to the free market. Regulatory bureaucracy, however, can be antithetical to free markets as well as morally hazardous and just plain hard on the senses.

SECOND UPDATE: A cynical reader might decide that I'm suggesting the resources of the SEC be co-opted for money managers! Bwha-ha-ha!

Posted by Mindles H. Dreck at October 23, 2002 06:28 AM | TrackBack | Technorati inbound links