Remarks at the 2nd Annual Institute for Corporate Counsel
Commissioner Daniel M. Gallagher
New York, NY
Dec. 6, 2013
Thank you, John [White], for that kind introduction.
Today, I am going to talk about disclosure reform. I will admit at the outset that it is very difficult to say anything really new about disclosure reform — so prepare to be bored! Seriously, though, it’s undeniable that disclosure reform is a must for the Commission. What may be missing in this longstanding discussion is a practical sense of where to begin. There’s an old adage: how do you eat an elephant? One bite at a time. Right, but in tackling the topic of disclosure reform, what piece of elephant do we take a bite of first?
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The SEC is first and foremost a disclosure agency. With respect to corporate disclosure, our bedrock premise is that public companies should be required to disclose publicly and in a timely fashion the information a person would need in order to make a rational and informed investment decision. On that foundation, our securities laws and the rules by which we administer them have been built.
And, by now, it’s become quite an elaborate edifice. We can’t foster capital formation in fair and efficient capital markets through private investment unless the critically important information about public companies is routinely and reliably made available to investors. We need to take seriously however, the question whether there can be too much disclosure. Justice Louis Brandeis famously stated that sunshine is the best disinfectant. As my friend and former colleague Troy Paredes pointed out some years ago, though, it is possible to create conditions in which investors are “blinded by the light.” That is to say that from an investor’s standpoint, excessive illumination by too much disclosure can have the same effect as obfuscation — it becomes difficult or impossible to discern what really matters.
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I often hear from investors that disclosure documents are lengthy, turgid, and internally repetitive. In their present state, they are, in other words, not efficient mechanisms for transmitting the most critically important information to investors — especially not to ordinary, individual investors. They are not the sort of documents most people are likely to read, even if doing so is in their financial self-interest. For that reason, today’s disclosure documents raise questions of what their purpose actually is and whether they are meeting it.
Here, it seems to me, we must acknowledge a dilemma. The good we have done in shaping a detailed disclosure regime to assist and protect investors has, in fact, led to some potential but, I submit, avoidable harm. Corporate disclosure filings didn’t naturally evolve into their present convoluted state. Rather, the rules that require periodic corporate reporting and the detailed instructions that implement them, as well as the staff interpretations and guidance that supplement those rules and instructions, have been the principal forces shaping modern corporate disclosure filings.
But other, external forces have played a role as well, most notably the risk of litigation -- much of it absolutely frivolous and solely for the benefit of plaintiffs’ lawyers, not investors. The failure to disclose anticipatorily is often enough to prompt a shareholder lawsuit based on the assertion of a material omission. It is rational, in other words, for those who prepare corporate disclosure documents to prepare for the worst, thus perversely prioritizing the need to avoid the penalties that accompany claims of insufficient disclosure, it seems, over rendering the required disclosure in a manner intelligible to the average investor. In sum, the Commission has cause for self-examination where the question of the utility and lucidity of corporate disclosures arises. And in that process we cannot ignore the impact of excessive and frivolous litigation.
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Here, we come to a fundamental fork in the road. Should we jump in with both feet to begin a comprehensive review and possible overhaul of SEC-imposed disclosure requirements under the securities laws, or should we take a more targeted approach, favoring smaller steps towards our ultimate reforming goals? Ordinarily, I would argue for a comprehensive approach to the solution of almost any problem. Where securities regulation is concerned, we often find that actions we take in one area have unforeseen and unintended effects in others.
However, disclosure reform may be the exception. Although I’ve publicly called on multiple occasions for a holistic, comprehensive review of market structure issues, I believe, on balance, that with disclosure reform it is better to start addressing discrete issues now rather than risk spending years preparing an offensive so massive that it may never be launched. On this point, I was very pleased to see the recent remarks by Chair White. I hope and expect that, under her stewardship, the Commission will begin to make real headway on disclosure reform. I am genuinely enthusiastic about the prospect of solving some of the real-world problems that have become obvious to all who focus on this area. In short, it’s time to get practical and time to get started.
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Here it is important to acknowledge a significant potential impediment. As I’ve noted on several occasions, everything we do as a Commission reflects priorities — the decision to do certain things now, others soon, and still others farther down the road or not at all. Between the time I departed the Commission in early 2010 as Deputy Director of the Division of Trading and Markets, and 2011, when I returned as a Commissioner — not coincidentally, the period that saw the enactment of the massive Dodd-Frank Act — major changes occurred at the SEC.
Since my return to the Commission, I have been struck by the degree to which new congressional mandates now dominate our agenda — regardless of their specific content or relative importance. These mandates have trumped, it seems, the duties that flow from our threefold regulatory mission and other existing statutory mandates. Dodd-Frank, we must remember, amended — it did not replace — the extensive existing body of securities law that the SEC is required to administer. Moreover, the Dodd-Frank deadlines to regulators for carrying out its mandates were and remain absurdly unrealistic, the product of an idealistic and ideological “book club” mindset, unburdened by the knowledge of how complicated it is to establish and oversee regulatory programs and of the impact of those programs on private markets. So now that we have blown past those deadlines, we need to set a rational agenda that includes a healthy dose of improving SEC regulatory programs that long pre-date Dodd-Frank.
The Commission is also increasingly being pressured to conform to the regulatory preferences of bank regulators and the policy organs of the Executive Branch. The most prominent example of this pressure comes from the Financial Stability Oversight Council (FSOC), a statutory creation that could make sense only in Washington. The FSOC brings the chairman of the SEC — not the Commission itself — together with the heads of various other regulators to consider topics relating to the safety and soundness of the financial system. Despite the SEC’s status as a statutorily constituted independent agency, the FSOC has already intervened in our rulemaking and regulatory priorities, most notably with respect to money market mutual funds.
Neither the FSOC nor the Dodd-Frank Act appears to view corporate disclosure reform as a priority. Of course, perhaps that’s best, since much of the new disclosure mandated in Dodd-Frank has nothing to do with making available to investors the information they need in order to make an informed investment decision. It is, on the contrary, designed to advance a set of policy preferences important, perhaps, to some, but irrelevant to the vast majority of investors. And that is a type of disclosure that needlessly clutters disclosure documents, making what is material to investors harder to find.
More helpful, by far, is the JOBS Act’s mandate that the SEC study Regulation S-K to see where its requirements could be updated “to modernize and simplify the registration process and reduce the costs and other burdens associated with” it for emerging growth companies. This S-K review, soon to be embodied in a published report to Congress, is an exercise of undoubted importance to any meaningful initiative for disclosure reform. Performing this review — and enacting any rule amendments arising from the review — is part of what I often refer to as the SEC’s basic “blocking and tackling,” the importance of which did not diminish with the passage of a slew of post-crisis congressional mandates.
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So where would I place disclosure reforms on the Commission’s overall list of priorities? There is no external mandate that tells us this is a problem we need to address any time soon. So, should this project take a back seat to the sixty Dodd-Frank-mandated rules we have yet to complete?
As I’ve said, I think it’s time to make a start on disclosure reform. And I am delighted to note that Chair White recently made much the same observation, raising many relevant questions. I look forward to working with her on this very worthwhile endeavor. It is better to get down to some brass tacks that call for our attention than to hold out for the perfect conditions to undertake a comprehensive redesign of our disclosure regime.
Let me give you a few examples of what I believe — based in part on what I’m hearing from market participants — might be good issues on which to focus:
The first would be “layering disclosure.” The idea of layered disclosure is based on the recognition that some information is inherently material, for instance a company’s financial statements. That information should be a focus of any disclosure document. On the other hand, some of the information that must be disclosed is not inherently material, for example the pay-ratio calculation required pursuant to Dodd-Frank section 953(b). Information of that sort is not inherently important to an informed investment decision and should be reported elsewhere — in a separate section or different document. Aside from the direct benefit to investors in having more readable documents, there are additional benefits to such an approach, such as enabling us to take a critical look at whether liability should attach to particular disclosures and omissions that are not inherently material and encouraging issuers to disclose additional information separately by relieving them of some potential non-fraud liability.
Second, we should also look at streamlining 8-K disclosure. Granted, Form 8-K is a document separate from a company’s annual and quarterly reports; that’s part of the point. Over the years, the categories of information required to be disclosed on Form 8-K have grown considerably. But should each such category of information require almost immediate disclosure on Form 8-K when a change occurs? Is it, for example, really necessary to require immediate disclosure of amended compensation plans of named executive officers, given that this would be reported in the company’s upcoming proxy or 10-Q? There has, moreover, been a creeping incursion of financial reporting traditionally made in quarterly and annual reports into Form 8-K filings. The gateway question, in looking at streamlining or curtailing the proliferation of 8-K filings, should be whether investors really need all of this welter of immediately updated information in order to know what is material about a company’s current condition. So, while acknowledging that the specification of information reportable on Form 8-K implicitly limits the types of information that must be disclosed immediately, the question is whether all such categories are of equal importance.
Third, we should have a targeted effort to reduce redundancy in filings. Here, the objective would be to tell issuers, authoritatively and explicitly, where they must disclose and where, by contrast, they need not disclose particular types of information. This would enable those looking for that information — professional analysts and advisers in particular — either to find it or to identify its absence more easily, while reducing unnecessary repetition within corporate filings. Such authoritative guidance would have the direct effect of enabling corporate filers to eliminate redundancies in their disclosures — surely a service to investors — while significantly reducing the risk of frivolous litigation as a result. For example, we could reduce redundancies between the notes to a company’s financial statements and its MD&A disclosure by requiring management only to discuss material information, rather than every aspect of a company’s financial performance, in the MD&A section — perhaps also suggesting appropriate cross referencing to the financial statement notes.
Fourth and more specifically, it’s high time that we gave priority attention to streamlining proxy statements. Proxies are the principal means by which public companies communicate with their shareholders with respect to matters of material importance. Their contents should, therefore, be as clear and concise as possible. Inundating investors with charts, tables and torrents of legalese increases the chance that they will miss the forest for the trees. So one potential reform would be to permit some of the tables, say those other than the summary compensation table, to be included in an appendix to the proxy. This would ameliorate the problem of Item 402 disclosure being too dense and unwieldy for most ordinary investors, yet still allow those interested to view the information. The basic corporate information required in annual proxies might also be a good area in which to test a more standardized, online disclosure system that could require one-time online disclosure of basic corporate information and mandate that such disclosure be updated as necessary, with changes tracked, rather than rotely repeated each year.
We should also focus on streamlining registration statements. One idea would be to permit forward incorporation by reference in Form S-1 registration statements. Forward incorporation by reference permits a registrant to automatically incorporate reports filed pursuant to the Exchange Act, such as Forms 10-K and 10-Q, subsequent to the effectiveness of the registration statement. Because this is not now permitted for Form S-1s, registrants must continue to update the S-1 filing after effectiveness either by supplements or post-effective amendments. That such forward incorporation is permitted for Form S-3 registration statements but not for Form S-1s may help explain why issuers and practitioners seem to prefer S-3s for follow-on offerings.
We should also consider increasing the reliability of SEC guidance by enhancing its authority by issuing significant guidance with the Commission’s endorsement, rather than by the staff alone. While Commission consideration of draft guidance would take some additional time, there can be little question that an issuer and its advisors would feel more confident, including from a litigation standpoint, in following guidance issued under an explicit Commission imprimatur.
We need to renew our focus on the potential of technology to improve corporate disclosure. Here, we must acknowledge that our present corporate disclosure requirements are almost certainly not those we might have devised today in our technology-enabled environment. EDGAR is a simple example, because EDGAR filings are really just electronic shadows of the paper filings they replace. A disclosure system taking full account of the potential of technology might look dramatically different. But our priority at present should be to begin moving in the right direction, rather than swing for the fences. I would therefore be remiss if I did not point to XBRL as an investor-empowering analytic tool. True, XBRL has its limitations. It is a rendering language that does not, in itself, change our system of disclosure, and it does not readily lend itself to describing the nuances of un-structured discussions in disclosure documents. What XBRL does do very effectively is ensure that information is disclosed and presented in a manner that promotes ease of analysis and comparison. So, it seems to me, we must recognize that XBRL was and is a major step forward and must fully realize its potential for improving investors’ ability to analyze corporate disclosures. We must also acknowledge that we have not yet fully explored the potential technology holds for improving our present disclosure regime. That, too, is an inquiry that calls for your expert attention.
Finally, we should treat special, meaning politically-motivated, disclosures as the anomalies they are. We have no reason to expect that Congress will give up issuing specific disclosure requirements any time soon. Indeed, if the recent past suggests anything, it is that we should expect policymakers to continue their efforts to use the securities disclosure regime to further policy objectives fundamentally unrelated to providing investors with information that is material to their investment decisions. With that in mind, I can commend the thinking behind Form SD, despite its adoption as an adjunct to two rules driven wholly by social policy mandates. At the same time, I worry that the existence of Form SD invites more politically-motivated Congressional intervention into our materiality-based disclosure regime. This is a bipartisan problem, something that the Commission must monitor continuously and resist consistently. The Commission should not be put in the position of seeming to pick and choose which disclosure mandates a majority of Commissioners like. Today’s proponents of a special disclosure should keep in mind that they might not be in the majority for the next one. As those of us who have been in Washington a long time know, what goes around, comes around!
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I have no doubt that many of you could readily supplement, revise, or otherwise comment helpfully on this list. I very much hope you will engage in the discussion on disclosure reform. That is very important, because we need to hear directly from the people who are engaged hands-on each day in the business of ensuring that issuers meet their disclosure obligations. Where we see practical improvements we can make to assist ordinary individual investors in identifying and understanding what is truly material in a company’s public disclosure documents, making those improvements should be an SEC priority. We should, moreover, resist successive rounds of concept releases and roundtables in areas where such specific problems and practical solutions have already become evident. The Commission should also reward with our priority attention staff initiatives that advance such practical improvements to our system of corporate disclosure.
Our disclosure regime, in all its aging and accreted complexity, is not perfect in view of its objectives. But in seeking to improve it, a fixation on the perfect will certainly put at risk achieving further good in the near term. So my plea today is this: let’s put ordinary individual investors, materiality, and practicality at the heart of a priority effort to improve public companies’ disclosure documents. It’s high time for the SEC — with your active assistance — to take the initiative on this crucially important issue.
Thank you for inviting me here today, and I wish you a successful conclusion to this conference.
 Louis D. Brandeis, Other People’s Money at 92 (1914).
 Troy A. Paredes, “Blinded by the Light: Information Overload and Its Consequences for Securities Regulation,” 81 Wash. U. L. Q. 417 (2003). Available at: http://digitalcommons.law.wustl.edu/lawreview/vol81/iss2/7.
 M. J. White, “The Path Forward on Disclosure,” speech to the National Association of Corporate Directors — Leadersip Conference 2013 (Oct. 15, 2013). Available at: http://www.sec.gov/News/Speech/Detail/Speech/1370539878806.
 Dodd-Frank, sec. 111 et seq.
 JOBS Act, sec. 108(a).
 See, M.J. White, supra note 3.
 This is in considerable measure due to the enhanced requirements in Section 401(b) of the Sarbanes-Oxley Act.
 Professor (and former SEC Commissioner) Joe Grundfest and former SEC Director of Corporation Finance Alan Beller made this point in their 2008 paper, “Reinventing the Securities Disclosure Regime: Online Questionnaires as Substitutes for Form-Based Filings,” Rock Center for Corporate Governance, Stanford University, Working Paper Series No. 2 (Aug. 4, 2008). Available at: http://ssrn.com/abstract=1235082.
 The Commission adopted Form SD (17 CFR 249.448), in conjunction with adopting its rule to implement Section 1502 of the Dodd-Frank Act (“Conflict Minerals”) (Rel. No. 34-67716 (Aug. 22, 2012)). That same day, the Commission also adopted a rule to implement Section 1504 (“Disclosure of Payments by Resource Extraction Issuers”) of that Dodd-Frank Act, to which Form SD would also apply (Rel. No. 34-67717 (Aug. 22, 2012)). Both rules were subsequently challenged in court. The district court upheld the conflict minerals rule; its decision was appealed. The resource extraction rule was vacated and remanded to the Commission.