Speech by SEC Commissioner:
Remarks at the Plain Language Association International's Fifth International Conference
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
November 4, 2005
Does SEC Disclosure Eschew Obfuscation? Res Ipsa Loquitur!
Good afternoon. I am delighted to be here today. A fundamental goal of the Plain Language Association International is to help people understand and use plain-language principles. As a Commissioner at the SEC, whose mission is to protect investors and maintain the integrity of the securities markets, I believe disclosures to investors must be clear to be effective. The title of my remarks - Does SEC Disclosure Eschew Obfuscation? Res Ipsa Loquitur - is an excellent example of what not to do. Before I continue, I am required to state that the views I express today are my own, and do not necessarily reflect the views of the Commission or its staff.
Unfortunately our rules, and the disclosures that result from them, are often not as easy to understand as I would like. The problem is that the securities laws, which share as their underlying goal the disclosure of material information upon which the investing public may make informed decisions, are sometimes written in dense legalese. The complex language in these statutes is in turn incorporated into many of the Commission's rules and regulations, which are then mirrored in the marketplace disclosures. As a nonlawyer - I am an economist - I have a real problem with that. I don't speak legalese and neither do most investors.
Based on numerous discussions I have had on this subject since becoming a Commissioner, it is clear that there is a difference in goals of the disclosing parties and the recipients of those disclosures. Very simply put, it is my perception that disclosing parties and their lawyers - be they mutual funds, broker-dealers, investment advisers, or operating companies - view their disclosure obligations with an eye toward limiting their potential liability. Thus, the disclosures that they make, while often voluminous, do not necessarily provide information in a helpful, informative manner. In contrast, the recipients want timely, complete, and useful information that is readily understandable.
In my view, limiting the liability of the entity making disclosure is the wrong emphasis. Instead, the focus of disclosure should be to enlighten investors. In order for the Commission to protect investors best, the goal must be to provide investors with access to clear, concise, and accurate information to enable them to make good investment decisions. After all, we cannot and should not make investment decisions for the public - but we can demand that investors have the information they need to make informed decisions. This is best achieved through plain language disclosures that make the message clear. Clear disclosures are also critical to maintaining the integrity of the securities markets. If there is anyone here who doubts this observation, a simple example is the Enron case where the company failed to disclose accurately its off-balance sheet transactions until it was too late. Arguably, had such disclosure been made at the onset, investors would have been able to consider the off-balance sheet transactions and make informed investment decisions before the company's collapse.
To make the point, I reviewed some current disclosures by reporting companies. What I thought I would do is read you the disclosure, and then translate it into English. Although I paraphrase rather than quote the actual disclosure, I assure you that I am not making up the gist of these disclosures.
Disclosure Number One Regarding a Mutual Fund: No salesperson, dealer or any other person has been authorized to give any information or to make any representations, other than those contained herein, in connection with the offer contained herein and, if given or made, such other information or representations must not be relied on as having been authorized by the fund, the fund's investment adviser or the fund's distributor.
Translation: You should rely only on the information contained in this document. We have not authorized anyone to provide you with different information.
Disclosure Number Two Regarding a Security: Any interest collections on the loans remaining after payments of interest on the notes and the company's expenses will be available to cover any losses on the loans that are not covered by the insurance policies.
Translation: After we pay our expenses and interest on the notes, we will use any remaining funds to cover uninsured losses.
Disclosure Number Three Regarding a Variable Annuity: You may select an annuity payout that varies depending on the performance of the underlying investment options. One ascertains the contract's annuity units by dividing the initial annuity payment of such option by the parallel accumulation unit value as of 30 days before the day annuity payments begin. An annuity unit is used to measure the annuity payment's dollar value. Although the value of annuity units may vary, during the annuity period the total number of annuity units remains fixed.
Translation: Actually, I have no idea what this says. It sounds important to know. I realize this is out of context and that I don't have the benefit of my broker explaining it to me.
As the foregoing examples demonstrate, there is much work to do before we achieve universal acceptance of plain language in the market. Indeed, when I was appointed by President Bush in early 2002, then Chairman Harvey Pitt asked me to undertake a review of our rules and regulations, from an economic - not a legal - perspective, to make sure they are clear and are accomplishing their objectives in an efficient and effective manner. I had contemplated that this review would include whether our rules are written in plain language. Due to unforeseen events, including Enron, WorldCom and other corporate failures as well as the mutual fund trading scandals, this project had to take a back seat. However, I have not lost my enthusiasm for the project and hope that we can get back to it.
The good news is that the Commission is aware that many of our rules and regulations are complex and has long recognized that these rules have contributed to the legalistic language and tone of documents used in the market. Over the years the agency periodically has engaged in a self-evaluation of the effectiveness and clarity of our rules and regulations. To this end, the Commission has repeatedly taken steps to promote the use of plain language, particularly with regard to the language in a prospectus - the traditional offering document that describes a company's business, management, and financial condition to enable investors to make informed investment decisions. Over time the Commission has revised our disclosure requirements to avoid complex legal and other technical language in favor of short, clear disclosure. For example, in 1966, the Commission issued a release urging issuers to avoid complex legal and other technical language in their prospectuses for various employee stock purchase, savings, stock option and similar plans. The Commission stated that the "chief goal of registration is disclosure for the benefit of investors and that involves, among other things, the use of language that can be understood readily by the persons to whom it is addressed."1 The Commission then observed that the "[f]ailure to use language that is clear and understandable by the investor may operate to defeat the purpose of the prospectus." Although the release was issued nearly forty years ago, the observations made then are every bit as relevant today.
In 1967, the Commission constituted an internal study group to examine and make recommendations for improving its disclosure regime.2 This resulted in the 1969 "Wheat Report," named for then Commissioner Francis M. Wheat.3 Among other findings, the Wheat Report noted the problem of prospectuses that were so long and complex, the average investor could not readily understand them - thereby diminishing their utility and defeating the very purpose of having them.
In 1982, the Commission again took action to promote the use of plain language when it adopted an integrated disclosure system that was a comprehensive revision to the rules and forms governing the registration of securities.4 The Commission encouraged issuers to deliver their more readable glossy annual reports to shareholders rather than the legalistic Form 10-K annual report. The Commission specifically noted that the more readable annual reports would "promote the goal of concise, effective communication in the Securities Act context." The Commission also codified by rule the requirement for clear, concise, and understandable presentation of information in prospectuses.
In 1991, Congress and others raised concerns about the complexity and length of limited partnership prospectuses. The problem of unreadable disclosure was sufficiently serious that then Chairman Richard Breeden, in testimony before Congress, stated that after taking a look at some of the documents, he "would like to meet the person who can understand all of the disclosure in some" of them.5 The Commission responded by issuing an interpretive release advising issuers on the requirements for clear, concise, and understandable disclosure in limited partnership offerings.6
Throughout the remainder of the 1990s, the Commission undertook a variety of efforts to promote more readable documents and to encourage the use of plain English. In 1996, the Division of Corporation Finance began a plain English pilot program that encouraged companies to draft their prospectuses and other disclosure documents more clearly. Working with the Commission's Office of Investor Education and Assistance, the staff offered advice on how to organize these documents, and provided examples of how to rewrite the legalese in plain English.
The Commission had a banner year in1998 promoting plain English. The Commission adopted its plain English disclosure rules (both for corporate issuer prospectuses and mutual fund prospectuses),7 and its new disclosure option for mutual funds.8 The Commission's Investor Ed Office published "A Plain English Handbook, How to Create Clear SEC Disclosure Documents" which provides practical tips and is posted on the Commission's website.
The plain English disclosure rules required issuers to write the cover page, summary and risk factors sections in plain English using short sentences; definite, concrete, everyday language; active voice; tabular presentation of complex information; no legal or business jargon; and no multiple negatives. Issuers were also instructed to design the page layout so as to make it inviting for the reader. As for the remainder of the prospectus, the Commission provided guidance to purge the entire document of legalese and repetition that blurred important information.
In addition, the Commission permitted a mutual fund to offer investors a new disclosure document, called a "profile," which would summarize key information about the fund in a concise, standardized format, including the fund's investment strategies, risks, performance, and fees. The rule required the profile to be in plain English, and provided an investor with the option of purchasing the fund's shares either after reviewing the information in the profile or after requesting and reviewing the prospectus.
The plain English disclosure rules for issuers, although initially challenging to adopt, have been successful in their implementation for both corporate issuer and mutual fund prospectuses. Today, an issuer's prospectus (while still cumbersome and not always as informative as it could be) is far easier to read and understand as a result of this industry-wide revision. Conversely, the mutual fund profile has had far less success. My understanding is that few funds have chosen to use the profile for fear that they will have some liability exposure if an investor purchases fund shares based only on the summary contained in the profile rather than the robust (if not overwhelming) disclosure in the fund prospectus.
I hope by now you appreciate that the Commission understands it is a serious challenge to write what are essentially legal documents in a way that is clear to the non-legalese speaking public. Even though I am not a lawyer, I have personally experienced the pitfalls of using legal jargon and the danger of taking for granted the notion that terms commonly used in the industry are readily understood by the investing public. Let me explain.
In late 2003, the Commission began working on draft "point of sale" disclosures for purchasers of mutual funds through broker-dealers. The purpose of these proposed disclosures is to make sure that investors who contemplate purchasing funds through broker-dealers understand, before they buy, what it is that they are paying for and whether the broker has any conflicts of interest relating to the sale. Conceptually, this seems straightforward. In practice, the drafting has been a serious challenge.
When I reviewed the first draft of the proposed forms, they were so laden with industry jargon that I could not understand them even though I knew what they were trying to convey. While I had no doubt that the forms were technically correct, I did not think that the average investor would get the message. With the aid of one of my counsels, I decided to take a stab at improving the forms to make them more understandable. I also enlisted help from the Commission's Investor Ed Office and its Division of Market Regulation. Ultimately, in January 2004, we put out forms for comment that I thought were pretty good at getting the message across.
To be sure about that, however, and with my strong encouragement, our Investor Ed Office undertook a major outreach program to get comment from real investors. As part of that program, the Commission hired a consultant to conduct focus group testing in various cities. I cannot emphasize strongly enough how important the focus group testing proved to be. By testing various versions of the forms we learned that they did not work as well as we had hoped. Using those findings, we revised the forms and sought additional comment. We continue to evaluate comments on the disclosure forms based on what the investor focus groups found most useful and may seek further comments.
The lesson we learned from this process - and it is one that marketers have known for years - is that not only is the choice of words critical, but a document's format and placement of information on the page are equally important elements in getting the message across.
I am happy to report that the Commission has applied this learning to other initiatives. For example, this past April the Commission adopted a rule to allow broker-dealers to offer fee-based brokerage accounts without treating them as advisory accounts. You might ask why this rule was needed. The reason is that broker-dealers and investment advisers operate under different regulatory regimes that impose different obligations. In particular, investment advisers owe an overall fiduciary obligation to their clients. While brokers may have an overall fiduciary duty depending on the customer relationship, the emphasis under their regulation is different and in many instances they might not be obligated to do what an adviser must do - for example, they might not be required to disclose certain conflicts of interest. In 1940, Congress created an exception from investment adviser regulation for brokers that give investment advice that is "solely incidental to" their brokerage business and for which they receive no "special compensation." The recent rule was adopted to make clear that fee-based accounts are within the exception.
In January 2005, the rule the Commission proposed contained several conditions, including making certain disclosures to investors. The proposed disclosure language was intended to convey that fee-based brokerage accounts are brokerage accounts, not advisory accounts, and that there are differences between the two types of accounts, including in some cases the extent to which the broker has a fiduciary obligation. To determine whether this disclosure would be useful to investors, our Investor Ed Office arranged for the language to be tested on actual investors. The results were surprising and paradoxical. While our proposed disclosure was successful in alerting investors to the need to ask questions about the differences between brokerage and advisory accounts, it was not successful in answering these questions, but instead raised their anxiety level. This is because the testing showed that focus group participants did not appreciate the distinctions among various financial professionals, and the proposed disclosure did little to explain those distinctions. For example, many investors did not understand what the term "fiduciary" meant.
Once again, insight from focus group testing was invaluable for informing our final rule. In the final rule, we included disclosure that we modified to be in plain English and that provides some information on the nature of conflicts involved in the broker-customer relationship and also encourages investors to ask questions about their rights and the broker-dealer's obligations to them. The testing also highlighted for us the question of whether disclosure alone - particularly since it is required only in the context of fee-based brokerage accounts - is sufficient to address the broader investor protection concerns raised during the rulemaking which extend well beyond fee-based accounts. As a result we are considering what additional steps could be undertaken to reduce investor confusion, including a longer-term study examining the interplay of broker-dealer and investment adviser regulation and ultimately possible further rulemaking or legislation.
Another important area where disclosure can be improved concerns a company's financial information. I believe companies can make better use of their Management, Discussion and Analysis, or MD&A, to inform investors. Specifically, management can better explain a company's financials, using plain English to provide a narrative explanation of the material elements of a company's financial condition and results.
Further, the time and effort required to extract financial details from a full set of financial statements may lead investors to rely substantially on summary data, resulting in an incomplete or even misleading picture of the company's operations. Given the importance of providing investors with a complete picture of a company's finances, the Commission is working to make that financial information more transparent and useful to investors. Since February, the Commission has been testing financial data tagging technology through a voluntary program that allows reporting companies to submit their reports to the Commission using eXtensible Business Reporting Language, or XBRL, a computer language that makes interactive financial data possible. Last month, the Commission released a Request for Information or RFI seeking feedback from the software industry concerning interactive financial data technology. For simplicity, I analogize interactive data technology to Lego building blocks - when a company uses "tagged" interactive data to disclose its financial information, investors can analyze the data in any combination of ways to construct for themselves a financial picture of that company much like Lego pieces can be used to construct a variety of structures. Interactive data makes it possible to transform static, text-only documents into dynamic financial reports that can be quickly and easily accessed, analyzed, and compared. I look forward to seeing progress on this exciting initiative.
As we move forward it is imperative that the Commission continues to promote the use of plain language disclosures. I am particularly concerned with disclosures to individuals who are investing their retirement savings. In the past thirty years or so, the responsibility for making investment decisions for money invested in retirement plans has shifted from employers to the individual employees. This is because a generation ago many employers offered defined benefit plans that promised employees a specific benefit payable upon retirement. Individuals therefore relied on their employer and had little incentive to review their plan's investments. Since then, more employers have instead offered a defined contribution plan in which employees bear the responsibility to determine the investments for their individual accounts, based on a menu of available investment options. As a result, the number of individuals making investment decisions over their retirement savings continues to grow. It is incumbent on us to make sure that these investors have the information they need, in an easily understandable format, to enable them to make informed decisions.
In conclusion, I would like to stress that each of you can help the Commission promote plain language disclosures. As part of the rulemaking process, the SEC seeks public comment on its proposed rules, including the ones that I have mentioned today. I encourage anyone who is interested in our rules to please submit your comments to us. I assure you that we greatly appreciate your input and take your concerns seriously.