Improving Information for Investors in the Digital Age

Address at the Council of Institutional Investors 2018 Fall Conference

Thank you, Ken [Bertsch], for that kind introduction. I would like to start out by thanking the Council of Institutional Investors for inviting me to speak with you. It is a pleasure to be here.

I last spoke to you in May 2014 about “Building Momentum.”[1] At the time, I was a rookie Commissioner. Now, I stand before you after five years as a Commissioner and over 5,700 votes under my belt. It has been an amazing time to be on the Commission, and I’ve learned a great deal about what matters to both companies and investors. Today, I’d like to share with you some of my thoughts borne from my experience. Specifically, my thoughts on how the Commission should improve disclosure to investors in the Digital Age.[2]

Nearly 100 years ago, the United States was undergoing an unprecedented amount of change. Growing companies provided Americans with new inventions, such as the car, electricity, the radio, and the skyscraper.[3] Instead of tweets, there were newspapers sold by paperboys on the street corners, who shouted out the day’s headlines. Radio waves, invisibly sent through the air, let large numbers of Americans hear events as they happened—and it also shaped their opinions. Social media was thriving in the 1920s.

The United States was the world’s wealthiest nation. The economy looked good—in fact, it was growing at an impressive rate. Unemployment was on a rapid decline—approaching 4%.[4] And, both retail and institutional investors were buying into a surging stock market.[5] Then, almost without warning, the country was reeling in an unprecedented tailspin. Eighty-nine years ago tomorrow—October 24, 1929—our markets crashed in an event known as “Black Thursday.”

After the stock market crash in 1929, Congress began to investigate the crisis and find solutions to the problems it uncovered. The investigation revealed investors’ dissatisfaction with information they received about the companies they owned. For example, most companies only produced a balance sheet. And the companies that produced an income statement provided very little detail about the sources of their income and their operations. These voluntary disclosures weren’t very useful, as there were different ways of reporting profit.[6] In essence, investors couldn’t perform basic analysis or compare one company to another or the same company over different time periods.

Further, economic factors in the 1920s encouraged companies to withhold financial information or to disclose less than the amount of information desired by market participants. Company management said they were afraid too much disclosure would put their companies at a disadvantage when competing with other American companies and their foreign counterparts.

However, even when companies provided voluntary disclosures, investors and others questioned the veracity of the information. As one observer noted, “[t]he written records, the accounts of business transactions in a vast number of cases, were imperfectly, inaccurately or fraudulently stated.”[7] This led Congress to find that “[t]here cannot be honest markets without honest publicity. Manipulation and dishonest practices of the marketplace thrive upon mystery and secrecy.”[8]

This essential truth forms the bedrock of the Securities and Exchange Commission’s mission. And it is as true today as it was 89 years ago. This is because, while the capital markets have evolved—new products and technology abound—the Commission’s tools to help the markets thrive remain robust and flexible.

Often, I speak about the incredible pace of change in our capital markets. Our society, and our capital markets, are not just evolving, they are transforming before our eyes. Digital technologies offer new ways to more efficiently and effectively solve complex problems.

Looking across a room or across a subway car, instead of faces, we see small handheld computers. Smartphones. These small, but mighty devices are propelling unprecedented and fundamental changes in how we do things—how we parent our children, how we communicate, how we do business, how products and services are delivered, and how we invest.

We’ve been through similar transformations before. In some ways, we started this particular journey over 200 years ago (1792), when the telegraph set in motion a dramatic change in how we communicate. Later, the telephone improved upon this one-way method of communication. The advent of the radio (perhaps the first social medial platform) allowed the telling of the same story to thousands of people at the same time. It also allowed people to call in with questions or comments. In the 1960s, the first emails were exchanged. In the 1970s, electronic bulletin boards were in vogue, as ARPANET (the early predecessor to the internet) was making new connections to colleges and universities. The 1980s revolutionized email with software applications that began blasting messages to many users at the same time. In the 1990s, the development of an easy to use and graphic-friendly web browser (Mosaic) accelerated and popularized the World Wide Web. This allowed nearly instantaneous sharing of information. From that platform, social networking and new forms of social media have flourished.

No matter the means of communication, timely, relevant, and reliable information has always been critical to the success of the American capital markets. Today in the Digital Age, the Commission faces the same question it faced 84 years ago—how to ensure that the markets have the best information environment possible.[9]

Much has changed since the Commission was created in 1934. Nonetheless, the fundamental principles adopted by the Commission—transparency and fair presentation still serve as a Rosetta Stone in today’s Digital World. By applying these fundamental principles from the past, I believe we can find thoughtful ways to address the new challenges of the Digital Age. We have all the tools we need. We just need to apply them.

As I discussed earlier, there have been a lot of changes since the days when radio dominated the media landscape. Given these changes, there has been a debate about how the information needs of today’s investors have changed. For example, on the one hand, we hear that public companies are “overloading” investors with information. In particular, they are so inundated that “it [is] difficult for investors to focus on the information that is material and most relevant to their decision-making.”[10] Moreover, one report called information overload a “pressing concern.”[11] However, I must reveal that during my five years on the Commission, I have not heard this concern expressed by even one investor. Not one.

In fact, it has been my experience that investors and others are asking for more information. In 2014, when the Commission sought comment on its disclosure framework, it received over 26,500 comments.[12] The “overwhelming response…seem[ed] to reflect an enormous pent up demand by disclosure recipients for more and better disclosure.”[13]

This demand has not subsided. Just a few weeks ago, a group of institutional investors, asset managers, state treasurers, and others petitioned the SEC. They asked the Commission to require disclosure of environmental, social, and governance (ESG) information by publicly traded companies in a standardized format.[14] Indeed, third-party providers are already collecting and assembling information and data to provide ESG ratings on companies. And, institutional investors, asset managers, financial institutions, and other stakeholders are increasingly relying on these reports and ratings to measure and assess a company’s ESG performance over time compared to peers.^[15] Furthermore, elsewhere in the world, we see legislation enacted to require periodic reporting of ESG information.^[16]

Companies also are electing to voluntarily provide more information. A recent report noted the explosive growth of non-GAAP metrics. Ninety-seven percent of all S&P 500 companies disclosed some form of non-GAAP metric last year.[17] However, these metrics are not standardized or uniform. Many are based loosely on measures prescribed by generally accepted accounting principles (GAAP), but contain additions, subtractions, or other changes. Once used sparingly, non-GAAP metrics, such as adjusted operating income, Earnings Before Income Taxes Depreciation and Amortization (EBITDA), Adjusted Operating Income Before Depreciation and Amortization (Adjusted OIBDA), core earnings, average revenue per customer, and free cash flow are increasingly common.[18] Indeed, they have become nearly ubiquitous. However, non-GAAP metrics are often criticized because, for the most part, the non-GAAP numbers remove significant expenses and therefore may disguise financial performance. Nonetheless, one study found that companies may be rewarded for using non-GAAP metrics. These companies tend to produce quarterly earnings per share that exceed analysts’ forecasts by 5 to 15 cents, not a penny or two.[19] As a result, some have raised the concern that such metrics are “designed to present results in a more favorable light.”[20]

While these voluntary disclosures increase information to investors and the marketplace, I am concerned that the lack of uniform standards and the lack of comparability may result in presentations that are not fairly balanced or fairly presented. In effect, what non-GAAP metrics measure, or attempt to communicate, more often are in the eye of the preparer rather than the beholder. In fact, one analyst study showed that a popular non-GAAP metric, “core earnings” was on average 30% higher than earnings reported under GAAP. [21] Also, misaligned incentives, such as customized measures linked to executive compensation may fuel this growth.

The issue of non-GAAP metrics may be even more acute in the private markets, with forward-looking adjustments, such as speculative cost savings to be realized in the future, or go-forward revenue assumptions underlying loan documents. Even sophisticated investors, such as public pension funds, are potentially being left in the dark because these metrics are not uniformly defined and, often, they are unable to see the inputs or deductions from GAAP-determined measures.

Companies compute these customized measures differently, use different definitions for similar terms, and create bespoke titles such as “adjusted consolidated segment operating income.” Moreover, companies change the way they compute their non-GAAP metrics from time to time. Some have characterized these custom measures as “fuzzy math” or “earnings before bad stuff.” Others value these non-standardized metrics as alternative measures for obtaining greater detail regarding management’s assumptions. In fact, some argue that non-GAAP measures provide more and better information and that these metrics benefit investors and reduce uncertainty and risk.[22]

Key performance indicators (KPIs) are another type of measure increasingly being reported by companies. KPIs are metrics and data that companies use internally to measure their performance. But, more and more, companies are choosing to publicly report some of these measures. KPIs can be financial performance measures, such as same store sales, sales per square foot, customer churn rates, or sales conversion rates. But companies also use KPIs to present non-financial performance measures, such as customer retention, employee satisfaction, or even the number of “likes” they receive on social media platforms.

It is clear that, during the past decade, managers of U.S. companies are communicating more information about how they run their companies, perhaps in an effort to meet both the market’s and investors’ demand for more information. Alternative measures—such as non-GAAP metrics and KPIs—that were once used sparingly, now appear in a host of documents and situations, including road shows, analyst meetings, and quarterly earnings calls.

However, the lack of uniformity in definition, or computation methods, limits comparability. In addition, some fear these measures tend to be “detached from reality.”[23] These concerns revolve around the actual quality of information companies are providing. Investors, analysts, and other market participants desire more high-quality information, not less. They want to ensure that information is useful and truthful. And companies are responding by providing more. However, uncertainty about the quality and veracity of the information may be contributing to a poor information environment.

Again, returning to our roots, we can learn much from the SEC’s beginnings. In the 1930s, the SEC was focused on a debate about the form and content of financial statements. As I mentioned earlier, there wasn’t much uniformity at the time.[24] The struggle then, as now, was how to imagine financial reporting as a form of social media—a means by which a company may effectively engage, communicate with, and inform its investors. As the SEC said in 1942, financial statements exist to “enlighten[].”[25] Accordingly, that’s the starting point.

As the Commission explained, “[e]ven if [all significant data] had been given, there is an additional obligation to present the material in a way in which it will be useful to [both] the informed and less sophisticated readers.” That requires further emphasis—the obligation is to ensure that disclosures are useful to everyone—both sophisticated and less sophisticated readers.

The Commission should not be focused on information overload or decreasing the amount or timeliness of information in the market. Instead, the Commission should be focused on how to organize it and ensure that it is fairly presented. We should be encouraging better communication between investors and issuers to the benefit of both parties.[26] Since 1934, the Commission has insisted on full, complete, accurate, and informative disclosure. We should continue to do so in 2018 and beyond.

That does not mean that the Commission needs to impose its own standards. The Commission has historically looked to the private sector to help establish standards, which has created an important joint responsibility.[27] In particular, the accounting profession was instrumental in narrowing varying practices into financial reporting standards that were uniform and consistent (e.g., GAAP).[28]

However, despite the growing integration of ESG disclosure into corporate reporting, there are still competing private groups and competing methodologies, leaving both companies and investors in a state of confusion. And that, in and of itself, is unsustainable.

Furthermore, the Commission’s issuance of mere “guidance” regarding cyber-related disclosures falls short of providing useful and reliable disclosure, and it leaves companies in a state of quandary. The Commission should lead by helping to create standards for disclosure, using structured data and taxonomies, where applicable. Facilitating the establishment of standards resolves uncertainty and reduces the cost of information.

These are but two examples of how we should be improving disclosure. If capital moves to jurisdictions that are perceived to have higher quality disclosure systems, it may be too late to act. We, at the SEC, must improve both the end product and the system of disclosure so that our capital markets remain the gold standard.

In the past, I’ve suggested a number of ways to go about making such changes. For example, I have advocated for the formation of a Digital Disclosure Task Force to include investors, analysts, academics, companies, and technologists to leverage today’s technology for a modern disclosure system. But even more importantly, the Commission needs to engage in overseeing, and encouraging, a robust information environment. And, as the early SEC did, one that fairly presents information that is relevant, reliable, and decision-useful. The Commission must work to set forth acceptable standards that contribute to the provision of useful information to investors. Quite simply, the Commission needs to focus on information that is relevant to today’s investors. And, it goes without saying that the information must be trustworthy and credible.

As we all know, after the stock market crash in 1929, Congress adopted a disclosure-based framework for regulating the securities markets. The challenge for Congress was how to ensure that disclosures were fair and truthful.[29] One way Congress sought to achieve this was by allowing investors to sue companies for false statements. Congress also imposed liability on those individuals responsible for these statements, including directors, officers, and underwriters. And, a third way Congress approached the problem of inaccurate information was to require the certification or validation of financial statements. The initial drafts of the “Truth in Securities” Act required government auditors to examine and validate corporate financial statements. But, Congress ultimately decided to turn to private, independent, public accountants for this task.[30] It is interesting to note that public accountants, at the time, were relatively unknown. Fortune described the auditor in 1932, as “walk[ing] in the shadow of virtual anonymity.”[31] Others described auditors as appearing only when there were suspicions of “fraud or irregularity” and at times “investigating…secretly, often at night and on Sundays.”[32]

When information credibility concerns again threatened confidence in our financial markets, Congress again stepped in. In 2002, Congress passed the Public Company Accounting Reform and Investor Protection Act (also known as Sarbanes-Oxley Act)[33] in response to a series of corporate frauds—in particular, Enron and WorldCom. The Sarbanes-Oxley Act was an overwhelmingly bipartisan effort (99-0 in the Senate; 334-90 in the House) to strengthen our capital markets. President George W. Bush quickly signed the bill into law, which was characterized as “the most far reaching reforms of American business practices since the time of [the Securities Act].”

The Act focused on restoring investor confidence through a number of reforms that enhanced corporate responsibility, strengthened financial disclosures, and combated corporate and accounting fraud. Congress also created the “Public Company Accounting Oversight Board,” also known as the PCAOB, to oversee the activities of the public company auditing profession.

One of the biggest changes made by the new law was the expansion of the role of the public company auditor to include an independent examination of a company’s internal controls over financial reporting. Prior to 2002, there was considerable debate about whether strong controls would reduce the incidence of financial reporting fraud.[34] Since that time, both companies and investors have benefited.[35]

For example, companies benefit by enjoying greater access to lower cost capital and increased liquidity. [36] Companies also have benefited with higher credit ratings, and lower costs of debt. In a survey of company CFOs, 85% said that the examination of internal controls has either “greatly” or “somewhat” helped their company.[37] Another study found that companies that did not have an independent assessment of their controls over financial reporting had lower aggregate market values than those with the assessments.[38]

Investors also have benefited by having higher confidence in a company’s reported numbers.[39] In addition, studies have found reports that cite material weaknesses provide a meaningful signal of increased fraud risk.^[40] In fact, many investors believe that the independent auditor’s role has been too circumscribed, and I think the early Commission would agree. As one former SEC Commissioner opined, following the events of the 1930s, “the auditor became the surest friend of the investor.”[41] Later, in 1957, the Commission made its position clear: the auditor’s “duty is to safeguard the public interest, not that of [the] client.”[42] And the Courts agreed, calling the auditor, a “public watch-dog.”[43]

For more than seventy years, the role of auditors and their central communications tool, the auditor’s report, has remained largely unchanged—essentially a pass/fail report card. However, here, investors also are demanding more. Recent changes to audit standards in the United States and elsewhere around the world are revamping both the form and content of the auditor’s report. The new auditor’s report should provide investors with more meaningful information about the audit, including significant estimates and judgments, significant unusual transactions, and other areas of risk at a company. The new information from the auditor will add to the total mix of information available to investors when making voting and capital allocation decisions. This is a good start, but more needs to be done.

In fact, an early auditing manual from 1892 argued that “it is only by voluntarily accepting, and even increasing, the responsibilities of our position that we can hope to maintain and increase the large measure of public confidence that we at present enjoy.”[44] The Digital Age presents that opportunity. The development of audit tools that leverage data and technology, including blockchain, could revolutionize the audit assurance model. This means that auditors could benchmark corporate data and expand their assurance beyond the financial statements.

The very nature of the auditor’s privileged position provides him or her with information that may be valuable for investors. For example, auditors could offer their views on corporate culture, diversity, or cybersecurity preparedness. Moreover, the auditor could offer assurance to a company’s audit committee about the fair presentation of non-GAAP measures, KPIs, or a host of other information communicated to investors. In effect, independent auditors remain an untapped resource. Their role should evolve to meet the changing information needs of investors.

Conclusion

Since its founding, the Commission has been concerned about creating a robust information environment that is characterized by full, complete, accurate, and informative disclosure. The Commission should ensure that its disclosure system meets the needs of investors by providing information that is truthful and useful. We must remember the principal outlined by President Roosevelt during the creation of the SEC: “What we seek is a return to a clearer understanding of the ancient truth that those who manage banks, corporations, and other agencies handling or using other people’s money are trustees acting for others.”[45]