In 2000, the U.S. Securities and Exchange Commission (SEC) imposed new regulations to eliminate the practice of "selective disclosure," in which business leaders provided earnings estimates and other important information to analysts and large institutional shareholders before informing smaller investors and the rest of the general public. The regulation—Regulation FD—forces companies to make market-sensitive information available to all parties at the same time.
Regulation FD addresses the selective disclosure of information by publicly traded companies and other issuers. Regulation FD provides that when an issuer discloses material nonpublic information to certain individuals or entities—generally, securities market professionals, such as stock analysts, or holders of the issuer's securities who may well trade on the basis of the information—the issuer must make public disclosure of that information. In this way, Regulation FD aims to promote the full and fair disclosure.
More changes were made to the SEC's disclosure rules in the summer of 2002 with the passage of the Sarbanes-Oxley Act, which is often referred to as SOX. The Sarbanes-Oxley Act came about because of a bankruptcy filed by Enron, a big energy-trading company, in late 2001. The bankruptcy filing was the largest to date in 2001, costing investors billions of dollars and employees lost their jobs and in many cases their life savings. A market consensus developed that the Enron debacle would have been prevented if audits of the company had detected accounting irregularities or if the company would have been required to disclose transactions not directly reflected on its balance sheet. To a large extent, Enron's failure was the result of corrupt practices. Concern quickly grew about how easily these practices had been carried out and hidden from investors and employees alike.
Sarbanes-Oxley was a reaction to this failure, though during the same period, however, pending bankruptcies of WorldCom, a long-distance telecommunications company, and Tyco, a diversified equipment manufacturer, influenced the content of the legislation.
SOX thus deals with:
- Reform of auditing and accounting procedures, including internal controls;
- The oversight responsibilities of corporate directors and officers and regulation of conflicts of interest, insider dealings, and the disclosure of special compensation and bonuses;
- Conflicts of interest by stock analysts;
- Earlier and more complete disclosure of information on anything that directly and indirectly influences or might influence financial results;
- Criminalization of fraudulent handling of documents, interference with investigations, and violation of disclosure rules;
Requiring chief executives to certify financial results personally and to sign federal income tax documents.
Regulation
Privately owned companies are not required by law to disclose detailed financial and operating information in most instances. Small businesses and other enterprises that are privately owned may shield information from public knowledge and determine for themselves who needs to know specific types of information. In contrast, companies that are publicly owned are subject to detailed disclosure laws about their financial condition, operating results, management compensation, and other areas of their business.
The SEC requires disclosure of relevant business and financial information to potential investors when new securities, such as stocks and bonds, are issued to the public, although exceptions are made for small issues and private placements. The current system of mandatory corporate disclosure is known as the integrated disclosure system. By amending some of its regulations, the SEC has attempted to make this system less burdensome on corporations by standardizing various forms and eliminating some differences in reporting requirements to the SEC and to shareholders.
Publicly owned companies prepare two annual reports, one for the SEC and one for their shareholders. Form 10-K is the annual report made to the SEC, and its content and form are strictly governed by federal statutes. It contains detailed financial and operating information, as well as a management response to specific questions about the company's operations.
SEC regulations require that annual reports to stockholders contain certified financial statements and other specific items. The certified financial statement must include a two-year audited balance sheet and a three-year audited statement of income and cash flows. In addition, annual reports must contain five years of selected financial data, including net sales or operating revenues, income or loss from continuing operations, total assets, long-term obligations and redeemable preferred stock, and cash dividends declared per common share.
In order to meet the disclosure requirements of new issue registration, companies prepare a basic information package similar to that used by publicly owned companies for their annual reporting. The prospectus, which contains all information to be presented to potential investors, must include such items as audited financial statements, a summary of selected financial data, and management's description of the company's business and financial condition. The statement should also include a summary of the company's material business contracts and list all forms of cash and noncash compensation given to the chief executive officer (CEO) and the top five officers. Compensation paid to all officers and directors as a group must also be disclosed. Essentially, a company seeking to go public must disclose its entire business plan.
CFA Institute Viewpoint
Companies have ongoing obligations to disclose in a timely manner information that investors would weigh in making informed investment decisions, including events that pertain to the dynamics of a company or otherwise have the potential to affect share value. This information should be made readily accessible to the investing public.
Without a certain level of appropriate guidance, issuers of securities may fail to clearly and consistently disclose the relevant information that allows investors to make informed investment decisions. Poor-quality or missing information can mislead investors about the financial condition and performance of a company, so in many instances, regulatory oversight of disclosures only improves investor protections.
The benefits of disclosure should be weighed against practical issues, such as the cost of gathering and reporting or any competitive disadvantages a firm suffers in the process. But providers of financial information − regardless of size, industry, locale, or maturity − will best serve investors by adhering to the highest standards of transparency, accuracy, relevance, and timeliness in financial reporting.