FROM THE OFFICE OF PUBLIC AFFAIRS

“Restoring Investor Confidence: The Key is Disclosure”

Restoring the vitality of our nation’s securities markets is dependent upon improving the quality of information that investors receive.  Nothing is more important.

Our securities markets are extremely efficient at pricing and allocating capital on the basis of all available information.  Unfortunately, the important information is too often not available.  When critical information is absent, or where great disparities exist in the quality of information available to different players, the power of markets is misdirected and the allocation of resources becomes skewed, mocking the claim - which both you and I make - that our securities markets are the most efficient means we have of converting our collective savings into investment.

Today, I want to ask you to promote the idea that investors have a fundamental right to see the companies in which they invest through the eyes of management.  I think that you should work to ensure that investors see both the real, economic leverage and the key indicators of business value that are available to insiders.  If we cannot find a way for companies to disclose these basic financial and business facts, I fear we will never align the interests of corporate insiders with those of their investors.

Public attention has focused on conflicts of interest borne by securities analysts.  This is an important subject, worthy of your remedial efforts. But if neither analysts nor investors have the right information with which to price a company’s securities, the mere removal of conflicts of interest between them will not get us as far as we need to go.

If we are incapable of putting both investors and analysts on the same footing as insiders, particularly with respect to companies’ real, economic leverage, then I fear that the best days of the securities industry may be behind you. 

If, however, we can find a way to provide investors with sufficient information to price a company’s securities on the same basis as insiders, then I think that our traded capital markets can prosper.

We do have the best disclosure regime in the world.  But this is the wrong comparison, and sets the bar too low, because we also have the most evolved - and rapidly evolving - capitalist economy in the world.  As good as our disclosure regime is compared with other those of nations, it is not good enough compared with the quality, timeliness, and analytic rigor of internal management and financial information now available to corporate leaders.  Disclosures to investors have not kept pace with the communications and data management revolution that has transformed American business over the last twenty years.

Investors should know two kinds of facts that corporate insiders know: first, the handful of key indicators of business value that management actually uses to assess the company’s current performance and near-term prospects, and second, the company’s real asset-liability ratio - the fundamental financial information about all of the company’s contractually-obligated assets and liabilities, whether on- or off-balance sheet.  The best businesses in America have already found ways to provide their shareholders and creditors with a clearer picture of the business and financial reality of their operations.  These firms are the ones that we have not been reading about in recent months and whose credit spreads have narrowed rather than widened.

Dozens of times I have asked CEOs and other corporate leaders how they stay on top their large, complex businesses: "How do you know what's really going on in your company?" Invariably, I receive the clear answer that they have five or six - maybe 10 or 12 - key business indicators that they track daily or weekly.  These indicators tell them what they need to know about their company’s current performance and near-term prospects.  Without notes or preparation, most CEOs can tell you in just a few minutes exactly what these indicators are and what the current numbers are telling them.

More often than not, the conversation takes an abrupt turn when I ask whether the company discloses these indicators in any way for shareholders.  The same CEOs, who had just been explaining how simple it is for them to keep track of their businesses, now tell me how complicated these indicators are and that they would be too confusing and too difficult to provide, even in summary form, to their shareholders and creditors.

Why don’t more firms disclose their core indicators of business performance?  The claim is made that they don’t want to aid competitors.  I don't buy it, at least not for most of their business indicators and nearly all financial measures.  Moreover, this claim simply reflects a value judgment that keeping secrets from competitors is more important than informing the owners - that investors are better off if they remain ignorant of what’s going on inside the companies that they own.  Our publicly-traded capital markets cannot function on so faulty a foundation.

The simple, observable fact is that management has lacked sufficient incentive to provide this information to investors.  Their lack of incentive is a reflection of the much bigger problem that there are two completely different valuation methodologies at work in our economy today: one for those inside the temple of modern finance and who have access to insiders’ data, and a different one for the outsiders who don't understand the basics of modern finance theory and who must rely only upon publicly-available data.

When a corporate CEO plans to buy or sell a subsidiary, or when a private equity firm considers purchasing a company, they don’t begin by looking at trailing quarterly earnings.  Instead, they hire an MBA with a spreadsheet who begins by identifying all of the firm’s assets and liabilities.  The MBA analyst discounts to present value all of the firm’s contractually-obligated future cash out-flows, the firm’s liabilities whether on- or off-balance sheet.  Then the analyst discounts all of the firm’s future, contractually obligated cash in-flows, their long-term customer contracts.

The little secret of capitalism is that it involves risk.  In most cases, the net present value of the future streams of contractually-obligated outflows and inflows is negative.  So the analyst will look to see where the revenues to close and exceed that gap could come from.  Does the firm have particularly good customer prospects?  A powerful brand name or customer loyalty?  A leading inventory management system or whatever else would suggest the ability to generate the additional revenues needed to meet the company's liabilities and still leave a little something to reward the equity holder?  The analyst will inevitably look at those core indicators of business value to complete the picture and put an overall valuation on the firm.

This valuation method is forward-looking.  It takes no heed of the distinction between what’s on and off the balance sheet and gives equal consideration to all contractual obligations.  It appreciates the real economic leverage that the firm has employed.  It focuses on the real drivers of value and ignores accountants' notions of earnings.

Unfortunately, the valuation method used by those outside the temple of finance theory, the method that we teach and reinforce in the public culture of our securities markets, is quite different.

This valuation method is backward-looking and fixated on trailing quarterly earnings.  It is driven by accounting standards that are a function of habit and history, of often archaic and abstract principle, and of a short-sighted conviction that it is better to obscure rather than illuminate the real sources of earnings.  It is grounded in the half-truths of the balance sheet.  It leaves investors struggling through footnotes and appendices to calculate even crude approximations of the total, economic leverage employed through the use of off-balance sheet devices.

Let me be clear: there are lots of legitimate purposes for derivative instruments, structured finance and special purpose vehicles as means of transferring and pooling risk.  But hiding a firm’s total, economic leverage from its shareholders and its creditors is not one of them.

Investors should not tolerate this practice.  Indeed, the low price-earning ratios of some of our leading companies, today, reflect the markets’ intolerance for even the suspicion of hidden, off-balance sheet leverage.  Corporate practice should catch up with where market prices have already gone.

As long as a gap exists between corporate insiders and investors, in both the method used and the data available to determine the firm’s value, then the opportunity and the temptation for insiders to game the system will be too great.  If fundamental information asymmetries are allowed to persist, whole armies of independent directors, accountants, auditors, and regulators will fail to align the interests of insiders and investors.

In the past twelve months, the Securities and Exchange Commission has made a series of proposals and statements aimed at transforming the quality of corporate disclosure.  Bluntly put, the SEC has made clear that disclosure to investors is too important to be left to the accountants.  It has restated - and enforced - the long-standing principle that GAAP compliance does not satisfy disclosure obligations under our securities laws.  Last spring, the SEC proposed rules to require companies to highlight critical accounting policies and judgments and their impact on financial results, and to flag any significant changes in the application of accounting principles.  It proposed real-time disclosure of material events.  And just this week, following through on one of the provisions of the Sarbanes-Oxley bill, the SEC published proposed new rules on comprehensive disclosure of off-balance sheet items.  Taken together, these efforts represent the most important pro-investor initiative that the SEC has taken in many years.

If you want our securities markets to prosper, if you want to remove the cloud of investor skepticism, you must support the SEC’s proposals and you must also become genuine leaders in improving the quality of disclosures by publicly-traded companies.  The federal government can set minimum standards for acceptable behavior and punish those who violate these standards. But if you want our securities markets to continue to play a vital role in our society, you cannot wait for the federal government to fix the current problems for you.

In the division of labor in our securities markets, too many have complacently accepted  the status quo of corporate disclosure; too few have seen it as their responsibility to work systematically to improve the quality of information that investors receive.  If you in the securities industry won’t stand up for the idea that investors have a fundamental right to know the real economic leverage and the real indicators of business value, why should investors put their money at risk in the instruments you try to sell them?

I can understand why risk-averse CEOs, CFOs, directors, lawyers and accountants would prefer to maintain the status quo of different valuation methods for insiders and outsiders.  But your stake in this should be self-evident.  If investor confidence in the disclosures of publicly-traded companies is not restored, your industry cannot prosper.

You must breathe life into the fundamental right of investors to see the financial and business reality of the companies in which they invest through the eyes of corporate management.  If you do this, if you speak up on behalf of the investor’s right to quality information, you will restore investor confidence.

 You will also make a reality of our claim that the securities markets are the most efficient means that we have of converting our savings into investment.