CHAPTER XX THE NATURE OF MANDATED DISCLOSURE When the Securities Act of 1933 was enacted, Congress felt that a mandated disclosure system was needed to protect the public against fraud in the sale of securities. The Securities Exchange Act of 1934 adopted a year later continued to reflect this philosophy. The purpose of this chapter is to discuss some of the economic issues involved in a mandated disclosure system. This paper was prepared for the Advisory Committee by The investment process involves the giving up of current consumption in exchange for securities, which are claims to future, uncertain cash flows. The investor must decide how to allocate wealth between current consumption and investment and how to allocate the funds set aside for investment among the various securities available. The investor naturally has a demand for information that will aid in assessing the future cash flows associated with the securities and the firms that offer those securities. However, the investor is not acting in isolation but within a larger investment environment. This environment consists of several attributes. (1) Investors, some perhaps with limited financial and accounting training, have the opportunity to avail themselves of the services of financial intermediaries, such as investment companies, to whom they can defer a portion of the investment process. (2) Investors, some perhaps with limited access to and ability to interpret financial information, have the opportunity to avail themselves of the services of information intermediaries, such as analysts, to whom they can defer a portion or all of the information gathering and processing function. (3) The information intermediaries compete with one another in the gathering and interpretation of investment information, including firm-specific information. Moreover, corporations, competing with one another for the investors' funds, have incentives to provide information to the investment community. [(4) Investors and the intermedi aries have a set of information available that is more comprehensive and, perhaps in some cases, more timely than the SEC filings. (5) Recent security price research, primarily on listed securities, indicates that, as a reasonable approximation, security prices fully reflect publicly available information (sometimes referred to as market efficiency). 1/ By recent estimates, there are over 14,000 analysts. Corporate management has incentives to provide information to the analysts, and the analysts have incentives to seek out and disseminate such information. This private-sector information system appears to be large and active. Results of research, commissioned by the Advisory Committee and discussed elsewhere in this Report, document the extent and nature of this system with respect to a selected sample of corporations 2/ and analysts. Moreover, private-sector information search 1 may explain why security prices quickly reflect a broad set of For example, it has been argued that competition information. 1/ The membership in the Financial Analysts Federation is reported in the May-June, 1977 issue of the Financial Analysts Journal. 2/ The results of this research are reported in Part I of the Committee Report. among analysts results in security prices that reflect a At the time of the enactment broad set of information. 3/ of the Securities Acts, statements of legislative intent indicate that at least some reliance was placed upon competition within the professional investment community to interpret the SEC filings and to effect efficiently determined security prices. 4/ The current mandated disclosure system consists of a series of highly technical documents which are filed with the SEC and reside in its archives. Many investors, the intended beneficiaries of the Securities Acts, usually do not read and, in the case of 10-K, 10-Q and 8-K filings under the 1934 Act, do not usually even receive copies of these filings. There is an implicit reliance on the functioning of the professional investment community in order to justify the current system as an effective mechanism for disclosure. Moreover, this community often relies on investment information that is more comprehensive and in some cases more timely than that contained in the mandated filings. Under these conditions, the question arises concerning the role of the SEC and its mandated disclosure system in the entire framework. Why is it desirable to have a portion of that disclosure system 1 contain a mandated set of disclosures? 3/ A further development of this argument appears in 4/ In this respect, see statements by Justice Douglas (1933) and discussions in The Wheat Report (1969). Legislative intent has been examined in detail by Anderson (1974). II. Role of Mandated Disclosure Previous Rationale There have been two common forms of justification for the desirability of disclosure regulation. The first approach consists of citing a litany of perceived abuses. Several questions can be raised in connection with such an approach. Were the actions in question in fact "abuses?" What one person might label "manipulation" However, more fundamentally, the point is that perfection sure. Moreover, it is as inappropriate to judge a disclosure system solely on the basis of its perceived abuses as it would 5/ After analyzing the perceived abuses at time of the enactment of the Securities Act, Benston (1973, 1974) has concluded that they constitute an inadequate basis on which to justify the securities legislation. |