Do disclosure rules actually work?

December 30, 2010, 6:09 PM UTC

Disclosure failed during the run up to the financial crisis. As a result, the SEC developed new disclosure requirements for U.S. companies this year. So how well have they worked?

By Eleanor Bloxham, contributor

Disclosure is the often sought remedy in regulation. Rather than specify what a company is required to do, disclosure itself is often used as the regulatory mechanism.

The idea behind requiring disclosure from companies, rather than coming up with specific behavioral requirements, is that, if you specify too much, you run the risk of getting the requirements wrong.

Disclosures can inspire external pressure on corporations from shareholders, creditors, customers, government agencies, rating agencies, members of the community, and the media. But the beneficial impacts of disclosure are highly dependent on two factors — careful reading of the disclosures and actions taken, based on the disclosures.

Sometimes disclosure leads to corrections; other times it fails miserably.

Disclosure failed during the run up to the financial crisis. The available warning signals, both inside and outside corporations, failed. As a result, the SEC developed new disclosure requirements for U.S. companies this year.

So how well have these disclosures worked?

One recent change in the requirements this year was that the annual proxy must now disclose the “reasons for the decision that the person should serve as a director”, including the “particular experience, qualifications, attributes or skills that led the board to conclude that the person should serve as a director.”   This provides shareholders with more information about the company’s board.

Board composition and competence is an important issue to stakeholders of firms. When you go to work for a company, it’s something you should care about. But did the new requirements change the thinking of anyone on boards with respect to who should serve?

According to a recent survey by PricewaterhouseCoopers, with responses from 1,100 directors representing 819 boards, it did.

While 76% said it did not cause them to re-think, it did cause 20% to re-think (which is a good thing).

But thinking, of course, is one thing; taking action is another.  Of the 20% who re-thought, 3% of respondents have already taken action to “ensure the right mix of competencies” while 8% say they will take action in future elections. Nine percent, however, nearly half of those who re-thought, say “no action was taken or is expected.”

The new disclosure rules this year also require boards to explain their current leadership structure, including why it has chosen to combine or separate the principal executive officer and board chairman positions, why it believes that its leadership structure is appropriate for the company, whether and why there is a lead director and the role the lead director plays.

Did this disclosure cause the board to re-think?

The answer, according to the survey, was yes for 10%. Forty percent already had a split of the CEO and chairman roles and the board was satisfied; 46% had the roles combined and were satisfied with that.

What about action for those that re-thought? Only 1% of those surveyed plan to separate the CEO and chair position in the near term — and 2% plan to do so when they hire the next CEO.  Seven percent (or 70% of those that said it caused them to re-think) don’t plan to take any action.

PwC also asked whether directors were surprised by their review of compensation policies and practices that create “material” risks (also an area of new disclosure required by the SEC). A whopping 91% said no and only 2% said yes.  This is very troubling because compensation schemes that encouraged excessive risk taking were one of the primary drivers of the financial crisis.  So some directors (more than 2%) should have been surprised.

So how do these figures compare with the population in general? Are directors more or less likely to rethink or to change their actions than the general population? How often do people rethink a decision when prompted?  And how often after rethinking will people take action?

“Once people make a decision, they want … to justify it — a need that is undermined by rethinking,” says Cornell psychology professor Tom Gilovich.

In fact, Gilovich notes, there is “research showing that everyone — students, professors, uninterested observers — believes that it is better to go with one’s original impulse (not rethink it) when answering multiple-choice questions. In reality, the opposite is true — one is a bit better off, on average, by going with one’s more considered opinion.”

The urge to go with your original impulse becomes even stronger when you have a vested interest in that original idea.

“We are reluctant to think we made wrong decisions … even if we know they are dysfunctional,” says Kareem Johnson, a psychology professor at Temple University.

For corporate boards, that would translate to feeling good about who is on the board (including ourselves) and feeling justified in rejecting new candidates, no matter what other benefits and skill sets they could bring.

People who sit on boards of directors are generally considered successful — they view themselves that way and are likely to attribute their success to their own efforts.

“People who are doing their best are actually a bit out of touch with reality,” Johnson says.

They are more optimistic and believe they have more control over events than they do. It is called “positive illusions.”

“Everyone sees themselves as above average” Johnson says. This kind of optimism is “adaptive — it gives individuals perseverance and actually helps them succeed.”

Along with that view, however, comes a strong trait to rationalize one’s own behaviors and justify prior actions.

So, then, does disclosure make a difference?

Disclosure has a long hill to climb to overcome individual tendencies to justify past beliefs and actions. Considering that it led to any action at all means it works — even if to a very small degree.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance, a board advisory firm.