Much like a snowball that gathers mass and momentum as it rolls down a hill, individual investors are gaining power with each on-line trade. Five years ago, it was an accepted fact that there was a two-tiered disclosure system. Public companies regularly released information to analysts, who then interpreted the news for the market. Today’s savvy investor tunes into live Internet broadcasts of firms’ conference calls with analysts, thus receiving and being able to trade on news at the same time as professionals.
Two forces have led to this revolution in the disclosure of information: gains in information technology that have empowered individual investors by providing low-cost access to information, and efforts by market regulators to encourage firms to practise full and fair disclosure. While the interests of the individual investor are now served better, gaps in disclosure requirements still exist. As I will illustrate, some TSE firms disclose significant changes in corporate strategy to the market, and some do not. Either practice, as I will also illustrate, has an important impact on the market, and ultimately, the firm.
INVESTOR POWER AND INFORMATION TECHNOLOGY
In 1999, an Angus Reid survey commissioned by the Canadian Securities Administrators found that approximately one in four investors surfed the Internet for information. David Brown, Chair of the Ontario Securities Commission, recently reported that on-line trading accounts for 40 percent of the volume on the TSE. In less than two years, individual investors have gone from researching stocks on the Net to executing their own trades without a broker or other intermediary. Furthermore, the trend is continuing as individual investors participate in after-hours trading, a practice which was, until recently, the exclusive domain of institutional investors.
Before they were able to trade on the Internet, individual investors were heavily dependent on either brokers or the press for up-to-the-minute market disclosures. Public companies also depended on this type of information dissemination, because it was too costly to communicate regularly and directly with all investors. Today, thanks to the Internet, cost barriers are so low that public companies can release information to their shareholders daily. From the individual investor’s perspective, market research is no longer a slow and costly endeavour; he or she need not have a large investment in a firm to make research cost-effective. In only a few minutes, an individual investor can access more information about a firm than can be carried around. Everything from securities filings with the OSC (available through SEDAR), and historical financial information or transcripts of speeches and meetings on corporate Web sites, to patent applications and other competitive intelligence can be found with the click of a mouse. This fact makes market research a potentially lucrative activity for an individual investor, who now has low-cost access to the same information as professional investors, and who can trade directly on this information.
Recent regulatory changes in Canada and the U.S. have targeted the elimination of selective disclosure and strengthened the requirements for firms to make adequate disclosure of material events. Selective disclosure refers to the practice by corporate managers of releasing information only to select groups of individuals, like analysts, and not to the general public. Understandably, market regulators consider selective disclosure to be a significant threat to the credibility and integrity of capital markets.
In a recent survey of corporate disclosure practices, undertaken by the Ontario Securities Commission, corporations confirm that the practice of selective disclosure is widespread. While less than 20 percent of the public companies surveyed broadcast conference calls over the Net or make transcripts of the calls available through other means, 81 percent indicate that they have one-on-one meetings with analysts on a regular basis. Furthermore, 97 percent of the companies confirm that they comment on drafts of analysts’ earnings and investment reports. This practice, which is also prevalent in the U.S., led Arthur Levitt, the former Securities and Exchange Commission Chair, to comment on the conflict of interest it creates. He believes analysts try to please companies with the content of their investment reports, so that companies will continue to disclose selected information to them. The end result is that analysts’ reports cannot be considered to be independent. Thus, they do not reflect an unbiased opinion of future earnings prospects.
In response to these practices, both Canada and the U.S. have recently taken action to protect investors. However, the underlying rationales are quite diff e rent. In the U.S., recent regulation enacted by the SEC (effective October 2000) requires companies to disclose material events and facts simultaneously to all market participants. If a corporate executive unintentionally makes a “selective disclosure,” the firm, upon realizing that an inappropriate disclosure has been made, must immediately make a public announcement of the information. Regulation FD (Fair Disclosure) also expands the definition of what is considered to be material, and extends it to areas such as new product development, customer relations and other key elements of corporate strategy that are likely to affect future profits. Regulators suggest that by citing specific examples of potentially material events, firms will go beyond the traditional practice of only disclosing material information about earnings or changes in corporate control.
In Canada, regulators have taken a multipronged approach to disclosure compliance by strengthening both the monitoring of disclosure by regulators, and by empowering investors to monitor the disclosure practices of companies in their investment portfolios. In terms of regulatory monitoring, the OSC has created the Continuous Disclosure Team that reviews or audits each listed company’s disclosure practices on a revolving four-year schedule. In addition, the team may review disclosure practices surrounding a specific event at any time it deems that a public company may have potential disclosure issues. This suggests, for example, that the team may audit the disclosure practices of a firm that is currently a takeover target to ensure that no disclosure breaches have occurred, and to ensure that investors are fairly informed of the events.
The second prong of the regulators’ program involves investors in the compliance-monitoring process. A proposed regulation by the Canadian Securities Administrators (the Canadian organization of provincial and territorial regulators) would give investors the right to sue a company if they deem the firm has made inadequate or misleading disclosure. In contrast to the U.S. approach, which attempts to explicitly discourage civil liability related to disclosure, the Canadian approach is to give investors the incentive to act as monitors. Court approval of a claim is required before a shareholder can proceed, but with a potential settlement of the greater of $1 million or five percent of market capitalization, it is worthwhile for individual investors to be diligent monitors.
AN EXAMPLE OF SPECIFIC DISCLOSURE: CHANGES IN CORPORATE STRATEGY
In theory, any event that can have a material effect on an investor’s decision should be disclosed to all market participants. A change in corporate strategy (e.g., a major shift in production technology or a major cutback in long-term production capacity) is a significant event that impacts future profits, and hence, future share price. Currently, however, there are no explicit requirements to disclose changes in strategy to the market. In a sample of TSE firms undergoing strategic change, the majority of firms stated they believed they had no obligation to report the change, although some firms chose to do so voluntarily. Given this lack of full disclosure, the potential exists for some investors who are affiliated with the firm (e.g., a supplier or customer) to observe that the company is undergoing significant strategic change even though this may not be public knowledge. This creates an opportunity for these “informed” investors to trade unfairly at the expense of other investors who are unaware of the change. It can be argued that this situation involves a form of “selective” disclosure. Even though the firm is not actively disclosing the information to the informed parties, the fact that the information can be observed by potential investors is the same as if the firm had selectively disclosed. From a market perspective, it is problematic because some investors can have access to the information while others do not, thus creating the conditions under which some investors are not on a level playing field.
Researchers can assess whether all investors are privy to the same trading information by looking at the bid-ask spread during the change event. The bid-ask spread is the compensation a market dealer receives for facilitating trade in a firm’s shares. It is equal to the difference between what a dealer will pay for shares in a purchase from one investor (the bid price) and what the dealer will “ask” from another investor who wishes to purchase the shares. The dealer cannot identify informed traders from other traders but can detect, via trading patterns, when some market participants appear to be trading on information that is not known to other investors. In response to this trading variance, dealers widen the spread (i.e., they buy for less and/or sell for more) to protect themselves from losses they know will occur from trades with informed investors. The bid-ask spread can then be used as a proxy to indicate when there are informational differences between investors. From a market perspective, it can be argued that disclosure regulations should target the elimination of informational differences and seek to provide all investors with equal access to information. Such access is integral to the smooth functioning of capital markets. From a firm’s perspective, the wider the spread, the more expensive it is for an investor to trade in a firm’s shares. This has the effect of lowering share liquidity, as fewer investors continue to invest in the firm’s shares. Ultimately, lower share liquidity is reflected in a higher cost of capital for the firm, something that is undesirable for the firm and its shareholders.
Recently, I conducted a study to assess the impact of firms’ selective, voluntary disclosure of changes in corporate strategy, and whether informational differences arose between investors in those settings where the firm did not disclose the change. The firms in the sample were large and medium-sized ones and traded on the Toronto Stock Exchange. Corporate executives were asked to report the nature and level of strategic change during a one-year period, as well as whether the firm disclosed the change to the market.
Amongst the firms studied there was a total of 162 significant changes in corporate strategy. Of the 162 changes, executives reported that only 113, or 70 percent, of these changes were disclosed to the market. Statistical analysis of the market data revealed that the bid-ask spreads widened in relation to the extent of change in strategy. This evidence suggests that there were informational differences between investors, i.e., some investors were aware of the change in strategy while others were not. Furthermore, the data also showed that there was a negative relationship between disclosure about the change and the size of the spread. This means that in those cases where the firm voluntarily disclosed information about the change to the market, the disclosures were effective in informing all investors of the event, and in reducing the informed investors’ potential trading advantage.
Market researchers have already demonstrated that firms can create a competitive advantage by voluntarily informing investors of their activities. While there are costs of disclosure, the benefits of increased analyst following, enhanced share liquidity and a lower cost of capital for the firm may far outweigh those costs. Furthermore, the costs of not disclosing will certainly escalate if investors sue over inadequate disclosure. Recently, we have witnessed first-hand how shareholders have acted to hold Nortel accountable for its disclosure practices. There have been two criticisms of Nortel’s actions. The first issue is whether Nortel made adequate disclosure of the earnings decline, as it appears that Nortel’s management may have known of the decrease for a significant period of time before warning the market. The second criticism is that in communications with analysts, Nortel’s management may have inadvertently selectively disclosed the earnings decline before this information was made public to all investors a few days later.
While the OSC’s Continuous Disclosure Team may investigate the timing and content of Nortel’s disclosures, this investigation will probably be important from an evidentiary perspective, not from one of compliance. In other words, due to technology and disclosure regulation, individual investors have low-cost access to information and have become vigilant monitors of the firms in which they invest. As more investors make use of this capability, the market becomes self-regulating and compliance monitoring by the regulators becomes less onerous. While the strategic change example suggests that there are still challenges in preserving the integrity of the markets and ensuring that all investors are on a level playing field, great gains have been made and will continue to be made as individual investors emerge as important participants in the market.