Transcript Document

Financial
Communication and
Regulation in the UK
Andrew W Stark
Coutts Professor of Accounting
and Finance
Some Background
• In the UK, full financial reports come out annually,
including accompanying narrative to the financial
statements
• Listed firms produce interim (half-yearly) financial
reports – they are not as full as the annual financial
statements
• They also produce quarterly management statements in
the other quarters
• In the USA, listed firms report quarterly
• Key issue I – if information significantly relevant to the
value of the firm exists that has arisen between these
dates, under what circumstances can investors have
confidence in stock market prices, and that those prices
are ‘fair’ (and, in investing in stock markets overall), in
the presence of such potentially large information
asymmetries between corporate insiders and investors?
• Key issue II – if investors do not have confidence in
stock markets, what implications does this have for the
raising of capital and the efficient allocation of resources?
Introduction
• There are two types of financial communication to
be considered:
– disclosures outside of the financial report; and
– narrative disclosures within the financial report
• We will initially consider the relevance (actual and
potential) of such information for prices
• Accounting information (i.e., P&L accounts,
balance sheets, etc. – the financial statements,
together with associated notes) is just one part of a
much larger information set (some of which is also
provided by firms) that can inform market prices –
how useful is this other information and should its
provision (at least, when firms are providing it) be
regulated?
• After all, the provision of accounting information by
firms is regulated
Are Market Forces Sufficient to
Guarantee Honest and Timely
Disclosure?
• D. Skinner (Accounting and Business Research,
Special Issue - International Accounting Policy
Forum, 2008, Vol.38, pp.191-204), in the
context of disclosures about intangibles,
suggests that market forces should be sufficient
to ensure appropriate voluntary disclosure,
perhaps subject to disclosure guidelines than
can act as ‘safe harbour’ rules
• His example focussed on the under-pricing of
RD activities – but what about when such
activities are over-priced?
A Theoretical Model of
Disclosure - I
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This discussion is based upon that found in A. Beyer, D.
Cohen, T. Lys and B. Walther, 2010. ‘The financial
reporting environment: Review of recent literature’,
Journal of Accounting and Economics, 50, pp.296-343,
specifically pp. 300-305
Consider a world in which:
– disclosures are costless
– investors know that firms have private information
– all investors interpret the firms’ disclosure in the same way
and firms know how investors will do it
– managers want to maximise their firm’s share price
– firms can credibly disclose their private information (i.e.,
they reveal it truthfully)
– firms cannot commit, before the event, to a specific policy
•
Under such circumstances, an ‘unravelling’ result occurs
in which all managers reveal their private information –
no regulation is required to generate this result
A Theoretical Model of
Disclosure - II
• Under such circumstances, an ‘unravelling’ result
occurs in which all managers reveal their private
information – no regulation is required to generate
this result
• The ‘unravelling’ result occurs because, in this
model, not disclosing (versus disclosing truthfully)
implies that investors will revise the share price of
the firm downwards, hence providing incentives for
managers to truthfully disclose, other than for the
manager with the worst possible information, for
whom non-disclosure and disclosure are equivalent
• Much theoretical work has occurred which
considers the relaxations of these assumptions – we
will not consider the outcomes and how the
‘unravelling’ result has to be modified
• Instead, we will consider some of the circumstances
that require the assumptions to be relaxed
Relaxing the
Assumptions - I
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Why might disclosure be costly?
Communication mechanisms are inherently costly
But there are other reasons – for example, the disclosure
of information can give away information to competitors,
workers, and regulators
Whether full disclosure will remain optimal depends on
how third parties react to the information
If it is assumed that managers are uncertain how investors
will respond to disclosures, full disclosure tends to break
down
Ways in which investors might have unpredictable
responses include:
– different investors have different private information about
the firm – hence, they will interpret a given disclosure in
different ways
– some investors are sophisticated, and able to interpret the
disclosure, and some are not and, hence, are unable to
interpret the disclosure at all
Relaxing the
Assumptions - II
• Do managers want to maximise share price whilst,
at the same time, truthfully revealing their private
information? The ex post costs of making a
disclosure that isn’t truthful will affect the
likelihood of disclosure when truth-telling cannot be
credibly committed to
• In a situation where credible commitment to truthtelling is impossible, reputations can be built for
truth-telling in a multi-period setting
• There are no incentive problems (e.g., effort; empire
building; perquisites) in the model – if this is
relaxed, how do these incentive problems interact
with incentives to disclose?
• Overall, this (brief and selective) discussion
suggests that analysing actual firm disclosure policy
is going to be difficult and will involve the interplay
of a number of factors
Possible Benefits of
Disclosure - I
• This discussion is mainly based upon C. Botosan,
2006. ‘Disclosure and the cost of capital: what do
we know?’ Accounting And Business Research, 36,
pp. 31-40
• There are two lines of theory that suggest a link
between disclosure and the cost of capital:
– increased disclosure reduces priced estimation risk which
reduces the cost of capital
– increased disclosure reduces information asymmetries
which reduces transactions costs (e.g., bid-ask spread)
which increases market liquidity which increases demand
for the stock which decreases the cost of capital
• There are question marks about both lines of theory:
– why isn’t estimation risk diversifiable and, hence, unpriced?
– does increased disclosure indeed reduce information
asymmetries (public versus private information – substitutes
or complements)?
Possible Benefits of
Disclosure - II
• What are the results?
• In general, Botosan (2006) argues that the results
suggest that:
– there appears to be a negative link between the level of
disclosure and the cost of capital
– there appears to be a negative link between the level of
disclosure and bid-ask spreads, etc.
– around capital raising events, managers act as if greater
disclosure decreases the cost of capital
• As with all academic studies, all the results are
subject to caveats about interpretation – for
example, ceteris paribus, why don’t all firms
disclose as much as possible to increase their share
price?
Possible Benefits of
Disclosure – Information Content I
• UK financial reports are large in terms of page
numbers, but the financial statements
themselves are fairly small (although the notes
to the accounts take up much space, as do
various governance reports)
• But, what about the various narrative elements
in the financial reports – are they a waste of
space, or do they provide useful contextual
information that can help in, for example,
forecasting future earnings/cash flows (even if
they are not audited or regulated)?
• If the latter, then this narrative information
could be associated with share prices
Possible Benefits of
Disclosure – Information Content II
• This discussion is based upon that found in T.
Schleicher, K. Hussainey and M. Walker, 2007.
‘Loss firms’ annual report narratives and share price
anticipation of earnings’, British Accounting
Review, 39, pp.153-171 (SHW)
• SHW argue that there might well be differences in
the potential of narrative disclosures to inform share
prices between listed profit and loss firms – why?
– because most listed loss firms do not go bankrupt (at least,
not quickly – why this might be?)
– if they don’t go bankrupt, they likely will become profitable
at some stage in the future
– if such is the case, the current loss is not a very good
indicator of future profits (profit growth)
– whereas, the current profit is a better (if not necessarily
perfect) indicator of future profits for a profitable firm
Possible Benefits of
Disclosure – Information Content III
• Overall, the results of SHW are consistent
with the idea that narrative disclosures with
respect to future earnings are informative
in the price-setting process for loss firms in
particular, if not for profit firms
• This is good news, in the sense that it is
consistent with the idea that the disclosures
are not a waste of space for some firms
• Further, loss firms are surprisingly
prevalent on the Official List and AIM, and
loss-making can be persistent
• Nonetheless, what are the disclosures
achieving for profit firms (cost of capital
effects?)?
Disclosure Scandals - British
Biotech (BB) - I
• Once the darling of the UK biotechnology
industry – listed in both the UK and the
USA - now essentially it has disappeared
• Directors (including the CEO) traded at a
time when Phase III drug trials for a drug,
Batimastat, had been halted but the
information had not yet been disclosed to
the market
• Provided highly positive information about
the progress of another drug, Marimastat,
that doubled the market price and allowed
BB executives to exercise stock options
more profitably and also exercise rights
issue warrants
Disclosure Scandals - British
Biotech (BB) - II
• Subsequently it became clear that BB had
overstated the likelihood that the drugs
Zacutex and Marimastat were going to
reach production – only revealed by a
whistleblower
• The LSE publicly censured BB for failing
to tell the market about the European drug
regulator’s negative stance on Zacutex –
for misleading the market
• The SEC filed a ‘cease and desist’ order on
three BB executives over failing to tell the
market about extra clinical trials required
by the FDA with respect to Marimastat –
another case of misleading the market
• No BB drug ever made it to market
Disclosure Scandals Cortecs
• Consistently gave over-optimistic
assessment of progress of its RD activities
towards marketable products
• This was only discovered when the CEO
was fired over excessive perquisites and a
new non-executive chairman ordered a
review of RD activities via a recently
appointed, new, RD director
• The new non-executive chairman also
discovered that the board were not being
informed of negative outcomes
• The new non-executive chairman had to
inform the stock market that it had been
‘over optimistic’
UK Regulation - I
• Overall, the UK has concluded that market forces
cannot be generally relied upon to ensure honest and
timely revelation of information
• The (now-discontinued) Financial Services
Authority (FSA) established a number of principles
about the disclosure of price sensitive information
(PSI)
• The FSA’s responsibilities in this regard have been
transferred to the Financial Conduct Authority
• These principles were in place at the time of the BB
and Cortecs scandals, however
• General principles for the disclosure of PSI:
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a fair and transparent market
safeguarding the interests of investors
timely disclosure of relevant information
equal treatment of all investors
UK Regulation - II
• What is the definition of PSI?
• It is information which, if disclosed, can be
expected to change the market’s expectations of
future cash flows
• PSI then is ‘surprising’ information
• There is no precise definition, however, of the types
of events the revelation of information about which
will definitely be price sensitive
• Therefore, managers must have a good idea of what
information and expectations are reflected in market
prices, and know how market participants will react,
in order to know what is PSI
• This suggests judgement has to be applied to
generating a sound financial communication
strategy with respect to what to disclose and when
to disclose it
• In this sense, even though regulated, disclosure still
has a ‘voluntary’ element – but legal action could
occur if judgement is incorrectly exercised
UK Regulation - III
• Issues surrounding the disclosure of PSI
are also directly linked to insider
information/trading, and regulations
require insiders to seek permission before
trading from the Chairperson or another
designated director
• Rules are laid out as to when permission
should be denied, relating to the existence
of PSI within the organisation
• The EU Market Abuse Directive
strengthens these policies including
requiring firms to keep lists of which
employees have access to what ‘inside’
information
UK Regulation - IV
• The UK corporate governance codes sometimes
seem to add confusion to the FSA’s rules (although
the FSA rules are aware of this potential)
• The Combined Code, for example, encourages firms
to enter into dialogue with their major shareholders
– suggesting possible privileged access to
information to these shareholders
• This has the potential to turn such shareholders into
insiders – a fact that the Institutional Shareholder
Committee (ISC) is well aware of
• The ISC require firms not to provide information to
institutional shareholders, or their agents, which will
harm their ability to trade (turn them into insiders)
• This also raises issues of analyst briefings and the
information given out at such meetings
UK Regulation - Overall
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Notwithstanding some ambiguities in the regulatory
framework(s) surrounding the disclosure of PSI in
general, the framework(s) have one common feature –
they do not tend to specify what ‘should’ be disclosed
(other than for certain specific events)
Instead, they establish principles for the features of timely
and honest reporting – what needs to be disclosed, and
how to disclose it, is up to the firm
Further, they clearly recognise that there are market
incentives for dishonest disclosure (including the absence
of disclosure) caused by the existence of executive share
option schemes and director/manager shareholdings,
although there can clearly be circumstances when market
mechanisms will produce appropriate disclosures
No cases appear to have arisen recently of disclosures that
are seen to be clearly dishonest – this could be because:
– firms now disclose in a timely and honest fashion; or
– the detection and enforcement mechanisms are inadequate