In mid-July, Jay Clayton, chairman of the U.S. Securities and Exchange Commission (SEC), announced his support for scaling back the scope and breadth of disclosure rules imposed on public companies, explaining that regulators have “significantly expanded the scope of required disclosures beyond the core concept of materiality.”

Undeniably, diligently satisfying disclosure requirements takes time and resources that management at public companies would prefer to apply to managing and growing their business, particularly where it does not improve investors’ and other stakeholders’ understanding of the company. Furthermore, the quarterly reporting cycle may inadvertently drive management into short-term thinking and strategies that are not necessarily to the benefit of their long-term investors.

At NEO, we have been vocal advocates for ways to reduce the regulatory burden for publicly listed companies in Canada and commend the Canadian Securities Administrators (“CSA”) for their recent initiative seeking comments on how to effectively do this.

While we are of the opinion that there is substantial opportunity for reducing regulatory disclosure requirements that are not enhancing the understanding of the company, that are already publicly available or that could drive the wrong management behaviours, we also believe that such exercise must include three other critical considerations:

• Investors’ and stakeholders’ understanding of companies should not, as result, be negatively affected;
• Investors’ interest in companies should not, as result, be lessened; and
• Investors’ information should, as a result, be made easier to understand.

Instead of discussing the various areas where the regulatory burden can be reduced, largely discussed in the CSA request for comments and the subsequent comment letters, I would like to share some thoughts about these additional considerations.

Investors’ and Stakeholders’ Understanding of Companies

As we all agree, investors need to have easy access to information that will allow them to make informed investment decisions. This information allows them to understand a company’s business and financial condition based on current facts and expectations for the future, and is available through accurate reporting on operating results, cash flows, assets and liabilities, economic and business realities and outlook, risks, material events, etc. The good news and the bad news. Let’s never forget why disclosure requirements were initially implemented in the 1930s: selective disclosures were putting the general investment public at a disadvantage when, for example, insiders used material non-public information for their own gain and at the expense of everyone else. Fundamentally, regulatory disclosure requirements are in place to ensure a level playing field amongst all investors, and that needs to be maintained at all costs.

Having a good understanding of a company is also critical for other stakeholders: inaccurate or incomplete reporting can lead to sub-optimal deployment of capital and resources, customers and suppliers making wrong business decisions, employees making wrong career and retirement decisions, lenders and insurers miscalculating risks, etc.

What this means with respect to reducing the regulatory burden is that a lot of focus needs to be put on identifying what information is material for understanding a company and what information is not. Since the introduction of disclosure requirements, regulators have taken an approach of requiring more and more disclosure – not necessarily because it was material, but because it was safer to ask for more than to take the risk of missing something important. This approach has placed an unnecessary cost and burden on public listed companies that needs to be fixed and cannot reoccur in the future.

Investors’ interest in companies

A lot of the debate about regulatory burden on public companies has been driven from the perspective of these companies. We generally agree with the concerns these companies, and many of their agents, have raised.

It is important, however, not to forget the investors’ perspective on the matter. While in the previous section, Investors’ and Stakeholders’ Understanding of Companies, we looked at what type of information is important for a company to make available, in this section we will zoom in on one of the strategies frequently considered to reduce regulatory burden: differentiated requirements depending on the nature, size and/or industry of the company. This type of approach was also put forward for consideration in the OSC request for comments.

Research on the potential consequences of such a differentiated approach is limited but a paper published by the CFA Institute in January 2015 gives us very interesting insights into how sophisticated investors look at differentiated reporting. While this paper is more focused on accounting standards and what to do for private companies vs. public companies, we can still clearly extrapolate from it that differentiated reporting leads to major challenges for sophisticated investors because of:

• Decreased comparability among companies;
• Increased complexity; and
• Loss of decision-useful information.

In other words, savings for companies resulting from less stringent requirements are converted into additional investment analysis costs for the investors. But this is only one of the possible outcomes as it could also lead investors to seek a higher risk premium, thus increasing the cost of capital for these companies, or even investors no longer being interested in investing in these companies. Canadian listed venture companies are a good example of the latter scenario whereby institutional investors will not consider them and we can see the consequences: a large number of “orphan stocks”.

While it is important to make it easier for companies to raise capital through the public markets, regulators must ensure that reducing the regulatory burden will not lead to more public companies being ignored by investors. This is detrimental to the investors who are shareholders in those companies, and the listed companies themselves because they will face a higher cost of capital and erratic price movements, and the credibility of our Canadian market overall. Incumbent stock exchanges are partially to blame for this issue as, driven by their own profit considerations, they have not reconsidered their approach to smaller companies by continuing to encourage them to go public too early despite the fact that the private markets have become more accessible and a public listing for these companies may be more harmful than beneficial. Reducing the regulatory burden without careful consideration could allow these exchanges to continue this practice and even accelerate it. That is why at NEO, we do not list venture companies and have been an advocate for an efficient private market solution that will provide the companies that are not ready to go public with the capital they need.

Investors’ information

An effort of reducing the regulatory burden for public listed companies should also be complemented by an assessment of how easy to understand the information is, under the current regulatory requirements. This is particularly true for the retail investors who typically do not benefit from the analysts and advisors that institutional or high net worth individuals may have access to before making an investment decision – an extreme issue in the context of public listed venture companies that represent, by their mere nature, a substantially higher investment risk while at the same time being left aside by institutional investors and research analysts.

We believe that many of the reasons that led Canadian regulators to initiate and implement the Point of Sales Disclosure for Mutual Funds project also apply to publicly listed companies:

• Investors have a hard time understanding and finding the information they need because it is buried across a multitude of complex documents issued under the regulatory disclosure requirements;
• Investors are in a difficult position to compare information about different companies;
• Investors typically have no easy access to the information they need before they make their investment decisions;

Many investors are not using any of the information provided under the disclosure requirements but base their decisions on information collected from a multitude of less reliable sources that typically don’t provide them with a good understanding of the risks and comparative information that is critical to a good investment decision.

As such, we believe that while looking at reducing the regulatory burden on publicly listed companies the regulators should also look at implementing a ‘Fund Facts’-like document for publicly listed companies that provides key information about the company, in language that can be easily understood, and available at a time that is relevant to the investment decision.

In Summary

There is a capital formation crisis at the heart of Canada’s IPO drought, and while it is important to make it easier for companies to publicly raise capital, regulators must ensure that reducing the regulatory burden will not come with unintended consequences that could be detrimental to these companies, their investors and all their other stakeholders. Moreover, they should leverage this initiative to further improve retail investors’ experience and ability to make informed decisions by providing them with the key information they need in a simple and understandable way.

NEO is a firm believer in solutions that eliminate superfluous and redundant information but that, at the same time, provide investors with pertinent information in an efficient way.

 

Jos Schmitt is President & CEO Aequitas NEO Exchange