NORTHWESTERN UNIVERSITY SCHOOL OF LAW

LAW AND ECONOMICS SERIES • NO. 10-07

A Call to Reform
US Disclosure-Based Regulation

Simon C. Y. Wong
Northwestern University School of Law

Electronic copy available at: http://ssrn.com/abstract=1556542

 A CALL TO REFORM US DISCLOSURE-BASED REGULATION
KEY POINTS
 The US approach to regulating the securities markets is underpinned by disclosure, Feature
and US policymakers have tended to respond to corporate and systemic crises by
strengthening disclosure requirements.
 US disclosure-based regulation, however, suffers from two critical failings. First, it lacks
coherence in that shareholder rights are presently too weak to compensate for the hands-
off regulatory approach. Second, disclosure has been deployed excessively as a regulatory
tool, resulting in inundation of information and other unintended outcomes.
 To remedy these deficiencies, US policymakers should strengthen shareholder rights
– perhaps by emulating the UK model – so that US investors will truly be able to hold
boards and management accountable.
 In addition, regulators should periodically review the continuing relevance of existing
areas of disclosure and consider requiring companies to prioritise discussions. US
policymakers could bolster the Securities and Exchange Commission’s (‘SEC’) authority
to impose substantive regulation so that it would be less reliant on disclosure to regulate
problematic conduct. Author Simon C Y Wong

A call to reform US disclosure-based

regulation
Disclosure lies at the heart of the US
approach to regulating the securities
markets. A prominent law professor once
remarked that the core characteristic of
US securities laws is ‘disclosure, again
disclosure, and still more disclosure’.
Fearing excessive government intervention
and believing that investors are able to protect
their own interests if relevant information is
made available to them, American policymakers
have tended to react to corporate scandals and
systemic failures by strengthening disclosure
requirements. In the aftermath of the Enron
and WorldCom scandals nearly a decade ago,
the US Congress passed the Sarbanes-Oxley
Act (‘SOX’) to require disclosure of, inter alia,
the effectiveness of internal controls, codes of
ethics, insider share transactions, and financial
expertise on the audit committee while the
US Securities and Exchange Commission
(‘SEC’) demanded more extensive disclosure
of off-balance sheet arrangements and
executive compensation, expanded the list of
items subjected to immediate disclosure, and
accelerated filing deadlines. In response to
the global financial crisis, the SEC adopted
new rules last December enhancing disclosure
of risk oversight by the board of directors,
executive remuneration, and conflicts of interest
of compensation consultants.
PRINCIPAL DEFICIENCIES OF US
DISCLOSURE-BASED REGULATION
Although US disclosure-based regulation
has been emulated by a number of countries
and continues to be well regarded, it suffers
This article discusses the principal deficiencies of the disclosure-based approach
to regulating the US securities markets and proposes remedial measures for
consideration by US policymakers and regulators.
from two significant failings. First, it lacks
coherence in that shareholder rights are
presently too weak to compensate for the
hands-off regulatory approach. Second,
disclosure has been deployed excessively as a
regulatory tool, resulting in inundation and
poor quality of information as well as other
unintended outcomes. Moreover, disclosure
has been ineffectively used to address issues
that are better tackled through substantive
regulation.
Disclosure-based regimes rely on investors
– through influencing a company’s stock
price or intervening on such matters as board
structure and executive pay – to impose
discipline on boards and management.
When a European investor asked recently
if the SEC would ever impose a rule
requiring the separation of chairman and
CEO roles, a senior official responded that
the Commission’s philosophy is to compel
companies to furnish information on
matters that are critical to investors – such
as corporate strategy, financial performance,
board structure, and conflicts of interest
– and then leave it to shareholders to take the
necessary actions to hold boards accountable.
However, endowed with a weak set of
shareholder rights, investors in US companies
currently have limited means – apart from
expensive and time-consuming proxy fights
or litigation – to ensure that boards are
accountable. Despite recent changes, the
majority of American companies still elect
directors through plurality voting, where a single
‘for’ vote is sufficient to get a candidate on the
board because ‘withhold’ votes are not counted.
A 2008 study by research firm The Corporate
Library showed that while a majority of S&P
500 firms have adopted majority voting, only
a minority of Russell 1000 and Russell 3000
companies have followed suit.
Once they are on the board, it is extremely
difficult for shareholders – due to their
inability under company bylaws to requisition
a shareholders meeting, the requirement that
directors can only be terminated ‘for cause’,
and multiple-year board terms – to remove
underperforming directors. At a US petroleum
company, for instance, a shareholders meeting
can be convened only by the board or company
president and directors can be removed only by
other board members and only for cause.
Furthermore, due in part to inadequate SEC
clarification, Regulation Fair Disclosure (‘FD’) is
widely perceived as preventing shareholders from
engaging in meaningful one-on-one dialogue
with boards of investee companies on corporate
governance and other matters.
Some commentators support limited
rights for shareholders on the grounds that
the US features an active market for corporate

Butterworths Journal of International Banking and Financial Law February 2010 77

Electronic copy available at: http://ssrn.com/abstract=1556542
A CALL TO REFORM US DISCLOSURE-BASED REGULATION
78
Feature
control and the depth and liquidity of its
securities markets enable shareholders to sell
their investments easily and generally at a
fair value. Adherents of this view maintain
that market mechanisms such as stock price
impose sufficient discipline on boards and
management because a company would be
vulnerable to a hostile takeover or proxy fight
if its share price declines significantly. These
threats, however, are suboptimal because they
typically arise after considerable value has
been destroyed. Even then, poison pills and
other devices often constrain shareholders
from holding boards to account.
Moreover, for the growing proportion of
investors that – due to the comparatively high
management fees and underperformance of
active funds – have moved to passive, index-
based investment strategies, exiting individual
stocks is not a feasible option. Witness the
growing popularity of passively managed
exchange traded funds, which had nominal
amounts under management a decade ago but
nearly US$1trn today.
With disclosure as its primary regulatory
tool, the SEC has steadily expanded the scope
and detail of disclosure requirements. This
has contributed to inundation of information,
poor quality of disclosure, and other perverse
consequences. Notwithstanding materiality
thresholds, annual reports and related
disclosures have continued to lengthen
(reaching several hundred pages for some
firms), resulting in ample data but perhaps less
useful information. Furthermore, as a result
of SOX and other reforms, items requiring
prompt disclosure – such as the departure of a
director, waiver of a code of ethics, entry into
material agreements, and matters relating to
Regulation FD – have expanded appreciably
over the past decade. According to one study,
‘real-time’ disclosures on Form 8-K by US
companies increased 500 per cent between
2000 and 2004.
It is questionable whether investors
are able to digest fully the vast amounts
of information that is available today.
Behavioural research shows that people face
real cognitive limits regarding how much new
and complex information they can absorb and
use. Given this, more information may not
improve investment decisions and could prove
February 2010
Electronic copy available at: http://ssrn.com/abstract=1556542
harmful if investors end up unable to identify
the most pertinent facts. SEC Commissioner
Troy Paredes observed recently that
‘investors today are inundated with volumes
of information and, as a result, they get
overwhelmed or distracted, misplacing their
focus on less important matters.’ Others,
meanwhile, have asserted that the quantity
and complexity of financial data sowed
confusion and enabled critical information
pointing to a dangerous build-up of risk at
financial institutions to remain undetected by
shareholders, boards and regulators.
Poor quality of disclosure is also a
perennial problem. Regulatory filings, such
as the annual report on Form 10-K, are
typically quite lengthy and dense. Littered
with legalese, industry jargon, and boilerplate,
they appear to be designed principally to aid a
company in the event of litigation rather than
to improve the comprehension of investors.
At Enron, for example, it has been argued
that the activities that contributed to its
demise were in fact disclosed by the company
but largely escaped notice by investors and
other analysts because they were buried in
lengthy, ‘ jargon-filled’ regulatory filings. In its
examination of management’s discussion and
analysis (‘MD&A’) disclosures by Fortune
500 companies, the SEC found that 90 per
cent of the language remained unchanged over
a three-year period. Similarly, discussions in
annual reports and other documents about
a company’s key risks are often quite long
but generic, with little variance between
the company and its peers. For instance,
the 2004 IPO prospectus of a well-known
high-technology company devoted 22 pages to
discussing risk factors, noting such banalities
as the risk that current executives may depart
the company, operating results may fluctuate,
and the company may fail to keep up with
technological developments.
In certain situations, expansion of
disclosure requirements has brought about
harmful repercussions. For instance, the
reforms enacted by the SEC in 1992 on
individualised executive compensation
disclosure are widely perceived to have
contributed to ratcheting executive pay at
American companies in recent decades.
The changes introduced shifted reporting
Butterworths Journal of International Banking and Financial Law
from a general narrative discussion to
a more detailed, tabular disclosure on
different components of remuneration with
the objective of facilitating comparability
across firms. Although greater information
on executive remuneration was intended
principally for use by shareholders, it also
enabled executives to compare themselves
against peers. According to a veteran
compensation consultant, ‘Many executives
want to be the top dog and, if someone gets a
certain amount, then he wants to get the same,
if not more. It is about equity and fairness.’
Whereas the typical US chief executive made
71 times more than the average worker in
1989, this ratio surged to 275 in 2007.
Then there is quarterly reporting of
financial results, which has led to excessive
short-termism as management obsesses over
meeting quarterly earnings forecasts because
falling short of ‘consensus estimates’ could
hammer share price and discredit them.
According to a recent academic survey, 55
per cent of the 400 US chief financial officers
polled indicated they were willing to delay
investments in projects to meet short-term
earnings expectations, even when it meant
sacrificing long-term value creation.
Out of fear of stifling innovation and the
belief that the private sector can police itself
effectively, US policymakers have also opted
to address many important but complicated
issues – such as conflicts of interest among
intermediaries – through disclosure rather
than substantive regulation. The SEC, for
instance, issued regulations last December
to require companies to disclose fees paid to
compensation consultants that advise the board
on executive remuneration while concurrently
serving management on other matters.
While the disclosure of conflicts alerts
investors to potential impairments of
objectivity, it does not specify the degree to
which quality has been compromised. For
example, publication by a company of audit
and non-audit fees paid to an external auditor
is of limited use to investors because that
information does not reveal which aspects
of an audit should be treated with suspicion.
Given the severity of some conflicts – such
as remuneration consultants serving the
board and management contemporaneously

Biog box
Simon CY Wong is a partner at London-based investment firm Governance for Owners,
Adjunct Professor of Law at Northwestern University School of Law, and an independent
advisor. Earlier in his career, Simon was a US securities lawyer at Shearman & Sterling
and Linklaters. The opinions expressed in this article reflect the personal views of the
author only. Email: simon.wong@law.northwestern.edu
– disclosure may not be a sufficient remedy and
substantive regulation may also be required.
POTENTIAL REFORM MEASURES
How then to improve the functioning of the
US disclosure-based regulatory system? In
terms of potential policy reforms, perhaps
the most important is to strengthen
shareholder rights so that investors will truly
be able to hold boards and management
accountable. From a broader framework
perspective, enhancing shareholder rights
will help to compensate for the hands-off
regulatory approach and strengthen the
coherence of disclosure-based regulation as
a whole.
To determine the specific rights that
would be most critical to US investors, it may
be instructive for US policymakers to examine
the UK model as the two countries share
a common legal tradition and their listed
companies typically feature dispersed share
ownership. In Britain, director candidates
must receive a simple majority of votes cast
to be elected. Equally important, when
shareholders with aggregate holdings of 5 per
cent or more nominate a director for election
to the board at an annual general meeting, the
company must, at its own expense, circulate
to all shareholders information relating to the
director candidate. By contrast, at present US
shareholders must separately – and at their
own expense – distribute to other shareholders
materials relating to their board nominees.
To prevent entrenchment, UK
shareholders with a 5 per cent stake can
requisition a shareholders meeting at
any time to remove incumbent directors,
irrespective of the length of time remaining
on their current terms. At the same time,
British companies are not allowed to employ
poison pills to repel unwanted suitors.
US policymakers should also ensure
that existing regulations – particularly
Regulation FD – do not impede investors
from legitimately engaging with boards.
Potential steps in this area include
clarifying the scope of Regulation FD
or creating a specific safe harbour to
permit and facilitate one-on-one dialogue
between boards and shareholders. In the
UK, the Combined Code on Corporate
Butterworths Journal of International Banking and Financial Law
Governance – recognising that large
investors typically have stronger incentives
to monitor management – encourage regular
interactions between a company’s board and
its largest shareholders to discuss significant
strategic and governance developments.
The regulatory framework also provides an
environment that is conducive to informal
and candid discussions between these two
parties. Participating investors, of course,
are prohibited from trading on any material,
non-public information received.
Recent developments indicate a greater
urgency to strengthen shareholder rights in
the US. As discussed above, passive, index-
based investing has grown significantly over
the past decade and these investors do not
have the option of selling individual stocks
when they are dissatisfied with a company’s
performance or corporate governance
arrangements. Furthermore, the US appears
to be gradually embracing the UK’s ‘comply
or explain’ disclosure model. Under this
system, a company failing to comply with
a substantive provision of the Combined
Code – for instance, that at least half of the
board should comprise independent directors
– must explain why it does not. Possessing
a strong arsenal of rights, shareholders in
British companies are in a position to credibly
monitor and enforce adherence to the Code.
In the US, SOX similarly requires public
companies to disclose whether they have
adopted a code of ethics and whether there
is a ‘financial expert’ on the audit committee
– if not, companies must explain why. In
December 2009, the SEC introduced new
regulations to require companies to disclose
whether they have combined the chairman
and CEO roles and, if so, whether they
have appointed a lead independent director.
Recently, the NASDAQ stock market
conducted a public consultation on whether it
should adopt a ‘comply or disclose’ approach on
a variety of corporate governance topics, such
as the separation of chairman and CEO roles
and limits on outside board appointments.
To stem information overload, regulators
should be required to periodically review
the continuing relevance of existing areas
of disclosure and to prioritise disclosure
topics when they propose new requirements,
A CALL TO REFORM US DISCLOSURE-BASED REGULATION
Feature
including by eliminating those that have
become less pertinent. Other possibilities
include compelling companies to prioritise
disclosures by tiers, provide summaries, and
limit the length of discussion.
Additionally, US policymakers could
bolster the SEC’s authority to impose
substantive regulation – including on
corporate governance matters – so that
it would be less reliant on disclosure to
regulate problematic conduct. Historically,
because the authority of the SEC to employ
regulatory tools other than disclosure has
been in dispute, litigation often ensued
each time the SEC sought to introduce
substantive regulation. In 1990, for instance,
a federal appellate court struck down the
SEC’s attempt to institute a one-share, one-
vote rule, reasoning that it was a substantive
corporate law matter that fell outside the
SEC’s mandate of regulating disclosure.
To reduce the potential for perverse
outcomes, policymakers should examine
– including through cross-border analysis –
how proposed disclosures would impact the
behaviour of affected parties. As discussed
above, quarterly reporting of financial results
has led to company management placing an
inordinate focus on short-term performance
while detailed disclosure of compensation
packages has magnified the importance of
pay and contributed to executives demanding
ever-higher remuneration. Concerned about
inadvertently encouraging short-termism
and informed by the experience in the US,
the European Commission decided several
years ago to scale back the information that
companies must furnish quarterly.
CONCLUSION
Ultimately, the US disclosure-based
regulatory approach was not effective in
identifying the pressures that coalesced
to produce the market turmoil of the past
two years – much less in averting them.
As policymakers continue contemplating
measures to strengthen the US financial
system, they should give serious
consideration to reforming the existing
disclosure-based approach so that the US
regulatory regime will be more robust and fit
for purpose in the future. 
February 2010 79