Is there a dark side to transparency and disclosure?

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Inspector investigating financial documents © Igor Stevanovic / 123RF Stock PhotosWhile investors want more disclosure and transparency, it can come with consequences.

When the Securities and Exchange Commission launches an investigation of a firm for financial fraud, it’s voluntary for managers to disclose this. And even when the investigation doesn’t result in charges, firms that voluntarily disclose they were under investigation have significant negative returns that year, according to a new paper by David Solomon at Boston College and Eugene Soltes at the Harvard Business School.

The researchers used Freedom of Information Act requests to study all the financial fraud investigations started by the SEC from 2002 to 2005, so the outcomes of the investigations were also known.

When reviewing the documents, they found non-sanctioned firms that voluntarily disclosed they were being investigated underperformed non-sanctioned firms that kept silent by 12.7 per cent for a year after the investigation began.

Soltes notes it was interesting that the evidence found, at least in some instances, that disclosure appeared to be associated with adverse consequences, and not just in the short run. “And I think the short run is perhaps not surprising. Naturally, if you disclose some bad news, like being under investigation, we would expect that not to have a zero or positive response. But what we document in the paper is not just a short-run effect, but we actually provide evidence consistent with this having a longer-term impact on both the firm and its management, and that was somewhat less expected.”

The researchers also found the effects of disclosure could be measured beyond financial results. Chief executive officers who disclose an investigation are 13.8 percentage points more likely to experience turnover by the end of the following year.

There are a number of reasons for this, notes Soltes, highlighting that one potential explanation is that being under investigation consumes management attention and resources. “It’s a costly activity and we might see that as a form of managerial distraction. And so, for a CEO to do the best possible job that he or she can do and focus on growing the business, this is actually another source of activity that they actually have to balance. So that itself may actually explain the finding.”

In addition to this, the research found that when there are financial restatements associated with disclosures, investors can distinguish which investigations will result in enforcement actions.

According to Soltes, a hypothesis for this is with earnings restatements, investors know the underlying type of fraud and have a sense of the conduct’s magnitude.

“I think we’re in this awkward position where the firms that are actually being more transparent are actually being adversely affected, which is not, I think, a comfortable state of affairs,” he says. “I think what we would like to imagine is a world in which either there is actually mandatory disclosure so everyone has to disclose this. There may be good reasons to not do that; for example, this could actually then affect [when] regulators feel comfortable even beginning an investigation. So we’d need to think about those externalities.

“Or on the other side — if it wasn’t mandatory disclosure — to actually clarify the obligations firms have associated with this disclosure. Because right now we’re in this murky environment where firms are genuinely not clear about whether this is actually an event that they are required to disclose or there’s liability for not disclosing.”

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