The SEC Should Return To Its Roots: Disclosure

As the new Commission struggles to revive an agency which has been badly battered during the current market crisis, it is essential that it return to basics. Disclosure is the central theme of the federal securities laws. If investors are furnished the material facts, they can make an informed investment decision. If material information is available, the efficient market theory posits that it will be reflected in the market price. Investing, price discovery and trading are keyed to the full, fair and timely disclosure of material information.

As the current market crisis has unfolded with huge scandals, there have been repeated calls for reform, continued criticism of actions and inactions by the SEC and multiple charges of failure. Reforms are necessary according to many, because the regulatory structure is outdated and has not keep up with ever changing markets. Additional authority for the SEC and other regulators is necessary to supervise unregulated segments of the market such as credit default swaps. The critics have repeatedly charged that the SEC’s performance during the market crisis has been lackluster at best. There have been repeated charges of failure on the part of the enforcement program for not discovering at an earlier point giant frauds such as the Madoff Ponzi scheme.

Disclosure however is seldom mentioned in these comments and discussions. Also seldom mentioned is a report by the SEC’s Inspector General dated September 25, 2008. The report, discussed here, is titled “SEC’s Oversight of Bear Stearns and Related Entities,” Report No. 446.

In the report, the Inspector General carefully reviews the events surrounding the collapse of Bear Stearns. In part, it details the failure of the Division of Corporation Finance to complete a timely analysis of Bear Stearns’ then most recent 10-K filing. That failure, the Inspector General charges, “deprived investors of material information that they could have used to make well-informed investment decisions. … the information [about the firm’s exposure to the sub-prime market] could have been potentially beneficial to dispel the rumors that lead to Bear Stearns’ collapse.”

In the aftermath of Bear Stearns’ collapse many on Wall Street claimed the firm’s demise came in part from a bear raid — short sellers’ swirling rumors that put increasing downward pressure on the stock price until it collapsed. SEC enforcement is reportedly investigating the prospect of insider trading. Whatever the validity of these theories, they all begin with inadequate disclosure. As the inspector general’s report makes clear, Corp Fin’s review and comment process on Bear Stearns’ 10-K was much delayed and not completed until after the collapse of the firm. Critical information about the exposure of the firm to the sub-prime market was not available to the market because of this failure. A lack of information can lead to rumors, speculation and panic trading — the kind that surrounded the downward spiral of Bear Stearns’ share price as it collapsed.

This is not an isolated instance. A thoughtful article by Joe Nocera in the New York Times on Saturday March 7, 2009 (here, registration required) details potential a “Bear Stearns” spiral which is going on now. According to Mr. Nocera “G.E. spent the week fending off rumors that it was the second coming of Citigroup. G.E. has billions of dollars of unacknowledged losses in GE Capital, its huge finance unit, the bears claimed. G.E. is about to lose its prized AAA. Its debt is immense. GE Capital is going to need to shore up its capital base. And on, and on.” The company reportedly is doing everything it can to shore up its share price and dispel the rumors. Day after day the company is reaching out to investors in every way possible to try and dispel the rumors.

Nevertheless, traders continue to batter the share price of G.E. This, according to Mr. Nocera, is a predicament of its own making: “For many years, G.E. was one of the more impenetrable companies for investors. There was a kind of arrogance to its disclosures; even the most diligent analysts didn’t truly understand where its numbers came from.”

Previously G.E. benefited from its lack of disclosure by almost magically making quarterly numbers. The ability to somehow do this reassured traders and the markets despite a lack of disclosure. In the midst of the current market crisis however, G.E. apparently is not getting the benefit of the doubt. Rumors and speculation about possible losses at GE Capital are driving down the share price of G.E. just as similar rumors spiraled down the share price of Bear Stearns. The lack of information is battering G.E. despite its protests.

Bear Stearns, G.E. and no doubt others should remind the SEC and those searching for the causes of the market crisis, solutions to the collapse of the credit markets and answers on how to remake the system that it all begins with disclosure. While the rejuvenation of SEC enforcement is a popular topic, that alone will not be sufficient. Enforcement is, by definition a somewhat backward looking process. At best enforcement may be able to halt a fraud in mid-stream. The best preventative medicine for bear raids, rumors and speculation is the facts. Full, fair and timely disclosure arms investors with the facts and helps ensure that price discovery and trading is based on material information rather than rumors, guesses and speculation. As the SEC is rejuvenated, it is essential that the agency return to the basics — timely, full disclosure of material information.