Do the Securities Laws Promote Short-termism?

James J. Park is Professor of Law at UCLA School of Law. This post is based on his recent paper. Related research from the Program on Corporate Governance includes The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law by Leo E. Strine (discussed on the Forum here); and The Uneasy Case for Favoring Long-Term Shareholders by Jesse Fried (discussed on the Forum here).

Over the last several years, some of the most prominent representatives of Corporate America have argued that the pressure of quarterly reporting creates incentives for public corporations to focus on meeting the short-term expectations of the market rather than developing businesses that prosper over the long-term and make positive contributions to society. The scrutiny of quarterly reporting gained momentum in the fall of 2018 when President Trump asked the SEC to consider whether it should only require annual or semi-annual reporting to reduce the burden of quarterly scrutiny on public companies. The SEC responded to the Presidential request by asking for comments on the question of whether the “existing periodic reporting system . . . foster[s] an inefficient outlook among registrants and market participants by focusing on short-term results. . . .”

The proposal to eliminate quarterly reporting connects to a heated debate about whether short-termism, where public companies take “actions that are profitable in the short-term but value-decreasing in the long term,” is a significant problem. Over the last several years, legal scholars have generally focused on activist hedge funds as the primary driver of short-termism. Much of the debate has focused on the implications of such activism for corporate law.

The short-termism objection to quarterly reporting is worth analyzing because it raises questions about whether policies to protect investors can have a negative impact on corporate decisionmaking. Investor protection as a policy goal has generally been uncontroversial. If core securities regulation policies such as quarterly reporting promote short-termism, it is worth thinking more broadly about whether the orientation of the securities laws should be shifted. The fact that securities regulators in other jurisdictions have rejected quarterly reporting on short-termism grounds raises the possibility of a flaw in the U.S. approach.

This paper contributes to the debate on quarterly reporting by tracing its origins. It is important to recognize that this system has two components. First, the securities laws mandate quarterly disclosure for public companies. Second, investors judge the results reported in such disclosure in relation to quarterly projections of financial results. Short-termism has mostly been driven by the rising importance of projections rather than the mandate of disclosure.

Quarterly reporting reflects a closely intertwined blend of government regulation and private ordering. Both quarterly disclosure and quarterly projections originated independently from SEC regulation. Quarterly disclosure of earnings was required by the New York Stock Exchange decades before the SEC mandated it in 1970. Projections, which are typically issued by research analysts, became common in the 1960s, at a time when SEC policy sought to discourage them. However, in various ways, the SEC has reinforced the legitimacy of a system that judges companies based on their quarterly results. For example, it has emphasized the importance of issuing quarterly disclosure that accurately reflects whether a company has met market projections.

The evidence more clearly points to projections as the source of pressure on public companies than quarterly disclosure. There would be incentives to increase quarterly performance without projections, but projections clearly set forth investor expectations for a company’s performance. Even if companies reported somewhat less frequently, if their semi-annual or annual results are subject to a projection, there will be short-term pressure to meet that projection. Managers report that they are willing to cut expenditures to meet a projection. The experience of the frauds of the late 1990s and early 2000s illustrates how companies can destroy long-term value by seeking to create the appearance that they are meeting projections.

If projections are the source of short-termism, reform should be directed at such projections rather than taking the more radical step of reducing quarterly reporting. Increasing the obligation of public companies to provide their own projections and the assumptions behind such projections might reduce the risk that they are judged by unrealistic projections. The SEC might also consider relaxing rules that require precise accuracy in the reporting of quarterly results. Such modest reforms are warranted given the limited evidence that public companies are sacrificing long-term value. Quarterly reporting likely tilts public companies broadly towards short-termism, but it is unclear that the degree of such pressure is severe.

The example of quarterly reporting is also of interest because it illustrates the contrast between securities and corporate law. Because the securities laws primarily facilitate securities transactions, they generally favor short-term investors who purchase and sell securities more frequently than long-term investors. In contrast, rather than focusing on the narrow interests of investors when transacting, corporate law more broadly governs the interests of investors while they own a stock.

As securities regulation has evolved to meet the needs of markets that have become more liquid and demanding over time, corporate law has evolved in ways that increase the discretion of corporate managers. To an extent, weaker corporate law favoring managerial discretion can be a way of addressing the problems of strong securities law favoring transacting investors. Put another way, strong securities law can be checked by weak corporate law. (Cf. Mark J. Roe, Strong Managers, Weak Owners, 1996.)

The complete paper is available here.

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