Disclosure as an Instrument of Securities Regulation

The almost universally accepted strategy for securities regulation is to require issuers to make adequate disclosures in offering documents. The role of the regulators is to determine the extent of disclosures required. It is then left to investors to rely upon the disclosures and to make a decision as to whether to invest or not. Sophisticated investors such as financial institutions rely on their internal personnel such as analysts to decipher the information in the disclosures, while retail investors tend to pay heed to analyst reports of brokerage houses or analysis by the media or even simply rely on their own intuition.

Although offering documents were originally intended to be selling documents, they have metamorphosed into legal documents that are now drafted by lawyers as a matter of practice. A report in the Mint last week has an interesting take:

If the IPO documents of all 109 [filed this year] are piled up, at an average of 5,000 copies per company and an average 1.8cm thickness, it would create a stack some 9.8km high, about a kilometre taller than Mount Everest.

But that’s only one part of the story. How many people actually read these documents and what part do they play in helping them reach an investment decision?

Only about 1%, or say 50 people, on an average actually read them… .

The reasoning for this trend is as follows:

Bankers say they’re just following the legal requirements as set out by market regulator Securities and Exchange Board of India (Sebi) while drafting the prospectus.

The regulator has laid out the norms for offer documents in the Disclosure and Investor Protection Guidelines, an exhaustive document that even specifies the thickness of the prospectus cover and the colours that may be used. But there is no guidance on style or clarity.

SEC has tried to solve this problem by issuing a plain English handbook for underwriters that offers guidelines on clear writing with examples.

However, the fear of liability is the key concern for bankers and companies. In other words, the guidelines notwithstanding, US documents too are known to contain 89-word sentences with a dozen numbers.

The question that is being raised is whether disclosure continues to serve the ends of securities regulation. Is too much information and legalese confusing rather than aiding the investor? In a recent paper, Simon C.Y. Wong cautions overreliance on disclosure as a mode of securities regulation. Using the U.S. model as an example, he argues:

The US approach to regulating the securities markets is underpinned by disclosure, and US policymakers have tended to respond to corporate and systemic crises by strengthening disclosure requirements. For example, in response to the global financial crisis, the US Securities and Exchange Commission recently adopted new rules enhancing disclosure of risk oversight by the board of directors, executive remuneration, and conflicts of interest of compensation consultants.

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 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.

Over the last two decades, SEBI as the capital markets regulator has moved away from merit-regulation of public offering and towards disclosure-based regulation. This may be an opportune moment to revisit the approach, at least to streamline and simplify the disclosure requirements and to make it more user-friendly.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

1 comment

  • I find it inappropriate to analyse the disclosure based method of securities market regulation in India from an American vantage point. As you would yourself know, Indian and American securities markets are not at the same level. For eg. in India, the promoters are quite powerful and exercise significant control over the company and its affairs. There is a major incentive to suppress information and obtain better valuation. An extensive disclosure regime and the offer document being a liability document, compels the promoters to reveal, inter alia, their ability to run the company.

    Also in general, the justification for a disclosure based regulation should be analysed not just from the angle of primary market, but also from the angle of secondary market. Disclosure based regulation reduces the problem of secondary market investors gaining advantage over one another by procuring unannounced information about the company. It should be noted that the continual disclosure through stock exchanges is not as extensive and complete as at the time of listing. And the problem of insider trading is quite acute in India.

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