Rewriting the rules

Like the fabled flutter of a butterfly wing that can, in a series of stages, turn a light breeze into a violent whirlwind, a hushed SEC announcement made in late June could provoke a storm of change.

The media took little notice at the time. But SEC chairman Christopher Cox called the plan ‘the 21st century disclosure initiative’, a grandiose enough title that reflects his view of the potential magnitude of the activity. He told a Stanford Law School audience the project will consider how to ‘blow up’ the current structure of disclosure.

The goal of the project, he said, is to come up with a blueprint by the end of the year ‘for overhauling the SEC’s current form-based structure with one that truly meets users’ needs.’ It will then be up to a blue-ribbon panel to decide how to go about doing what the blueprint suggests.

Named to head up the first phase of the project is Rutgers University emeritus professor of English, William Lutz, known widely in legal and regulatory circles for his work on plain English, an initiative to remove legalese from the disclosure process, and in a wider global program, to make legal documents generally more understandable.

Lutz is both an English professor and a securities lawyer. He was the principal author in the late 1990s of the SEC’s ‘The plain English handbook’, a compendium still urged on public companies and their law firms along with other filers to help them be clearer in communications with the marketplace. Unfortunately for investors, change has been slow moving. Much of the filing done by corporations runs through a legal gauntlet, dominated by a belief that using strictly defined legal jargon is the only way to craft a legal document.

It is, of course, a well-trodden battlefield. Lutz says he once spent two hours arguing with corporate staff over one word. In any case, he is seasoned and his nomination to draft a blueprint for the project is seen as a good choice.

Peggy Foran, who recently was named executive vice president, general counsel and corporate secretary at Sara Lee, has worked with Lutz through the years and says the overhaul is overdue.

‘You have to give people information they can read and understand,’ Foran insists. Moreover, while most companies have been slow to act in this area, leading actors have been working to make progress. ‘I have spoken with other corporate secretaries and they are anxious to see [digital filings] work,’ says Foran. She was a key player in making filings and an implementer of the plain English ideas while serving in her previous position as corporate secretary at Pfizer.

A long and cautious process

According to the SEC, the plan is to move through two major stages. The first is a six-month period running to the end of the year dedicated to drawing up the blueprint under Lutz and his assembled small internal team. The second stage will be the hand-off of the team’s report to a committee to be named by Cox. That stage will take place at the beginning of 2009.

Then a year of study and consideration will occur, with research and wider public input designed to figure out how the recommendations will be implemented. This means the final report of the SEC is not likely to reach staff hands until the first quarter of 2010. Typically such findings are given to SEC staff who then drive policy forward using the committee recommendations as a central guide.

With this kind of timetable, it is difficult to predict the actual speed of change, but there is a strong force behind it. ‘This is directly attributable to chairman Cox who is pushing hard,’ Lutz says. ‘He has built a public awareness of this need and raised the issue many times. This is what this government agency should be doing for you. He has been prodding the public to raise their expectations for the SEC.’

Not keeping pace with change

Perhaps more important in the process of instigating change is the fact that the public can see that the securities industry and communications in general have changed technologically while the SEC has not, at least not at the same pace. As Lutz puts it, this is all about adjusting to the real world. ‘Basically my charge is to draw up a blueprint of how the SEC will do its disclosure in the future,’ he says, ‘moving from a paper-based to a data-based system. The rest of the world is moving that way; corporate America is already there.’

Included in that move is a review of all existing SEC forms and reporting requirements, as well as the manner in which information is provided to the SEC.

The official announcement reads: ‘It will also include consideration of various alternative strategic approaches to acquiring and publishing disclosure information. In addition, the study will consider ways that regulatory requirements for the collection of information might be tailored to get the best real-time distribution of financial and narrative disclosure to investors. Finally, the study will examine how best to integrate public disclosure with the SEC’s proposed new post-EDGAR architecture for investor search, assembly and comparison of data.’

The SEC states that the methods for filing need to be coupled with its plan for all filers to use XBRL computer language, announced earlier this year. It is all about automation.

One of the more intriguing aspects is the mention of narrative becoming machine readable and thus available for comparison between companies and industries through the use of XBRL. This change will allow investors to simply and instantaneously make computerized comparisons on scores of topics not normally reduced to numbers, such as financial controls, risk management, governance, social policy, work force issues and a host of other values, goals, problems and objectives.

While organizations have cropped up in recent years to score companies on many of these areas, the methodology is often criticized as a way for corporations to ‘tick the boxes’ on a laundry list of requirements. Shifting the activity to computer-generated parsing and comparison will change the game, making for a much broader and more complex set of analyses. It will mean that all companies, large and small, can be examined and rated not according to their pocketbook, but according to the wishes of the investing public.

An important aspect of the review, therefore, will be the type of software that comes along with it. ‘Once the data is filed with the SEC, the key becomes the user interface,’ Lutz explains. A user interface is the software controlling how a person interacts with machine-based information. The most commonly known interface at the moment is the browser that people use on the internet, such as Microsoft’s Internet Explorer or Mozilla’s Firefox. What the SEC is talking about is a customized interface for all investors.

‘The big brokers have that sort of thing,’ Lutz says. ‘Our premise is, Why can’t the average investor have that sort of thing?’ Ensuring that this interface is created alongside the recommended change from paper-based forms is crucial to the project, he adds. ‘One of the things that we are going to recommend is a user interface that will allow you when you go online – unlike EDGAR now – to call up a company filing and compare it using all data.

‘That was one of the things promised with XBRL, but that applied only to numbers initially,’ he says. ‘We also want to do it with the narrative. You may want to say, How has their risk assessment changed over the last four quarters? And you’ll be able to see that.’

This is all part of a broad set of modernizations at the SEC. This year, the Commission also finally promulgated its guidelines for companies using the web for disclosure. It followed that announcement with action on better financial reporting for investors.

The Advisory Committee on Improvements to Financial Reporting delivered its conclusions to Cox in August. Similar to the aim to streamline the architecture of disclosure that Lutz and his team are addressing, the Committee was charged with ‘reducing unnecessary complexity in the US financial reporting system and making financial reports clearer and more understandable to investors,’ Cox then referred the recommendations to staff for rule-making ‘where appropriate.’

The importance of language

No small amount of attention is given to language and clarity. The advisory committee made specific reference to problems with ‘dense language’. Thus Lutz’s expertise with English is important in his effort to set out the blueprint for disclosure reform. Indeed, he started off by shifting the way his group’s project is described.

People think one way when they hear the word ‘filing’, he says, but they react quite differently when the term ‘disclosure’ is used. Lutz maintains the former is the correct one to use in discussing the upcoming change because everything else, including disclosure, is included in ‘filing’.

‘So, when you say, Let’s change the way data is filed, then you encompass all the ramifications,’ he concludes.

Disclosure rules are among the things that listing agents – the stock exchanges – hand down to new companies going public. Their disclosure recommendations are often the first reference point for companies as they negotiate the task of being public and therefore subject to the SEC’s expectations and requirements.

However, the two big equity exchanges in the US expressed reluctance to provide so much insight into the process at such an early phase in what’s sure to be a raucous game. A simple ‘no comment’ was all NYSE Euronext was willing to muster, despite repeated requests for more feedback.

At NASDAQ OMX, vice president Doug Ventola was only slightly more forthcoming. ‘As a global securities exchange, technology company and data provider,’ he says, ‘NASDAQ OMX supports a modern disclosure system for the capital markets and public companies. We look forward to participating in a process that will simplify the disclosure process for our issuers, resulting in much greater transparency for investors.’

These responses seem rather slight given the SEC’s declaration that the study ‘will be a fundamental rethinking of financial disclosure, beginning with the basic purposes of disclosure from the perspective of investors and markets.’

Meanwhile, Lutz had no trouble expressing the remit, if not the outcome, of the team project. ‘What we want and what the chairman has charged us to do is to come up with a disclosure that is accessible, understandable and of the highest quality,’ he says.

At the same time the blueprint must look across the needs of three distinct groups. ‘We have to be concerned with the needs of the investors, the listed companies and the needs of the SEC’s enforcement and oversight functions,’ Lutz says.

Looking over your shoulder

That last category highlights another one of the major effects this project will have. The SEC has taken flack this year for not having been in front of some of the problems that beset US markets, although an argument has been made that it was acting vigilantly behind the scenes. Nonetheless, enforcement and oversight are a key aspect of its very existence and the moves to XBRL and full-narrative machine reading will add to, or free up, resources.

As an example, one of the rules generated by the Sarbanes-Oxley Act is the requirement that the SEC audit all listed companies once every three years, a major drain on staff and budget. The new automated software processing will massively streamline that along with a host of other oversight and enforcement activities. Freeing up the human and financial capital with the full suite of new tools, plus streamlined filings, will bring more teeth to the enforcement end of the SEC’s work.

A close look at the breadth and depth of the disclosure revamp gives one the impression of huge change but Lutz maintains the project is evolutionary, not revolutionary. ‘I am a big fan of the tipping point, and as I got here and talked with the senior staff and read lots and lots of documents, I found this idea has been percolating here since at least 1996 in various shapes and forms.

‘This is really a logical culmination of a lot of different people over time thinking about a lot of different aspects and I think what we are doing now is just pulling all of that together,’ he continues. ‘All of these ideas have matured and evolved to where they are ready to actually be clarified and then developed into hard plans.

‘Once you get a handle on it, you realize this isn’t coming out of the clear blue at all. In fact, I have sitting on my desk right now a report dated 2002 talking about some of the same technological issues we are talking about.’

In 2005 Cox was optimistic about getting it all together, saying that ‘during the next 12 months, the SEC will move beyond the EDGAR concept of electronic filing of paper-based forms to an interactive data concept, in which investors can have instant access to data that’s ready to use in myriad software applications on their desktops.’

 It has taken a lot longer, but the SEC and US securities markets are now sitting on the doorstep of that vision coming to life.