Volume 42 | Number 3 Summer 2007
Page 3 of 9
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II. Disclosure as a Public Policy Instrument
Disclosure is a key policy instrument in three respects: it serves as a transaction cost control device, a regulatory tool, and a governance-signaling device.8
As a policy instrument to control transaction costs, disclosure can serve to reduce the cost of access to capital and thus enhance efficiency in capital markets.9 Standardized and uniform disclosure requirements reduce transaction costs for issuers bringing securities to the market by reducing the costs of contracting for securities, including the cost of contracting contingency claims. These costs include third party costs incurred in the raising of capital, such as fees and the pricing of new capital in the market. Transaction costs, however, can vary given the frequency of rule changes, the amount of codification, and whether a rule change enhances confidence in the market. A particular level of codification can increase certainty and reduce costs; however, over-codification or rapidly changing standards can increase transaction costs as issuers try to understand and meet new requirements or market participants seek premiums for investment.10 Increased codification could result in an attendant increase in costs of disclosure compliance, which in turn means a higher cost of capital. Alternatively, a high level of codification could avoid making disclosure more costly but could create a “tick the box” compliance culture if it drives the system to a level of prescribed disclosure with little thought and time directed to compliance. In contrast, a well-designed, accessible system can facilitate issuer disclosure and investor decision making, resulting in more efficient trading.
Second, disclosure is a policy instrument in that it serves as a measure of compliance with regulatory requirements.11 In Canada and the United States, as in many jurisdictions, securities regulators assess fitness for market based on whether the issuer meets disclosure requirements. Disclosure is also the regulatory instrument for sanctioning or removing market participants. In addition, it is a tool for the creation of incentives for appropriate capital market participant behavior. For example, those issuers with recognized experience in the market and a history of compliance with securities law requirements have less onerous regulatory conditions imposed on them in bringing a new offering to the market. Hence there is an incentive to comply in order to reduce costs of future offerings. In this sense, disclosure is a regulatory tool to facilitate creating a culture of both pro-active disclosure and of compliance.
Finally, disclosure has a corporate governance role as a signaling device that communicates messages to capital market participants about the issuer’s governance effectiveness.12 It serves as a signaling device for investors in respect of operational efficiency, director oversight, and managerial skills. Increased disclosure of corporate governance under “comply or explain” policies of stock exchanges and securities regulators means that there is increased information about governance practices, contingency processes, insider trading decisions, executive compensation, and board independence measures. It is also a signaling device for corporate directors, as requirements to disclose corporate governance practices force corporate boards to assess and report on upside and downside risks, which facilitates the board’s own process of adjusting strategic planning and oversight of corporate officers accordingly.13
The quality of disclosure can influence market behavior, as the willingness of investors to expend their capital on a particular economic activity is affected by whether investors have confidence in the disclosures being made. Failure to achieve effective disclosure can reduce market efficiency because the cost of capital is higher and public confidence and willingness to invest are diminished.
In Canada, there have been two normative directions in disclosure policy for capital markets. On the one hand is the clear move by most regulators towards increased codification through national instruments, policies, and local rules, aimed at certainty in quality of information.14 In this respect, Canada has followed its largest trading partner, the United States, in large measure because of the highly integrated nature of the two countries’ capital markets. One concern is whether current codification initiatives are an overreach of regulation of primary offerings. It is estimated that currently twenty-five percent of all securities regulation in Canada is aimed at the primary market, yet this market accounts for only about six percent of all trading.15
The other normative direction is a Continuous Market Access (CMA) model, proposed by the British Columbia Securities Commission (BCSC), which is premised on the notion that principles/standards-based regulation, rather than detailed codification, will better promote the goals of investor protection, efficient markets, and public confidence in capital markets. The BCSC model aligns itself with initiatives in the United Kingdom, which the United Kingdom’s Financial Services Agency (FSA) calls a hybrid of high-level principles and detailed rules and guidance that focus on best practices more than rules, with the aim of continuing to change the balance “towards a more principles-based and less rules-based approach.”16
To date, these divergent approaches have created a barrier to implementing a single national securities law regime in Canada, to replace the existing thirteen provincial and territorial securities law systems.17 Both normative views have benefits and limitations. There is a risk to accessibility for both issuers and investors in terms of understanding the nature of highly-codified obligations. At the same time, if Canadian regulatory requirements do not align to a certain extent with highly codified U.S. disclosure requirements, there could be difficulties with continued access to U.S. markets. There is also a risk of issuers missing market windows, given time delays in bringing an offering to the market where approval of multiple regulators is required. The BCSC conducted a cost-benefit analysis that suggested that the CMA model provides more expeditious and less expensive access to capital without sacrificing investor protection, and that completion of an IPO under CMA would be up to nineteen percent faster and up to fifty one percent cheaper.18 Offerings after initial IPO could be up to fifty six percent faster and eighty two percent cheaper, depending on size of the issuer.19 Issuers would get to market faster, reducing the risk of missing market windows.20 The CMA is aimed at benefiting investors by improving disclosure and benefiting issuers by significantly lowering their capital-raising costs.
While there is not yet convergence of these normative approaches, there has been some loosening of the views regarding principles-based versus rules-based approaches to disclosure regulation. For example, in the United States, the SEC has recently recognized the need for at least a partially principles-based approach. To date, regulatory change in the United States has been highly rules driven, particularly in the years after Enron and other corporate failures. Yet the SEC has adopted a partially principles-based approach to its new requirements on executive compensation disclosure, effective December 2006. The new Compensation Discussion and Analysis (CD&A) document aims to provide clear and complete disclosure of senior officers’ compensation, using both the SEC requirements that it be in plain language and principles-based requirements to explain all material elements of compensation.21