Are You Responsible for Your ‘Passive’ Investments?
To what extent are we accountable for what goes into index funds?
Are You Responsible for Your ‘Passive’ Investments?Josh Stunkel
(light piano music)
Hal Weitzman: To many observers, the financial crisis was a powerful demonstration of the need for greater transparency in financial reporting. But does forcing companies to disclose more information more frequently actually improve corporate governance?
Welcome to The Big Question, the monthly video series from Capital Ideas at Chicago Booth. I’m Hal Weitzman, and with me to discuss the issue is an expert panel.
Haresh Sapra is professor of accounting at Chicago Booth whose research deals with issues of disclosure, transparency, and financial reporting for financial institutions. He has won numerous teaching awards, including being named one of the top-ranked professors in Businessweek’s guide to the top business schools. He’s also a certified public accountant.
Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance and the David G. Booth Faculty Fellow at Chicago Booth. He’s also a faculty research fellow at the National Bureau of Economic Research, a research fellow for the Center for Economic Policy Research, and president-elect of the American Finance Association. He’s a prolific op-ed writer and the author of the books, Saving Capitalism from the Capitalists and A Capitalism for the People.
And Scott Taub is the former deputy chief accountant and acting chief accountant of the Securities and Exchange Commission, where he played a key role in implementing the accounting reforms in the Sarbanes-Oxley Act. In 2007, he left the SEC and is currently a managing director at Financial Reporting Advisors in Chicago.
Panel, welcome to The Big Question.
Luigi Zingales, let me start with you. What is the basic fundamental case in favor of more transparency and financial reporting?
Luigi Zingales: I think that the fundamental case goes back to Justice Brandeis, when he was saying that the sunlight is the best disinfectant and the streetlight is the best policeman. The idea that no sort of shenanigans can take place when this is done in front of the public eyes.
So transparency is a way to prevent corruption, prevent fraud, prevent a misuse of funds by firms. Prevent many of the things we are worried about when we’re worried about bad corporate governance.
Hal Weitzman: Scott Taub, you were right in the thick of it at the SEC. Just define for us, what does transparency mean in financial reporting?
Scott Taub: From the perspective of accountants and the accounting profession, I think we think that financial statements, financial reports are transparent. If a reader of those reports can understand what the company did, why they did it, and what the economic effects of those actions were, that’s I think the accounting view of transparency.
Hal Weitzman: OK, and Scott, is it your view that more transparency is always a good thing?
Scott Taub: Well, I think you have to define in what area you’re thinking of. Certainly, my experience at the SEC, we were worried about making the capital markets run efficiently. So we’re concerned about efficient allocation of capital. And in that regard, yes, I think almost always more transparency would lead to better capital allocation. So in that respect, you’ll find regulators from the SEC tend to be in favor of transparency.
Hal Weitzman: OK, now Haresh, let me turn to you because your research, it paints a slightly different picture. You suggest that there’s an important cost to greater reporting requirements. Tell us about those.
Haresh Sapra: Well, I mean, at the end of the day, using Luigi’s analogy he used, I think too much sunshine can cause your skin to burn. So too much transparency, it’s not clear that necessarily that it’s a corollary solution in the sense that you want maximum transparency. There are clearly costs and benefits that have to be traded off. And that’s what my research shows, and other research have shown that there are some important benefits to transparency. Clearly. It’s not the idea that, you know, you want zero transparency.
The key, I think, trade-off is what is the optimal level of transparency? As you’re increasing transparency, the benefits are there, but there are certain costs that kick in, and those typically are not taken into account.
Hal Weitzman: OK, so tell us more about those costs.
Haresh Sapra: Well, a lot of these arguments for transparency seem to rely, as Scott was pointing out, that markets become more efficient, right? Because outsiders get more, better information, and that’s correct.
And if the role of regulators is to disclose so that outsiders get better information, that’s . . . I would agree that more transparency is better. But what is missing from this argument is the fact that how firms react to this. And a lot of the arguments for transparency look at the market and say, oh, we want to disclose more information so that outsiders all are homogeneously informed. They have information. Prices are more efficient. But price efficiency, research has shown, does not equate to economic efficiency, which means that, are firms in turn making more efficient decisions? And in turn, is that increasing value in society?
That’s not very clear.
Hal Weitzman: So what is the concern? I mean, what will firms do if there’s stricter requirements?
Haresh Sapra: If you start increasing transparency, prices in markets will become more efficient. But then we have to understand the environments in which firms are operating. It is very possible that firms start responding to these prices and start taking on risks or projects that make them look very good in the eyes of the market, but it’s not maximizing long-term value for the shareholders.
Hal Weitzman: So we’re talking about sort of manipulating what they’re doing in order to look good every quarter. Is that what you’re saying?
Haresh Sapra: Yeah, one example of that would manifest itself in manipulation. You could be . . . you’re so worried about the next earnings forecast and you know that more and more disclosure out there would make the market very sensitive to that. You start taking on projects that could potentially make you look very good in the short term, but not necessarily in the long term. So therefore you become myopic in a sense. Basically, this more disclosure could induce you to become more myopic, and that’s the danger. So that has to be traded off against these benefits.
Hal Weitzman: Luigi Zingales, what do you make of that? That there are costs and we have to, there’s a trade-off?
Luigi Zingales: Of course there are trade-offs. This is what economics is about. In a sense, if you never miss a flight, you waited too long at the airport, so it’s not optimal to catch all the flights.
So I think that the theoretical possibility is clearly out there. Whether it is a first-order consideration in practice remains to be seen. And I think that it’s right that any form of disclosure and any form of a meeting or performance induces distortion. Even in business school, we have teaching ratings, and some professors bring the pizza the last day before the evaluation to increase their ratings. That’s a distortion. We don’t want that to happen.
Now, should we . . .
Hal Weitzman: Not at Booth, of course.
Luigi Zingales: Not at Booth, of course. Occasionally also at Booth, but we have prohibited that. But do we want to abolish teacher ratings as a result of that? No. Do we want to be a bit cautious and not bet everything on teaching rating because we know that if we rely too heavily on this, this will have a backlash effect? Absolutely.
So I think that Haresh’s research is extremely useful as a word of caution to make people think that it’s not a one-handed world. We have two hands. But I am concerned that it’s taken too seriously in the direction of: let’s stop disclosure now. Because, of course, there is a pretty powerful lobby made by firms that doesn’t want disclosure. So any story . . .
Hal Weitzman: So that doesn’t necessarily mean that they’re wrong, does it?
Luigi Zingales: Doesn’t mean that they’re wrong, but I think that one has to be concerned about how the arguments are used, and I think that some arguments can be misused.
Hal Weitzman: OK, Haresh.
Haresh Sapra: Yeah, I actually agree with Luigi. The argument we’re making is not, you know, zero transparency, as you said. There’s a trade-off. I think the key thing to keep in mind is too much of this debate has been on outsiders getting the information and the reaction of the market. Even, you know, academic research has focused a lot on measures of market efficiency to make an argument that transparency is better.
I think that’s good. What has not been taken into account is, you know, firms, you know, how does that have real effects on firms’ behavior? I think that’s very important. I think both have to be taken together to argue: What is the optimal degree of disclosing?
Clearly in many, many cases, I would say that there is not enough transparency. Transparency has to be disclosed. But the question is, do we want to be pushing in that direction or do we want to step back and look at firms in general? Disclosure is one dial you’re turning. There are other dials that in my mind are more effective than just disclosure.
Luigi Zingales: Yeah, but I agree with you, but I would like to know practically what are the dimensions? Because we agreed that the feedback effect is very important. What I think we disagree on is that most of the time, what I look at, the feedback effect of more disclosure is positive.
So take the field of executive compensation. The more disclosure, the more boards internalize some of the concern about wrong compensation, and the better the compensation is—not worse. So I think this feedback is extremely important, must be analyzed. Many of the examples I have in mind go in the direction of more disclosure, but I’m open to see that there are alternatives.
Hal Weitzman: Scott Taub.
Scott Taub: With respect to something Haresh said, if it is true that additional disclosure is causing companies to make poor economic decisions, being myopic, focusing on the short term rather than the long term, and if it is the case that those are bad decisions, I’m not smart enough to know that, but if that’s true, fine. That suggests to me as a regulator or as an accounting standards setter, that there’s something missing from the financial reports. Because we are apparently reporting in a way that shows short-term benefits but doesn’t show possible long-term benefits.
So that doesn’t suggest to me that we should have less transparency, but that we aren’t achieving transparency.
Hal Weitzman: Is the point really about . . . we have kind of two issues. One is about the frequency of reporting, and one is about the kind of reporting. So for example, you know, firms complain that if they have to market some of their trades, then it will distort their reports.
Is the concern more about the frequency, that the more frequent the disclosures, the more distortions? Or is it about the type of information?
Haresh Sapra: I think it’s both. I think it’s both. I mean, the key point I think Scott pointed out is: How do we achieve transparency? There are various ways you could achieve transparency. I think fair-value accounting is one way that standard setters have been going after. Let’s value these assets of the banks of the financial institutions and just disclose them. Because prices have gotta be better versus, you know, using all prices or historical cost accounting, as they call it. I think that’s an important issue. How do you achieve it?
The other one, of course, is how frequently do you disclose? You know, I mean, there’s a push to disclosing more and more often. And the question is, do we start forcing firms to disclose? We’re quarterly right now mandatory reporting in the US. In Europe, it’s semiannual. Do we push them to be reporting, and there’ve been some debate about pushing them to report monthly, right? Because this information is already online. Why don’t we disclose this information monthly because that’s gotta be better.
And this is where I’ll start getting really worried. You know, I would say that, oh, if you’re disclosing monthly, then the whole decision-making nature of risk-taking becomes very short term in nature.
Hal Weitzman: Luigi Zingales, would monthly reporting be better?
Luigi Zingales: I’m not so sure. But I’m also not sure that European companies are so much more on a long-term horizon because they don’t have to report quarterly.
In a sense, I think that at the end of the day it’s an empirical statement. And I have to say, I’m not as much in this literature as you are, but I’m not seeing any convincing evidence that quarterly reporting induces short-term behavior. I think that it might. I’m open to the theoretical possibility. I’m not seeing evidence. And before I change something as important as this one, I would like to have some good evidence.
Hal Weitzman: Well, you have had financial firms doing complex repo trades in order to flatter themselves every quarter.
Luigi Zingales: Yeah, but that’s evidence that people try to disguise. So that’s not short-term behavior. That’s sort of financial gimmicks. And that’s, to me, an indication that it’s good to report more often because they force these gimmicks to come out.
Hal Weitzman: But let me turn the question back to you then. Does that mean that in the US you have better corporate governance than in Europe because you have more-frequent reporting?
Luigi Zingales: I think that overall in the United States, you have better corporate governance. Now why? Whether this is due because of the sort of a more-frequent reporting or part of it, I don’t know. It’s hard to tell, and I’ve not seen any paper that sort of nails this down.
But in my view, there’s no question that corporate governance on average is bad. Of course, there are the exceptions. And I think that transparency helps in that direction.
Hal Weitzman: Scott, do you think we’re at a point where we’re kind of at the perfect stage for reporting? We don’t want to have monthly reporting. We don’t want to go back to semiannual reporting. Is quarterly reporting, kind of, the perfect timetable?
Scott Taub: Quarterly reporting certainly feels right to me, but in part that may be because that’s all I’ve experienced. I can tell you that I don’t feel like we need more frequent reporting. Although, I find that firms actually do voluntarily report more frequently than that. Earnings estimates, and forecasts, and things like that that are not required. Firms report those and update them fairly frequently. Many of my clients will update their guidance every six weeks or so.
So we do see that the market wants some information more than quarterly, and some firms are responding. I’m always a little bit interested to know what the effects of having issued earnings guidance are, because I do find that that adds more impetus for companies to try to manage the result, as Luigi suggested.
Hal Weitzman: Haresh, you’re not suggesting, are you, that we go back to less-frequent reporting necessarily.
Haresh Sapra: No, no. Not at all, not at all. I just think that there are important costs that have been especially . . . you know, when you read exposure drafts from accounting standards setters, their whole objective function is: let’s disclose to make prices more efficient. And I think that’s missing a lot of the arguments that many firms . . . of course, firms are maybe engaged in their own objective function of taking on risks that make them look better, but at the end of the day, if we give the firm some benefit of the doubt, I think it’s important to weigh the arguments that, should that be the role of the standard setters, which is, to me, seems very narrow, which is disclosing to the market without efficiency considerations, stability considerations, or anything like that.
I think it’s the right time to step back and think about these issues, especially after the financial crisis.
Hal Weitzman: What about corporate governance? What would be the one thing that we could do to improve corporate governance in terms of financial reporting?
Haresh Sapra: I think corporate governance itself has its own instruments there that you could use. I mean, one important idea is more disclosure can be bad because you become so myopic. You focus on short-term measures. I think it’s important to understand the type of contracts that the board is writing with the executives.
You know, the contracts that they’re writing on, I think the contracts are getting better since the financial crisis. Now there are claw-back provisions. I think these are very important instruments that you could use so that you are, you know, you bear the consequences of your decisions. So I think corporate governance can be used simultaneously with disclosure to enhance shareholder value.
Hal Weitzman: Luigi Zingales, what more transparency would you like to see in US corporate reporting?
Luigi Zingales: I think that the increased disclosure and compensation has been very useful in [inaudible] these conversations were in some cases excessive, in some cases were purely structural, even the lack of a claw-back provision, for example. I think that’s an issue where disclosure’s been extremely helpful. I think that the disclosure of the . . . if we look at financial corporations, the important thing is understanding how solvent they are and what is the true capital. Every bank that went into trouble had enough accounting equity to be considered safe by any standard measure. So that suggests that those measures are useless because if those banks fail still qualifying on those measures, it means that they’re useless.
So either those measures are wrong or there wasn’t enough disclosure or combination of the two, probably the combination of the two.
Hal Weitzman: Scott Taub, you were at the SEC when Sarbanes-Oxley came in. It’s been a decade since. What have been the main successes and any downside to that legislation?
Scott Taub: It has been an awfully long decade in the accounting world dealing with Sarbanes-Oxley.
(all laughing)
I think the biggest success is that companies take financial reporting and accounting more seriously than they used to. And that shows up in fewer errors. It shows up in fewer restatements. It shows up in more investment in the finance function within companies. It shows up in more training.
Luigi Zingales: And more money paid to accountants.
Scott Taub: More money paid to accountants indeed, that’s true. So I think that’s been the biggest benefit, and you can see that confidence in financial reporting is up. Restatements are down over the decade.
It’s also helped in the corporate-governance side by clarifying that the audit committee should be making certain decisions and taking responsibility for certain things rather than management. I think that’s been a positive as well.
On the downside, there’s no question it cost more than we thought it was. In fact, if you want to really laugh, look at the SEC’s original proposal to implement the internal-control-reporting provisions of the Sarbanes-Oxley Act. The estimated cost was somewhere around $100,000 per public company. I suspect that the actual cost is at least on an average four to five times that amount.
And certainly for the largest companies, it is 10 or 20 times that amount. So we missed it, and it has been more expensive. That’s the main downside really.
Hal Weitzman: What about, there was some fear at the time that the US would be competing with London and Hong Kong for listings or that there would be delisting as companies would go private.
What’s the evidence actually telling us about that?
Scott Taub: There’s no question that some companies deregistered, went to London, Hong Kong, Toronto because we made being public in the US more expensive. So you would expect that on the margin, that’s going to cause some not to do it. I think private companies also have not gone public as quickly on average as they might otherwise have. Those were certainly expected results, and we have not seen a mass exodus. We haven’t seen a huge spate of delistings of public companies going private. In fact, I have three clients right now that were public, were taken private, and are going public again. So they’re actually doubling up on the costs. They’ve already incurred the IPO cost once. They’re doing it again. So I don’t see that it’s really putting a huge break on public companies.
Hal Weitzman: But is going private, Haresh Sapra, is going private another one of the costs that we might have . . . we forced companies into a timetable that they’re not comfortable with? We’ve seen examples recently like Heinz and Dell and NASDAQ in talks to go private. Is that one of the costs that if you force companies to do more and more reporting, they just take themselves out of the game?
Haresh Sapra: That’s, as Luigi posited, a theoretical possibility.
(Haresh laughing)
Scott Taub: It seems logical.
Harsh Sapra: It seems very logical, but again, just using these two cases, you know, it’s very difficult to, I mean, there are many other issues going on there for why Heinz, they’re going private.
But I would think that . . . I personally don’t believe that the cost of transparency could be so high that companies would just turn off the lights and become private. But I think the cost is severe enough that they could basically, again, as I said, take on the risks that are not shareholder maximization.
Luigi Zingales: To be honest, it’s more than a theoretical possibility. I did do some research on this issue. And there’s been a clear loss in competitiveness of the US market vis-à-vis the rest of the world that has brought the massive delisting of foreign companies. Now, US companies don’t have a place to go yet. So that’s the reason why they don’t delist, but they don’t list as much as they used to. So I think that the public market has lost appeal vis-à-vis the private market. Now is it just because of Sarbanes-Oxley? Absolutely not.
I think it’s a more broader phenomenon made of two facts. No. 1, in the rest of the world, people have gotten better. Twenty years ago, the NYC was the only place to be. Today, it’s not true anymore. So it’s not that we have gotten worse; it’s the other have gotten better. So that’s problem No.1.
And problem No. 2: in the United States, also the appeal of remaining private has increased. We’ve seen, like, Facebook being on the institutional market traded for a long time before it went public. You have almost all the benefits without having the cost. So in my view, and I’ve written a paper on this, is that the gap between the regulation that we have in the privately held companies and the publicly held is too big.
And how do you fix this gap? It’s by lowering one and increasing the other. I think there is too little disclosure, especially for large, privately held companies, and too much, if you want, for publicly held ones.
Hal Weitzman: Haresh Sapra, you talked about one of your concerns was that there were demands for ever greater transparency, more and more demands of the kind of information that’s released, and more frequent reporting. Is that a real danger, do you think?
Haresh Sapra: It’s a great danger in the sense that I think the focus then of insiders would be worrying about what’s in their financial statements 30 days from now. And that’s not the way, depending on your business model, but most business models is to create value for shareholders. I find it very hard to imagine that if you’re worried about producing the right numbers and analysts focusing on these numbers every 30 days, you can really maximize shareholder value. So I think it’s a grave, it’s a real concern.
Hal Weitzman: Realistically, we’re probably not going to go backwards though, right? We’re probably not going to go from quarterly reporting back to half-yearly reporting.
Haresh Sapra: I don’t think that’s going to happen. And I’m not saying that should happen. I’m just saying that, you know, we have to be very careful in weighing these costs and benefits, and this is the right time to do that.
What is important is while we’re increasing transparency, we need to make sure that corporate governance, the auditing framework also is changing. I mean, one of the real problems I think has been, since the financial crisis, is auditors are just not well equipped to understand the type of risk that financial institutions are taking. This is going in and then verifying the numbers based on the model that they have without understanding what these risks that the banks are taking on. They need to start understanding these risks.
Hal Weitzman: I mean, that’s certainly been a huge criticism of the SEC. They basically have missed big scandals because they didn’t know what they were reading.
Scott Taub: I think that that is a fair criticism, both of auditors and of the SEC in the past. And it is difficult. We, I think the public expects the auditors to report on risks. Professional standards for auditors don’t require them to report on risks. So there’s an expectation gap there.
And similarly, I think, you know, your research points out an expectation gap as well. And I think you said it very well, accounting standards setters focus on capital allocation, more transparency, information for investors. They do not and have not been asked to focus on how their actions affect companies’ actions.
Hal Weitzman: So they’re kind of losing the bigger picture.
Scott Taub: Well, they’re not being asked to look at it. And so the question is: Do we want them to? In which case, we have a lot of changes to do to the framework. Or should somebody else be doing that? The SEC, Congress, some other body that might try to balance these things. It’s very difficult.
Hal Weitzman: The system is so interlinked nowadays, the financial system, Luigi Zingales, were we wrong to sort of focus on the individual firms and should we be looking much more closely at the system in general?
Luigi Zingales: Yeah, I think we should definitely . . .sort of, the financial crisis showed the interdependence of all these aspects. So we should definitely look at the systemic component, but I think that this is what FSOC is about, is trying to sort of see all this.
Hal Weitzman: Sorry, what’s that?
Luigi Zingales: The additional board created by Dodd-Frank that is in charge of studying the risk in the market overall and so looking at the overall perspective.
Hal Weitzman: So that’s the job of government, just to have a look at it.
Luigi Zingales: Yeah.
Hal Weitzman: It’s not necessarily something that accountancy can shed any light on that.
Luigi Zingales: No, and this is, I don’t know exactly what accountants are supposed to do, because every time I talked to my accountant, they’re not supposed to do what I expect them to do. As you said, there’s an expectation gap. They’re not supposed to report on risk. They’re not supposed to report fraud. They’re not supposed to . . . what are they supposed to report?
Scott Taub: They are supposed to report fraud. Whoever’s telling you they’re not supposed to be responsible for fraud is just wrong.
Hal Weitzman: Presumably fraudulent accountants!
Well, on that note, I’m going to call time. But my thanks to our panel, Haresh Sapra, Luigi Zingales, and Scott Taub.
For more research, analysis, and commentary, visit us online at chicagobooth.edu/capideas. And join us again next time for another The Big Question.
Goodbye.
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