Financial Communication and Regulation in the UK

1. Financial Communication and Regulation in the UK Andrew W Stark Coutts Professor of Accounting and Finance

2. Some Background In the UK, full financial reports come out annually, including accompanying narrative to the financial statements Listed firms produce interim (half-yearly) financial reports – they are not as full as the annual financial statements They also produce quarterly management statements in the other quarters In the USA, listed firms report quarterly Key issue I – if information significantly relevant to the value of the firm exists that has arisen between these dates, under what circumstances can investors have confidence in stock market prices, and that those prices are ‘fair’ (and, in investing in stock markets overall), in the presence of such potentially large information asymmetries between corporate insiders and investors? Key issue II – if investors do not have confidence in stock markets, what implications does this have for the raising of capital and the efficient allocation of resources?

3. Introduction There are two types of financial communication to be considered: disclosures outside of the financial report; and narrative disclosures within the financial report We will initially consider the relevance (actual and potential) of such information for prices Accounting information (i.e., P&L accounts, balance sheets, etc. – the financial statements, together with associated notes) is just one part of a much larger information set (some of which is also provided by firms) that can inform market prices – how useful is this other information and should its provision (at least, when firms are providing it) be regulated? After all, the provision of accounting information by firms is regulated

4. Are Market Forces Sufficient to Guarantee Honest and Timely Disclosure? • D. Skinner (Accounting and Business Research, Special Issue - International Accounting Policy Forum, 2008, Vol.38, pp.191-204), in the context of disclosures about intangibles, suggests that market forces should be sufficient to ensure appropriate voluntary disclosure, perhaps subject to disclosure guidelines than can act as ‘safe harbour’ rules • His example focussed on the under-pricing of RD activities – but what about when such activities are over-priced?

5. A Theoretical Model of Disclosure - I • This discussion is based upon that found in A. Beyer, D. Cohen, T. Lys and B. Walther, 2010. ‘The financial reporting environment: Review of recent literature’, Journal of Accounting and Economics, 50, pp.296-343, specifically pp. 300-305 • Consider a world in which: • disclosures are costless • investors know that firms have private information • all investors interpret the firms’ disclosure in the same way and firms know how investors will do it • managers want to maximise their firm’s share price • firms can credibly disclose their private information (i.e., they reveal it truthfully) • firms cannot commit, before the event, to a specific policy • Under such circumstances, an ‘unravelling’ result occurs in which all managers reveal their private information – no regulation is required to generate this result

6. A Theoretical Model of Disclosure - II • Under such circumstances, an ‘unravelling’ result occurs in which all managers reveal their private information – no regulation is required to generate this result • The ‘unravelling’ result occurs because, in this model, not disclosing (versus disclosing truthfully) implies that investors will revise the share price of the firm downwards, hence providing incentives for managers to truthfully disclose, other than for the manager with the worst possible information, for whom non-disclosure and disclosure are equivalent • Much theoretical work has occurred which considers the relaxations of these assumptions – we will not consider the outcomes and how the ‘unravelling’ result has to be modified • Instead, we will consider some of the circumstances that require the assumptions to be relaxed

7. Relaxing the Assumptions - I • Why might disclosure be costly? • Communication mechanisms are inherently costly • But there are other reasons – for example, the disclosure of information can give away information to competitors, workers, and regulators • Whether full disclosure will remain optimal depends on how third parties react to the information • If it is assumed that managers are uncertain how investors will respond to disclosures, full disclosure tends to break down • Ways in which investors might have unpredictable responses include: • different investors have different private information about the firm – hence, they will interpret a given disclosure in different ways • some investors are sophisticated, and able to interpret the disclosure, and some are not and, hence, are unable to interpret the disclosure at all

8. Relaxing the Assumptions - II • Do managers want to maximise share price whilst, at the same time, truthfully revealing their private information? The ex post costs of making a disclosure that isn’t truthful will affect the likelihood of disclosure when truth-telling cannot be credibly committed to • In a situation where credible commitment to truth-telling is impossible, reputations can be built for truth-telling in a multi-period setting • There are no incentive problems (e.g., effort; empire building; perquisites) in the model – if this is relaxed, how do these incentive problems interact with incentives to disclose? • Overall, this (brief and selective) discussion suggests that analysing actual firm disclosure policy is going to be difficult and will involve the interplay of a number of factors

9. Possible Benefits of Disclosure - I • This discussion is mainly based upon C. Botosan, 2006. ‘Disclosure and the cost of capital: what do we know?’ Accounting And Business Research, 36, pp. 31-40 • There are two lines of theory that suggest a link between disclosure and the cost of capital: • increased disclosure reduces priced estimation risk which reduces the cost of capital • increased disclosure reduces information asymmetries which reduces transactions costs (e.g., bid-ask spread) which increases market liquidity which increases demand for the stock which decreases the cost of capital • There are question marks about both lines of theory: • why isn’t estimation risk diversifiable and, hence, un-priced? • does increased disclosure indeed reduce information asymmetries (public versus private information – substitutes or complements)?

10. Possible Benefits of Disclosure - II • What are the results? • In general, Botosan (2006) argues that the results suggest that: • there appears to be a negative link between the level of disclosure and the cost of capital • there appears to be a negative link between the level of disclosure and bid-ask spreads, etc. • around capital raising events, managers act as if greater disclosure decreases the cost of capital • As with all academic studies, all the results are subject to caveats about interpretation – for example, ceteris paribus, why don’t all firms disclose as much as possible to increase their share price?

11. Possible Benefits of Disclosure – Information Content I • UK financial reports are large in terms of page numbers, but the financial statements themselves are fairly small (although the notes to the accounts take up much space, as do various governance reports) • But, what about the various narrative elements in the financial reports – are they a waste of space, or do they provide useful contextual information that can help in, for example, forecasting future earnings/cash flows (even if they are not audited or regulated)? • If the latter, then this narrative information could be associated with share prices

12. Possible Benefits of Disclosure – Information Content II • This discussion is based upon that found in T. Schleicher, K. Hussainey and M. Walker, 2007. ‘Loss firms’ annual report narratives and share price anticipation of earnings’, British Accounting Review, 39, pp.153-171 (SHW) • SHW argue that there might well be differences in the potential of narrative disclosures to inform share prices between listed profit and loss firms – why? • because most listed loss firms do not go bankrupt (at least, not quickly – why this might be?) • if they don’t go bankrupt, they likely will become profitable at some stage in the future • if such is the case, the current loss is not a very good indicator of future profits (profit growth) • whereas, the current profit is a better (if not necessarily perfect) indicator of future profits for a profitable firm

13. Possible Benefits of Disclosure – Information Content III • Overall, the results of SHW are consistent with the idea that narrative disclosures with respect to future earnings are informative in the price-setting process for loss firms in particular, if not for profit firms • This is good news, in the sense that it is consistent with the idea that the disclosures are not a waste of space for some firms • Further, loss firms are surprisingly prevalent on the Official List and AIM, and loss-making can be persistent • Nonetheless, what are the disclosures achieving for profit firms (cost of capital effects?)?

14. Disclosure Scandals - British Biotech (BB) - I • Once the darling of the UK biotechnology industry – listed in both the UK and the USA - now essentially it has disappeared • Directors (including the CEO) traded at a time when Phase III drug trials for a drug, Batimastat, had been halted but the information had not yet been disclosed to the market • Provided highly positive information about the progress of another drug, Marimastat, that doubled the market price and allowed BB executives to exercise stock options more profitably and also exercise rights issue warrants

15. Disclosure Scandals - British Biotech (BB) - II • Subsequently it became clear that BB had overstated the likelihood that the drugs Zacutex and Marimastat were going to reach production – only revealed by a whistleblower • The LSE publicly censured BB for failing to tell the market about the European drug regulator’s negative stance on Zacutex – for misleading the market • The SEC filed a ‘cease and desist’ order on three BB executives over failing to tell the market about extra clinical trials required by the FDA with respect to Marimastat – another case of misleading the market • No BB drug ever made it to market

16. Disclosure Scandals - Cortecs • Consistently gave over-optimistic assessment of progress of its RD activities towards marketable products • This was only discovered when the CEO was fired over excessive perquisites and a new non-executive chairman ordered a review of RD activities via a recently appointed, new, RD director • The new non-executive chairman also discovered that the board were not being informed of negative outcomes • The new non-executive chairman had to inform the stock market that it had been ‘over optimistic’

17. UK Regulation - I • Overall, the UK has concluded that market forces cannot be generally relied upon to ensure honest and timely revelation of information • The (now-discontinued) Financial Services Authority (FSA) established a number of principles about the disclosure of price sensitive information (PSI) • The FSA’s responsibilities in this regard have been transferred to the Financial Conduct Authority • These principles were in place at the time of the BB and Cortecs scandals, however • General principles for the disclosure of PSI: • a fair and transparent market • safeguarding the interests of investors • timely disclosure of relevant information • equal treatment of all investors

18. UK Regulation - II What is the definition of PSI? It is information which, if disclosed, can be expected to change the market’s expectations of future cash flows PSI then is ‘surprising’ information There is no precise definition, however, of the types of events the revelation of information about which will definitely be price sensitive Therefore, managers must have a good idea of what information and expectations are reflected in market prices, and know how market participants will react, in order to know what is PSI This suggests judgement has to be applied to generating a sound financial communication strategy with respect to what to disclose and when to disclose it In this sense, even though regulated, disclosure still has a ‘voluntary’ element – but legal action could occur if judgement is incorrectly exercised

19. UK Regulation - III • Issues surrounding the disclosure of PSI are also directly linked to insider information/trading, and regulations require insiders to seek permission before trading from the Chairperson or another designated director • Rules are laid out as to when permission should be denied, relating to the existence of PSI within the organisation • The EU Market Abuse Directive strengthens these policies including requiring firms to keep lists of which employees have access to what ‘inside’ information

20. UK Regulation - IV • The UK corporate governance codes sometimes seem to add confusion to the FSA’s rules (although the FSA rules are aware of this potential) • The Combined Code, for example, encourages firms to enter into dialogue with their major shareholders – suggesting possible privileged access to information to these shareholders • This has the potential to turn such shareholders into insiders – a fact that the Institutional Shareholder Committee (ISC) is well aware of • The ISC require firms not to provide information to institutional shareholders, or their agents, which will harm their ability to trade (turn them into insiders) • This also raises issues of analyst briefings and the information given out at such meetings

21. UK Regulation - Overall • Notwithstanding some ambiguities in the regulatory framework(s) surrounding the disclosure of PSI in general, the framework(s) have one common feature – they do not tend to specify what ‘should’ be disclosed (other than for certain specific events) • Instead, they establish principles for the features of timely and honest reporting – what needs to be disclosed, and how to disclose it, is up to the firm • Further, they clearly recognise that there are market incentives for dishonest disclosure (including the absence of disclosure) caused by the existence of executive share option schemes and director/manager shareholdings, although there can clearly be circumstances when market mechanisms will produce appropriate disclosures • No cases appear to have arisen recently of disclosures that are seen to be clearly dishonest – this could be because: • firms now disclose in a timely and honest fashion; or • the detection and enforcement mechanisms are inadequate