Disclosure Effectiveness Weakened By Complicated Ownership

One reason for the verbose, complex disclosures is that legal and financial reporting have different objectives. On the legal side, risk factors are outlined to protect the client company. On the financial reporting side, risk factors are intended to describe possible circumstances that could make investing in the company risky.

Financial disclosures should be tailored to the business and written clearly and concisely for the investor, rather than verbose, overly complex reports that don’t meet the investors’ needs that are the product of legal and compliance departments.

“Risk factors have taken on the dynamic of sitting in the corner of the legal department, and the corner of the financial reporting, and have become more of [a] protective type of communication rather than [a] communicative document,” said Sam Eldessouky, SVP and Corporate Controller, Valeant Pharmaceuticals at a recent Pacesetters in Financial Reporting presentation in New York City.

Indeed, as a result of differing objectives of the legal department and financial reporting, disclosures can sometimes fail to be the effective tools for investors they should be. To combat this, disclosures should be continuously updated, based on factors unique to the business, as well and more concise and written in plain English.

According to a recent study by the Investor Responsibility Research Center Institute (IRRCi) and EY, “There is an opportunity for companies to streamline language around common risk factors and to offer more insightful, company-specific information. For risks that are particularly important, a company could enhance its disclosures by providing more descriptions of its risk mitigation efforts…”

Tailored to the company

Risk factors should be very company-specific and not be boilerplate. In practice, however, many are generic, unclear, overly voluminous and not particularly helpful in understanding the true risks of the company.

Unfortunately, many companies view disclosure preparation as a check-the-box type of exercise, instead of detailing the unique risk factors that are relevant and representative of their business.

Panelist Jonathan Nus, Executive Director, EY, shared that, though comparability exists within an industry, in looking at disclosure of the top 10 companies within an industry, risk factors are overly consistent and comparable because they copy each other.

“I think where it falls apart a lot of times is that risk factors are treated more like a photograph rather than a movie. The disconnect is really between risk factors and a risk profile of a company. Once upon a time it was very easy to compartmentalize companies within a sector.”

Companies can also fall into the habit of simply carrying forward disclosures from year to year without reassessing their continued relevance. “To the extent that the business profile and the risk profile of a company's changing, the risk factors just aren't keeping up,” said Nus. “I think what's happening is that there are some companies that are taking the lead in terms of connecting the dots, and making sure that the KPIs are aligned, the business model is aligned, their key metrics are aligned, but I think a lot of times it's still treated in silo. I think that's a major challenge.”

Clearly and concisely for the investor

Zeroing-in on the risk factors that are unique to the business is an effective way that companies are reducing the number of risk factors. By identifying risks specific only to them or combining some closely related risks, allows readers to better focus on and process the information that matters most to them and help streamline financial reports.

Valeant’s Eldessouky says companies should be thinking about the 10Q not just a compliance document, but as a communicative document. The focus should be: What kinds of information around risk and risk management are investors looking for?

Moderator Keith F. Higgins, Chair, Securities & Governance Practice, Ropes & Gray, former Director, SEC Division of Corporation Finance explained, “If I were an investor, I'd want to know: How is the company going to be run in the longer term so that my investment will continue to grow and the company I've invested in will be able to respond effectively to things that it can't always anticipate?”

On the lengths of disclosures, Eldessouky shared, “It is growing. 22 risk factors on average, and the average section in the filing is eight pages long. Another study found that the length of risk factor disclosure increased 85% relative to the rest of the 10K. It's an area where there's certainly a lot being disclosed. I still think they are somewhat overwhelming.”

Who owns the disclosure?

A reason that the length and complexity of disclosures has increased is that the preparers may have different objectives. On the legal side, risk factors can serve as mitigating factors if a lawsuit is brought against the company (i.e. if the securities don’t perform as well as expected, the investor was warned of such an outcome via the risk factors.)  On the financial reporting side, risk factors are intended to describe possible circumstances that could make investing in the company risky or speculative.

“When it comes to risk, there's not one measure,” said Eldessouky. “What I view from a financial reporting point of view as risky, someone else from the legal team, or someone else from the operation might not view it at the same level, or vice versa. Trying to balance the different views, what the risk is and putting it into risk factors, I think that's where the disconnect starts happening in terms of where we are today in terms of how companies outline risk factors.”

Lori Zyskowski, Partner, Gibson and Dunn admitted that risk factor disclosure is largely driven by the fear of securities litigation. Risk factors are used by companies to protect themselves from being sued for making statements about the future such as forward looking statements.

“There's boilerplate forward-looking statement language in everybody's 10K that looks at all of the factors and makes sure that the risk factors are also covered,” said Zyskowski. “The problem with that is it enhances the desire to make the risk factor disclosure longer, and to make it as all-encompassing as possible. The issue is it's not as effective if it's not tied to the company's actual risks, and if it's boilerplate and not specific. Quite frankly, the requirements under the rules are to make it specific to the company and not boilerplate. What companies can do is really think about whether or not the risks that they're listing and describing are truly risks of the company, or whether they're remote risks.”