Another animal is loose on Wall Street. An eyewitness who worked at a local hedge fund described what he saw. “I saw an animal that I think was a cat jump out of something that looked like a bag, which a man - I think he was from the Wall Street Journal - was holding. The cat ran toward the old Fulton Fish Market screaming, ‘short all the companies that changed their risk factors and buy all those that haven’t!’” The visibly shaken witness went on to describe what happened next. “Then a few arbitrageurs from my office jumped into a Ferrari and tore up Pearl Street yelling, ‘get that cat back in the bag,’ and then a different bunch of guys - I think they were General Counsels - ran toward the financial printer’s building screaming, ‘stop the press, stop the press’ while a third group - I think they were from the SEC - chased after the General Counsels with papers that looked like Wells Notices. It was total mayhem.”
The stock of companies that significantly change their risk factors perform worse than those that don’t. On June 13, 2017, the Wall Street Journal published an article that disclosed the results of a study conducted by Harvard Business School economist Lauren Cohen and his colleagues. The study entailed the downloading of all the Form 10-K and Form 10-Q filings with the SEC from 1994 through 2014 and using textual-analysis software to rank the companies based on how much the text differed from one period to the next. After looking at the performance of the stocks following the filings, it became evident to Cohen and his colleagues that shares of companies with significant changes in their recurring disclosures, especially the Risk Factors section, performed worse than those of companies that didn’t. The economists concluded that if traders bought the companies that didn’t change risk factors and sold short the companies that did, they would beat the market by 22 percentage points.
Lawyers have traditionally advised corporate clients against making unnecessary changes to recurring disclosures in Form 10-K/Q in order to mitigate the risk of frivolous lawsuits from an existing investor who might argue that the issuer should have made the new disclosure at the time the investor bought the stock, or of regulatory action from the SEC for similar reasons. Not likely behind this advice was a concern that making such alterations would negatively affect the client’s stock price. The results of Cohen’s study beg the question, ‘How will executive teams, boards of directors and lawyers react to Cohen’s study?’ Hopefully, they won’t, and they will do exactly as investors and the SEC have always expected them to do, which is to continue making additional disclosures that account for what existing and prospective investors would want to know in light of new circumstances. Although, they might consider adding a new risk factor along the lines of, “If we make significant changes to our recurring disclosures including these Risk Factors, the price of our stock could fall, and we could face lawsuits and regulatory actions, which could further negatively affect the price of our stock.”
Tying CEO compensation to stock price now has another apparent downside. Using a target stock price as a trigger for vesting of equity awards or cash bonuses is typically viewed as a good corporate governance mechanism because it aligns management with shareholders’ interests. However, some people have argued that tying executive compensation to stock price does not always work because CEOs can, on one hand, artificially bump up the stock price by pushing their company’s board to approve certain transactions such as stock buy-backs or unnecessary asset sales and, on another hand, position the company for long-term success that is not reflected in the near-term stock price. Now that the cat is out of the bag on the stock price effects of changes to certain corporate disclosures, it is only natural to wonder if Cohen’s study provides CEOs with a new trick.
If it is known that altering certain disclosures is likely to lead to a lower stock price, CEOs might be less forthcoming about newly identified risks simply because they know that alterations to disclosures could impact their near-term compensation. Certainly, it’s a risk, but is it a risk that carries with it greater ramifications than other tricks like stock buy-backs or unnecessary asset sales? Probably not when you compare the immediate effects. Unlike a transaction such as a stock buy-back or asset sale, a company’s decision to not alter recurring disclosures isn’t likely to give the stock a bump up. However, over time, inadequate or misleading disclosures are likely to result in a significant drop in stock price. When the short sellers catch on, or when a disgruntled employee blows the whistle and the class action lawsuits and SEC investigation commence, there’s no unwinding that downward spiral. So, while not engaging in a transaction such as a stock buy-back or unnecessary asset sale is not likely to send the stock price down, poor disclosure almost certainly will, eventually. So, what’s a General Counsel to do knowing what CEOs and other executive team members should now be presumed to know about the stock price effects of altered recurring disclosures?
Support the Business – Not the Stock. General Counsels have been feeling the pressure to prove that they are key contributors to the executive landscape by acting as team players who support the business with strategic business advise and not just legal advice. They have been conditioned to not say “no” without offering an alternative route to “yes.” However, having a reputation for being a “No Man” has its advantages because people within the organization are less likely to try to slip things by you or to try to sway you to their way of thinking. With the results of Cohen’s study, General Counsels have one more reason to maintain a stiff spine, not lose sight of their core responsibilities as the company’s chief lawyer, and act as the conscience of the company by stating simply, “No, we need to disclose this now.”